**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

FORM 10-K

**(Mark One)**

**x**                              AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe fiscal year ended December 31, 2004**

**OR**

**o**                                 TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe transition period from                  to                 **

**CommissionFile Number 000-28317**

----

DIGIMARC CORPORATION

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     | **94-3342784**                         |
|------------------------------------------------------------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) | (I.R.S.  Employer  Identification No.) |

**9405SW Gemini Drive, Beaverton, Oregon 97008**

(Address of principalexecutive offices) (Zip Code)

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act: **NONE**

Securities registeredpursuant to Section 12(g) of the Act:

**CommonStock, $0.001 par value**

----

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes xNo o

The aggregate market valueof common stock, par value $0.001 per share, held by non-affiliates of theregistrant, based on the closing price for the common stock on The NasdaqNational Market on the last business day of the registrant’s most recentlycompleted fiscal second quarter (June 30, 2004), was approximately$265 million. Shares of common stock beneficially held by each officer anddirector have been excluded from this computation in that such persons may bedeemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for any other purposes.

As of March 31, 2005,there were 20,723,429 shares of the registrant’s common stock outstanding.

**DocumentsIncorporated by Reference**

Portionsof the registrant’s proxy statement pursuant to Regulation 14A (the “ProxyStatement”) for its 2005 annual meeting of stockholders are incorporated byreference into Item 5 of Part II and Items 10, 11, 12, 13 and 14 of Part IIIof the Annual Report on Form 10-K. The registrant will file theProxy Statement not later than 120 days after the end of the fiscal yearcovered by this Annual Report on Form 10-K.

 

----

**Explanatory Note**

Digimarc Corporation previously announced that itwould restate certain prior period financial statements for 2003 and 2004. Theconsolidated financial statements for the year ended December 31, 2003,including each of the quarterly periods in the year ended December 31,2003, and the quarterly periods ended March 31, 2004 and June 30,2004 contained in this Annual Report on Form 10-K, have beenrestated. Concurrently with this Form 10-K, we are filing ourQuarterly Report on Form 10-Q for the quarterly period ended September 30,2004, which we delayed filing as a result of the restatement.

We have not separately amended our Annual Report on Form 10-Kor Quarterly Reports on Form 10-Q for periods affected by therestatement, and the financial statements and any independent registered publicaccounting firm’s report and related financial information for the affectedperiods contained in such reports should no longer be relied upon. Anydisclosures in any such amendments to our Form 10-K or Form 10-Qfor periods affected by the restatement would in large part repeat thedisclosures contained in this report. All financial and other informationincluded in this Form 10-K reflects the restatement of ourconsolidated financial statements for such prior periods.

This Form 10-K does not includemanagement’s assessment and report on internal control over financial reportingor the related attestation reports of our independent registered publicaccounting firm as required by Section 404 of the Sarbanes-Oxley Act of2002. We intend to file an amendment to this Form 10-K that includessuch reports within 45 days of the initial filing deadline for this Form 10-K.

For a description of the reasons for the restatementand the adjustments resulting from the restatement, see Notes 2 and 13 to theconsolidated financial statements included in this Form 10-K andItem 7, “Management’s Discussion and Analysis of Financial Condition and Resultsof Operation—Restatement of Financial Statements” in this Form 10-K.

----

 

**Tableof Contents**
| **PART I**   |                                                                                         |   |
|-------------------|----------------------------------------------------------------------------------------------|--------|
| Item 1.           | Business                                                                                     | 1      |
| Item 2.           | Properties                                                                                   | 27     |
| Item 3.           | Legal Proceedings                                                                            | 27     |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                         | 29     |
| **PART II**  |                                                                                         |   |
| Item  5.          | Market  for Registrant’s Common Equity and Related Stockholder Matters                  | 30     |
| Item 6.           | Selected  Financial Data                                                                     | 31     |
| Item  7.          | Management’s  Discussion and Analysis of Financial Condition and Results of  Operations | 32     |
| Item  7A.         | Quantitative  and Qualitative Disclosures About Market Risk                                  | 51     |
| Item  8.          | Financial  Statements and Supplementary Data                                                 | 51     |
| Item  9.          | Changes  in and Disagreements with Accountants on Accounting and Financial  Disclosure       | 52     |
| Item 9A.          | Controls and  Procedures                                                                     | 52     |
| **PART III** |                                                                                         |   |
| Item  10.         | Directors  and Executive Officers of the Registrant                                          | 57     |
| Item 11.          | Executive  Compensation                                                                      | 57     |
| Item  12.         | Security  Ownership of Certain Beneficial Owners and Management                              | 57     |
| Item  13.         | Certain  Relationships and Related Transactions                                              | 57     |
| Item  14.         | Principal  Accounting Fees and Services                                                      | 57     |
| **PART IV**  |                                                                                         |   |
| Item  15.         | Exhibits  and Financial Statement Schedules                                                  | 57     |
| SIGNATURES        | 61                                                                                           |

 

i

----

**PART I**

This Report on Form 10-Kincludes trademarks and registered trademarks of Digimarc Corporation. Productsor service names of other companies mentioned in this Report on Form 10-Kmay be trademarks or registered trademarks of their respective owners.

**ITEM1:   BUSINESS**

**Overview**

Digimarc was incorporated in 1995. We are one of theleading suppliers of secure personal identification systems, providing morethan 60 million personal identification documents and driver licenses peryear. We supply the issuance systems for the majority of driver licensesproduced in the United States (“U.S.”) and provide all or part of the issuancesystems for national identifications, voter identifications, and driverlicenses in more than 20 international programs. We estimate that our next-closestcompetitor with regard to U.S. driver license issuance systems holds contractswith approximately 13 driver license issuing authorities as of December 31,2004. We are developing and marketing enhanced security solutions for personalidentification documents enabled by our proprietary digital watermarkingtechnology.

We are a leading provider of patented digitalwatermarking technologies and solutions that allow imperceptible digital codesto be embedded in media content, including personal identification documents,financial instruments, photographs, movies, music, and product packages. Theembedded codes within various types of media content can be detected and readby software or hardware detectors in personal computers and other digital processingdevices. We provide solutions based on this technology directly and through ourlicensees. We believe we have the broadest intellectual property patentportfolio and commercial deployment of watermarking-based applicationsamongst entities of which we are aware.

The majority of our revenue comes from multi-yearcontracts with government agencies, including U.S. state departments of motorvehicles and federal agencies, and central banks from around the world.

Since the introduction of our first watermarkingproduct in 1996, we have built a broad technology platform that enables a widerange of applications. Our initial products were designed to help photographersand stock photography agencies communicate the copyrights for their images tousers of commercially-available image-editing software. We laterdeveloped image commerce applications that allowed our customers to use thepersistent copyright data in their photographs to track these photographs invarious places on the Internet and provide direct linking from digital versionsof these photographs to electronic licensing sites, permitting enhancedsurveillance for market research, copyright enforcement, and greaterconvenience in licensing.

In 1997, we began development of a system to deter theuse of personal computers in counterfeiting banknotes based on our core digitalwatermarking technologies. The banknote anti-counterfeiting project continuesto be a significant element of our business and financial performance.

Shortly thereafter, we began developing an innovativemarketing use of our technology to allow consumers to automatically link fromprinted materials to the Internet or to network-based services. The print-to-Websystem enables imperceptible digital codes to be embedded within printed media,such as magazine advertisements and articles, direct mail, coupons, productpackaging, stationery and envelopes, trading cards, catalogs, credit cards,bank cards and business cards. When recognized by web cameras, scanners, ormobile phones equipped with cameras enabled by our patented reader technology,the embedded codes automatically link the user directly to the specificInternet destination or network-based services chosen by the producer ofthe printed media. This application is still in the development stage.

1

----

In December, 2001, we acquired the assets and assumedcertain liabilities of the U.S. large government programs identificationsystems and international digital identification systems businesses of PolaroidCorporation and certain other affiliated entities of Polaroid Corporation(collectively known as the Large Government Program Identification Business or “LGP”).LGP provided secure personal identification card systems to the majority of thestate departments of motor vehicles in the United States, as well as to variousnon-U.S. government agencies. LGP was integrated into Digimarc through DigimarcID Systems, LLC and its affiliates, which is also referred to herein as DIDS.Following the acquisition of LGP, the personal identification systems businesshas become our largest source of revenue.

Financial information about geographic areas isincorporated by reference to Note 9 of our consolidated financialstatements.

We make available through our website atwww.digimarc.com our Annual Reports on Form 10-K, Quarterly Reportson Form 10-Q, Current Reports on Form 8-K, and amendmentsto these and other reports filed or furnished by us pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after we file such materials with the Securities and ExchangeCommission.

A summary of our currentproduct and service offerings and licensing activities is listed below:

**Products, Services and Licensing**

Our secure media solutionsbusiness has two primary areas of focus: secure personal identification systemsand digital watermarking.

*Secure PersonalIdentification Systems*

In North America, we are generally a prime contractor,providing full issuance systems to federal, state, and provincial departmentsof motor vehicles or other government issuing authorities. When we provide afull issuance system to a customer, we generally retain title to all assetsassociated with the system and are responsible for maintaining the system overthe contractual period. We are paid as cards are produced on a price-per-cardbasis over the life of the contract.

Digimarc is the leading supplier of U.S. state driverlicense issuance systems. At December 31, 2004 we had contracts with themajority of U.S. state driver license issuing authorities to supply andmaintain their driver license issuance systems.

Our U.S. driver license issuance systems, whichgenerate the majority of our revenues, vary from jurisdiction to jurisdiction.These systems are typically provided under long-term (normally five or moreyears) contracts and we are paid a fixed price per document issued by thegovernment jurisdiction. The systems provided include the hardware, software,consumable supplies (such as ink, laminate, and adhesives), and on-goingsupport necessary for a “turnkey” solution. They typically involve customsoftware and/or hardware development, integration services, and implementationservices. A digital driver license issuance system typically captures images(photo and signature) and other demographic information, produces the actualdriver license or identification document (either at the point of service or ata central production facility operated by us), provides or delivers thefinished driver license or other identity document to the individual licensee,stores the images in a database, and communicates with the governmental issuer’sother systems for completion of processing of the driver license applicants.

Our domestic market customers are increasinglysensitive to the issue of identity theft and fraud, to concerns aroundverifying personal identity, and to the role that the U.S. driver license playsas a primary form of identity verification for personal access to securefacilities, and public transportation, the conduct of financial transactions,and at point-of-sale for age restricted products such as alcohol and tobacco.As a result, we believe there will be increasing interest from our customers ina variety of fraud detection and 

2

----

prevention systems,including biometric-based solutions based on third-partytechnologies. As an example, our facial recognition solutions can help ourcustomers determine if an applicant may have already been issued a validlicense within a particular jurisdiction, and our fingerprinting andfingerprint matching solutions can be used to verify an applicant’s identityprior to issuance of credentials such as a commercial driver license. Severalstates incorporate identity verification solutions which employ a real-timebackground check on the applicant-supplied demographic data during theinitial enrollment process, further enhancing the integrity of the issuanceprocess. We are working on broadening our security offerings to provide moreintegrated identity verification and fraud detection capabilities within theirissuance workflow.

Digital driver license workstations installed ingovernment driver license offices typically consist of a personal computer,digital camera, signature capture device, and other associated peripherals asrequired, including card printers, receipt printers, dossier printers,scanners, fingerprint capture devices, and bar code readers. Most of thishardware is sourced from third party suppliers. We provide software applicationcomponents that drive the specific peripherals and process the applicantsthrough the capture and printing sequences. Graphical user interfaces, workflow sequences, and communication interfaces are custom developed to thespecific needs of the customer. Some commercial “off the shelf” software isalso provided, such as operating systems (typically Microsoft Windows XP), andvirus protection. Additionally, we often provide the necessary database design,hardware, and software to store portrait, signature, and biometric images forlater retrieval. We generally supply the document consumables, including cardmaterials, custom laminates, printer ribbons, mailing supplies, receipt paper,etc.

In the case of installations that issue documents froma central location, we provide a large-scale central production system,including color xerographic or liquid ink printers, a laminator, a die cutter,encoding equipment, workstations, files servers, and proprietary software tocontrol the production process. The typical central production capability isdesigned to produce tens of thousands of documents per day. We usually providethe production facility and staffing for turnkey production of the documentspursuant to a fixed price contract.

In 2003, we began marketing a new, secure cardstructure that incorporates advanced polycarbonate materials and offers anarray of personalization and security options, called Digimarc ExianDual. Thereliability of Digimarc ExianDual Polycarbonate Card Stock is directly relatedto the durability of the card under stress and excessive usage. With a strongcard core and an even stronger shell of polycarbonate, this new card productis, we believe, one of the most durable products in the market. Several U.S.driver license customers are already using ExianDual. We plan to marketExianDual and other secure card components to new channels of distribution,including system integrators and card suppliers focused on other commercial andfederal markets for personal identity documents.

Our sales and marketing organization for U.S. driverlicense issuing systems is organized into two geographic territories withsenior level sales/business development professionals and program managementassigned to the regional territories. Because our contracts are long-term innature, and the market is relatively homogeneous and stable, long-termrelationships are key to our successful positioning for new opportunities andfor maximizing potential within existing accounts. Contracts are most oftengranted through competitive bidding based on “best value” to the issuingjurisdiction. A “Bids & Proposals” organization, consisting of bidmanagers, technical writers, production assistants and technical support, isresponsible for working with our sales and program management staffs to deliverwinning bids based on sales positioning and strategy. Our marketing group isresponsible for translating market/sales needs into product plans, supportingthe sales effort with necessary collateral and market positioning, and managinglong-term company strategy. An industry association, the American Associationof Motor Vehicle Administrators, to which all North American driver licenseissuing jurisdictions belong, provides us with another vehicle for marketingand education within our North American customer community through regional andinternational conferences, seminars, and trade shows.

3

----

In non-U.S. markets, where we provide driver licenses,national identification, and voter identification systems, services, andcomponents in partnership with local card producers, security printers, systemintegrators, and others, we may serve as prime contractor or sub-contractor,depending on the circumstances. When we provide a partial driver license issuancesystem to a customer, we usually transfer title of the assets to the customerupon delivery and typically have no further obligations. We are paid onstandard billing terms upon delivery of the assets. When we provide servicesfor a partial driver license issuance system, we usually are paid on standardbilling terms upon performance of the services.

We recently began marketing various securityenhancements for identification documents in which digital watermarking is usedas a key feature. In addition to driver licenses, we have been working withvarious U.S. and non-U.S. governmental authorities and third party suppliers todevelop and market applications to secure and enhance the security of traveleridentification documents.

For the years ended December 31,2004, 2003, and 2002, revenue from secure personal identification systems madeup 88%, 89%, and 88% of our consolidated revenue, respectively.

*DigitalWatermarking*

We provide digitalwatermarking-based solutions directly to customers and through licensees.Our direct provision of products and services includes deterring the use ofpersonal computers in counterfeiting of banknotes, supporting digital rightsmanagement and image tracking with Digimarc ImageBridge and DigimarcMyPictureMarc, securing identity documents with Digimarc IDMarc, and solutionsfor the linking of printed materials to the Internet or other network-basedservices with Digimarc Mobile. We also license our intellectual property toothers who are, or have, developed their own watermarking technologies andrelated solutions for a wide variety of potential applications.

*Banknotecounterfeit deterrence*

We have relationships with a number of financialinstitutions that are involved in the issuance of high-value documents.These relationships include a development and license agreement with aninternational consortium of leading central banks related to deterring the useof digital reprographic equipment and personal computers in the counterfeitingof banknotes.

We have entered intolong-term agreements to provide ongoing engineering and marketing services toour central bank customers. These services, which we began providing to centralbanks in 1997, include technical development and systems integration tocustomize, integrate and deliver software systems that are based upon certainproprietary technologies. Our customers generally pay for these services on atime-and-materials basis.

*CommercialSolutions*

Our commercial solutions address a range of needs,including: communicating copyrights, enabling online licensing, andfacilitating digital rights and asset management for photographs; deterringcounterfeiting, tampering, and diversion of consumer packaged goods; andauthenticating and deterring fraud against secure personal identificationdocuments.

Digimarc ImageBridge and MyPictureMarc watermarkingsolutions provide notice of copyrights and enhance licensing opportunities forproducers and distributors of commercial photographs. These products areavailable in a variety of configurations, including plug-ins bundled with image-editingproducts from leading suppliers such as Adobe, Corel and Ulead. The plug-insenable embedding, and automatic detecting and reading, of digital watermarks inimages, allowing photographers, web designers, stock photo agencies and otherimage distributors to identify and license copyrighted materials. Softwaredevelopment kits are available to facilitate integration of ImageBridge andMyPictureMarc technology into third party 

4

----

rights and assetmanagement products and enterprise applications. Revenue from these productlines is primarily from the sale of software licenses and subscriptions to theImageBridge and MyPictureMarc services, which provide registry and linkingcapabilities. We also offer subscriptions to an Internet search service calledMarcSpider which searches parts of the public Internet for our digitalwatermarks, reporting to the owner when and where they were found. MarcSpidergives Web content developers, photographers, stock photography agencies, andpublishers of entertainment, sports and news images the means to trackdissemination of images on the public Internet and to use this information intheir copyright compliance and licensing programs.

We are also engaged inmarket development to motivate adoption of our Digimarc Mobile Platform,providing a means to link directly from printed materials, including productpackaging, stationery and envelopes, trading cards, magazine advertisements,articles, covers and subscription cards, direct mailers, debit and creditcards, greeting cards, coupons, catalogs, tickets and business cards, tospecific Internet sites by showing the enabled document to an imaging device,such as a camera-enabled phone or other imaging device, equipped with ourreader software. This platform has been licensed, and our partner in Japanis entering into early stage market trials. Development of the market for theapplication is largely dependent on broad scale adoption and use ofcamera-enabled cell phones and other imaging devices connected to networks thatinclude a camera function. In the long term, we believe that this applicationcan create new communications capabilities for media content that can promoteand enhance e-commerce. Digimarc is developing this market by building outrelationships with wireless service providers, publishers and mobile commerceInternet site operators, and through relationships with regional go-to-marketpartners who license the Digimarc Mobile technology. The first such partner isMediaGrid, Inc., based in Tokyo, Japan, which entered into a licenseagreement with Digimarc in 2004 to develop products incorporating DigimarcMobile for the Japanese market. As part of the relationship, Digimarc alsoacquired an equity stake in MediaGrid of less than 10 percent.

*DigitalWatermarking in Personal Identification Documents*

Digimarc IDMarc provides ameans of embedding covert digital data in personal identification documents toenable automated cross-jurisdictional document authentication, ageverification, and document forensic analyses. We began marketing this solutionin 2003. We have contracted for use of the solution with 12 U.S. statedepartments of motor vehicles for use in driver licenses, representingapproximately 15 million licenses per year of issuance volume when these statesare fully operational.

*Licensing*

We license our patents for a variety of applicationsrelating to audio, video, image content, and printed materials.

Various products and services licensed by our companyare being used to help track unauthorized distribution of pre-release music;identify movie “screeners” that are leaked onto the Internet or inappropriatelyre-distributed; monitor broadcast radio, television advertising and televisionprogramming; and communicate usage rights in audio content, communicatecopyrights in images, and identify alteration of digital images.

For instance, we licensed our patents to VeranceCorporation for audio digital watermarking in copy prevention and play controlsolutions to protect music and audiovisual content such as movies. We alsolicensed to Verance Corporation use of our technology for broadcastverification of television and radio advertising, programs, and music.Separately, we have issued licenses to Activated Content and Warner Music forforensic tracking of pre-release music and issued licenses to KoninklijkePhilips Electronics N.V. for a number of audio watermarking applications. Wehave also licensed our patents to AudioAudit for use 

5

----

in support of broadcastmonitoring and verification of television advertising and programming usingaudio watermarking.

In the video realm, we granted a license of ourpatents to Koninklijke Philips Electronics N.V. for its Video Watercast Systemfor video broadcast monitoring (currently offered through Teletrax, a jointventure between Philips and MediaLink), asset management, copyrightcommunication, forensic tracking, remote triggering, and other uses in consumerelectronics products. More recently, we licensed our patents to VerimatrixCorporation for forensic tracking and copy protection applications.

In digital imaging and printed materials, we havelicensed U.K.-based Signum Technologies for use of our intellectualproperty in their copyright communication and authentication solutions.

In digital rightsmanagement (DRM) more generally, we recently exclusively licensed a family ofDRM patents to Philips Electronics under a royalty-bearing agreement. Philipsplans to actively offer these patents to industry participants and license themin support of appropriate industry standards initiatives such as the OpenMobile Alliance. Philips also has the right to use the licensed Digimarc DRMpatents in its own products and services.

**Technologyand Intellectual Property**

Licensing of our watermarking and related technologiesis supported by a broad patent portfolio covering a wide range of methods,applications, and system architectures.

Most of our patents relate to various methods forembedding digital codes within video, audio, and images, whether such contentis rendered in analog or digital formats. The digital codes are embedded bymaking subtle modifications to the fundamental elements of the content itself,generally at a signal processing level. The changes necessary to create thesecodes are so subtle that they are generally not noticeable by people duringnormal use. Because the message is carried by the content itself, it is file-formatindependent. The message generally survives most normal compression, edits,rotation, scaling, re-sampling, file-format transformations, copying, scanningand printing.

To protect our significant efforts in creating thesetechnologies, we have implemented an extensive intellectual property protectionprogram that relies on a combination of patent, copyright, trademark and tradesecret laws, nondisclosure agreements and other contractual provisions. As aresult, we believe we have established one of the world’s most extensive patentportfolios in the field of digital watermarking, personal identification, andrelated technologies, holding rights to approximately 187 U.S. issued patentsand having approximately 400 U.S. patent applications on file as of February 28,2005. We have averaged over 100 patent filings per year over the last fouryears. We understand, based on our periodic reviews of published patentliterature and public patent filing records, that we currently hold more U.S.digital watermarking patents than any other entity in the world. Based on areview of published patents, we also believe that we hold some of the earliestinvention dates on issued patents in the field of digital watermarking.Separately, we own registered trademarks in both the U.S. and other countriesand have applied for other trademarks and have licensed rights to othertechnologies.

We continue to develop and broaden our portfolio ofpatented technologies, including digital watermarking and related applicationsand systems, and other technologies related to secure personal identificationsystems acquired in the LGP acquisition.

Although we devotesignificant resources to developing and protecting our technologies, andperiodically evaluate potential competitors of our technologies forinfringement of our intellectual property rights, these infringements maynonetheless go undetected or may arise in the future. We expect thatinfringement claims may increase as companies become more concerned withprotecting their content from electronic copying.

6

----

**Competition**

The markets in which we compete are diverse. In manycases, we are seeking to exploit market opportunities that are emerging, highlycompetitive, fragmented and characterized by rapidly changing technology andevolving standards. In others, we face entrenched competition with greaterfinancial and operational resources.

We believe that the principal competitive factors inthe markets for our products are customer service, functionality andinteroperability with major hardware and software platforms, and costs and timeto implement. We have experienced and expect to continue to experience competitionfrom security printers, system integrators, card producers, biometricsuppliers, and enterprises in high-technology industries that are developingwatermarking or potential substitute technologies of their own, many of whomhave significantly greater financial, technical and marketing resources than wehave.

Competition in personal identification systems comesfrom systems integrators, such as IBM, Unisys and Viisage; security printerssuch as De La Rue; card and materials manufacturers, such as Datacard and 3M;and biometrics vendors, such as Sagem Morpho. As the digital personalidentification market receives more attention due to general security concernsin the United States and abroad, additional competitors may enter the market.The global market for secure personal identification systems is complex. Therole of a provider may range from prime systems integrator, to sub-contractoror component supplier, to provider of consumables. In non-U.S. markets where weare not solely a prime contractor, depending on circumstances, our partners maycompete with us and our competitors may partner with us. In some situations, wecompete with vendors of “smart cards” containing embedded computer chips. Thesecure personal identification cards that we produce generally do not containsuch chips, although we have the capability to produce smart cards if requestedby customers.

Digimarc’s major competition in digital watermarkingcomes from the internal development efforts at consumer electronics, imaging,and information technology companies such as Canon, Sony, Philips, NEC, IBM,NTT, Microsoft, MediaSec, Matsushita, Hitachi, HP, Kodak, and Toshiba. Theseentities are known to have undertaken research and development efforts at theirlabs, or are known to have implemented early stage trial deployments of digitalwatermarking. Much of our competition is application-specific alternativetechnologies. For instance, in the print-to-Web applications under development,we face competition from companies, like NTT, who are using digitalwatermarking not yet licensed from us and others using traditional barcodes orother visible symbologies.

Elsewhere, we are experiencing direct competition toDigimarc IDMarc from companies such as MediaSec and Jura Group, primarily in Europe.As we monitor these activities, in some cases we may seek to compete directlybased on value, price, experience, and the quality of our offering; in somecases we may seek partnership or technology license or cross-licenserelationships; and in other cases we may assert our intellectual propertyrights.

Our watermarking technology may compete with, or becomplementary to, a variety of alternative technologies. In audio and videoentertainment, copyright protection applications of our licensees may competewith, or be complementary to, a variety of digital rights management solutionsfrom companies such as Microsoft, Apple, Real Networks, and Toshiba. Such DRMsolutions may also be implemented so that watermarking technology provides anadditional layer of security that is complementary to the DRM encryptiontechnology. For monitoring of media content, we compete with alternatetechnologies such as content fingerprinting, which seeks to categorize andidentify audio, video and image materials based on characteristics and patternsin the content. Such technology is available from IBM, Philips Electronics andAudible Magic, among others. In addition, we compete with other services fortracking content on the Internet, such as MarkMonitor and Cyveillence.

7

----

Most competition for digital watermarking in thefinancial systems area comes from traditional security features, such asholograms, security threads, and special inks and papers, and machine-readablefeatures, such as Scrambled Indicia, radio frequency identification tags, twodimensional barcodes, conductive inks, and data-carrying magnetic stripes. Ourproducts compete against such features for a share of the document productionbudget allocated by customers for security features.

Our current and potentialcompetitors, irrespective of the technology they use or intend to use, may havewell-established relationships with current and potential customers of ours,extensive knowledge of the markets targeted by us, better name recognition, andmore extensive financial, development, sales and marketing resources than wehave. Therefore, our competitors’ technology, products and services may achievegreater market acceptance than those offered by us.

**Employees**

Asof December 31, 2004 we had 394 full-time employees, including 50 insales, marketing, technical support and customer support; 137 in research,development and engineering; 65****in finance,administration, information technology and legal; and 142 in field operations.We also had 187 contract workers at December 31, 2004. Our future successwill depend, in part, on our ability to continue to attract, retain andmotivate highly qualified technical and management personnel, for whomcompetition is intense. Our employees are not covered by any collective bargainingagreement, and we have never experienced a work stoppage. We believe that ourrelations with our employees are good.

**Risk Factors**

Our business, financialcondition, results of operation and cash flows may be impacted by a number offactors, including the factors set forth below. The order in which these riskfactors are presented does not necessarily reflect their relative significance.

***Risks Related to Our Business***

*We are subject to risks encountered by companies developing and relyingupon new technologies, products and services for substantial amounts of theirgrowth or revenue*

Digital watermarking is a new and developing technology, and ourbusiness and prospects must be considered in light of the risks anduncertainties to which companies with new and rapidly evolving technologies,products and services, such as digital watermarking, are exposed. These risksinclude the following:

·        We may be unable to develop sources of new revenue or sustainablegrowth in revenue because our current and anticipated technologies, productsand services may be inadequate or may be unable to attract or retain customers;

·        The intense competition and rapid technological change in our industrycould adversely affect the market’s acceptance of our existing and new productsand services; and

·        We may be unable to develop and maintain new technologies upon whichour existing and new products and services are dependent in order for ourproducts and services to be sustainable and competitive and in order for us toexpand our revenue and business.

Some of our key technologies are still in the development stage.Consequently, products incorporating these key technologies are undergoingtechnological change and are in the early stage of introduction in themarketplace. Delays in the adoption of these products or adverse competitivedevelopments may result in delays in the development of new revenue sources orthe growth in our revenue. In addition, we may be required to incurunanticipated capital expenditures in the event product changes or improvementsare 

8

----

required. Additionally, new industry standardsmight redefine the products that we are able to sell, especially if theseproducts are only in the prototype stage of development. If product changes orimprovements are required, success in marketing these products and achievingprofitability from these products could be delayed or halted. We also may berequired to fund such changes or improvements out of operating income, whichcould reduce or eliminate our profitability.

*The majority of our revenue is subject to government procurementprocesses that may involve unpredictable delays and other unexpected changeswhich might limit our actual revenue in any given quarter*

We derive substantial portions of our revenue from government contractswhich are subject to periodic open, competitive bids. The timing of such bidsis solely within the discretion of the governmental authority. Consequently,large components of new revenue are tied to procurement schedules, which couldshift as the needs of the related government procurement agencies change. Manyof these governmental customers are facing continued budget pressuresintroducing added uncertainty. Any shift in the government procurement process,which is outside our control and may not be predictable, could result in delaysin bookings forecasted for any particular financial period, could impact thepredictability of our quarterly results, and might limit our actual revenue inany given quarter, resulting in reduced and less predictable revenue and lowerprofitability.

*Because some of our revenue models relating to anticipated products andservices are under development, the corresponding anticipated products andservices may fail to attract or retain customers, our revenue models and pricingstructures may not gain market acceptance, and we may not be able to generatenew or sustain existing revenue*

Some of our business involves embedding digital watermarks intraditional and digital media, including identification documents, secure documents,audio, video and imagery, and licensing our intellectual property. Through2001, our revenue stream was based primarily on a combination of development,consulting, subscription and license fees from copyright protection andcounterfeit deterrence applications. Beginning in 2002 and for the foreseeablefuture, we have seen, and we anticipate, that the majority of our revenue willbe from government and private-sector customers for providing security-relatedapplications relating to secure personal identification, copyright protection,and counterfeit deterrence to such customers. We have not fully developedrevenue models for certain of our future digital watermarking applications andlicensing endeavors. In addition, because some of our products and services arenot yet well-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure and marketing for them will be effective. We cannotassure you that our anticipated digital watermarking products and services andlicensable intellectual property will be able to compete effectively againstother alternative technologies or that we will be able to compete effectivelyagainst current or future digital watermarking suppliers in terms of price,performance, applications or other features of their technologies. In addition,as we develop models for generating digital watermarking revenue, these modelsmay not gain market acceptance or may not be sustainable over time, and, as aresult, we may not be able to generate new or sustain existing revenue fromdigital watermarking.

*The loss of any large contract may result in loss of revenue andpotential acceleration of amortization expense or impairment of intangibleassets*

Contracts between government agencies and DIDS have varying duration,averaging three to five years in length. Some contracts we enter into containcancellation clauses. In addition, after a contract period expires, generallythe government agency can re-open the contract for competitive bidding. If wewere to lose a contract due to cancellation or in a competitive biddingsituation, then, in addition to the 

9

----

loss of revenue and margin on a prospectivebasis, we could also incur accelerated amortization expense or impairment ofintangible assets related to the customer.

*We have a history of losses, and we cannot assure you that we will*attainsustained profitability,particularly if we were to lose large contracts

We incurred significant net losses from inception through the fiscalyear ended December 31, 2002, and during 2004. Our accumulated deficit asof December 31, 2004 was $64.9 million. In order to attain sustainedprofitability, we will need to generate higher revenue than we have in prioryears while controlling expenditures. Even though we have achievedprofitability in the past, we were not profitable in 2004 and do not expect to returnto profitability until after the first half of 2005 if not later. A return toprofitability will depend upon a variety of factors, including the impact ofnew regulatory mandates requiring us to expense stock options, the amount ofcosts we incur in connection with our compliance with Sarbanes-Oxley, and theextent of any ongoing expenses that we incur in connection with our restatementand related matters, such as our continuing remediation efforts with respect tofinancial controls as well as expenses related to litigation and otherproceedings that have arisen as a result of the restatement. In addition, weevaluate our strategy and market opportunities on an ongoing basis and willadjust our approach to market conditions that prevail from time to time. Accordingly,in the short term we may focus more on growing our revenue and taking advantageof market opportunities than an immediate return to profitability. Finally,various adverse developments including the loss of large contracts or costoverruns on our existing contracts could have a negative impact on our revenueor our margins. Accordingly, increases in our expenses may not be offset byrevenue increases and as a result we may not be able to regain and/or sustainprofitability.

*Our future growth will depend to some extent on our successfulimplementation of our intellectual property in solutions provided by thirdparties, including partners and suppliers.*

Our business and ourstrategy rely, in part, on deployment of our watermark reader technology bythird parties. For example, one form of our watermark reader is commonlydeployed in image editing applications (offered by vendors including Adobe,Corel and Ulead) to permit users of these products to read watermarks embeddedin imagery, and thereby discern the identities of image owners. Another form ofour watermark reader is used in our anti-counterfeiting product offerings. Ifthird parties who include such technology in their products, and other partieswho we expect to include such technology in their products, decline to do so,then we would lose a portion of our currently anticipated revenue and we maysuffer other adverse affects to our business model. Although such anticipatedrevenue amounts are not currently significant, they may be in the future.

Some of the products,services, and licensing of intellectual property that we intend to provide inthe future will rely on the successful implementation of our technology,including our reader technology, by third-party software developers andoriginal equipment manufacturers. We anticipate entering into agreements withthird-party vendors to create, promote and service products that incorporate,embed, integrate or bundle our technologies. If we fail to obtain partners thatwill incorporate, embed, integrate or bundle our technologies, or thesepartners are unsuccessful in their efforts, our efforts to bring ourtechnologies to market would be adversely affected and, consequently, we wouldnot generate revenue as anticipated. In addition, if our technologies do notperform according to market expectations, our future sales would suffer ascustomers seek other providers and, consequently, our anticipated futurerevenues would decrease.

We are materially dependent on a limited number of third parties toproduce systems or assemblies necessary for us to produce some of our products.While we strive to have alternative suppliers provide us with many of ourproducts, a loss of one or more of such suppliers could have a material adverseeffect on our ability to perform effectively, if at all, for some of ourlong-term contracts.

10

----

*A significant portion of our business depends on contracts that aresubject to a variety of terms and conditions, including damage paymentobligations and fixed price terms, as well as a variety of other influencesthat may cause our quarterly results to fluctuate and our anticipated revenueto potentially decrease significantly*

Our contracts fordriver license and other identification issuance systems and their relatedproducts typically include terms relating to supplier dependencies, time-basedperformance, development and delivery schedules and milestones, and othercontract terms that may create situations where a customer may assert that weare late in meeting our delivery obligations and that we owe them latepenalties, charges or other damages. Such provisions are common in large scalegovernment contracts at the state and federal levels. These contracts includeinstallation, customer acceptance and testing, and other delivery and relatedprocedures. Because procedures often require compliance over extended periodsof time, they give rise to an increased risk that we may fail to meet timing orother delivery requirements and milestones pursuant to the terms of suchcontracts. If we failed to meet such requirements or milestones, customers mayassert against us compensatory or liquidated damages, breach of contract, orother claims. Consequently, our failure to meet contractual milestones or otherperformance requirements as promised could result in our having to incurincreased costs, lower margins, or compensatory obligations in addition toother losses, such as harm to our reputation. Such unexpected increases incosts to meet our contractual obligations or any other requirements necessaryto address claims and damages with regard to our customer contracts could havea material adverse effect on our business and financial results. We anticipatethat future contracts will continue to have such provisions unless and untilindustry practices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on such contracts inthe recent past. Such contracts involve greater financial risks because we bearthe risk if actual project costs exceed the amounts we are paid under thecontracts. A material percentage of our revenues are derived from fixed pricecontracts and our reliance on fixed price contracts may grow.

A significant portion of our business depends on a limited number oflarge, public-sector contracts, which are generally subject to termination forconvenience, as determined by the subject agency, or for lack of budgetaryappropriation provided for the subject agency. Some government contracts alsomay be one-time events, such as in the case of some personal identificationsystems in non-U.S. markets involving voter registration programs. In suchcases, we may generate substantial revenue that may not be subject to futurerenewal. Moreover, government contracts result from purchasing decisions madeby public sector agencies that may be subject to political influence, unusualprocurement procedures, strict legal requirements, budget changes and cutbacksduring economic downturns, variations in appropriations cycles, and protests ofcontract awards. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain largerestricted cash reserves as a guarantee, reducing our ability to use thesefunds for our other business purposes. Even with the availability of such cashreserve guarantees, we may not be able to obtain such performance bond underwritingat a favorable rate or at all. Our failure to be able to provide suchperformance bonds may preclude our ability to bid on new government contractsor maintain our existing contracts for the entirety of their full terms. Thesize, nature and purpose of, and the risks and uncertainties associated with,public sector contracts can potentially cause our quarterly results tofluctuate and anticipated revenue to decrease significantly.

11

----

*We may decline to pursue new, or renew existing, business opportunitiesin secure identification markets due to objectionable terms required by thecontracting agencies, or we may agree to objectionable contract terms forcompetitive reasons.*

Government agencies sometimes insist on unduly onerous terms in theircontracts with vendors of secure identification issuance systems. For example,it is customary for state agencies to require that a vendor fund thecapital-intensive initial deployment of a driver license issuance system (thecosts of which the vendor normally recoups over the life of the contract inper-card fees), while reserving the right to terminate the contract. Similarly,in connection with intellectual property rights, a contract may require thatour pre-existing issuance system software be written in a different languageand a state may then argue that it falls within the class of works for which itowns the copyright, enabling the state to turn the Digimarc-authored softwareover to one of our competitors, dedicate it to the public domain, or otherwiseuse the software in a manner detrimental to our business. Objectionablecontract terms may lead us to decline to bid on identification issuance systemsto new customers, or to decline to retain business with customers we havehistorically served, which could reduce our market share and lower ourrevenues or profits. In addition, if we decline to retain business withcustomers we have historically served, it could result in the accelerateddepreciation of intangible assets. Alternatively, we may decide to accept at least some level ofobjectionable terms rather than cede an important contract to a competitor,which could also lower our revenues or profits.

*Products that we are developing for new secure identification marketsand components and subsystems markets may not be accepted as quickly as we haveprojected or at all, which may negatively impact our revenues, margins,earnings and stock price*

We have investedsignificant time and resources in product development activities for new secureidentification markets, including designing and building numerous enhancementsto our driver license systems and improving our cards’ ability to withstandintrusions or alterations without detection. If we do not experience a timely,positive reaction from issuing authorities to our new offerings, our projectedrevenues, margins and earnings may be negatively impacted and, consequently,the future market price of our common stock might experience significantvolatility.

In addition, we are developing new sales channels in domestic andforeign markets for certain components and subsystems of our domestic driverlicense solutions. During 2004 we increased our initiatives in these areas andanticipate continuing to do so in future periods. We believe these new saleschannels may contribute significantly to our future results, as our productsget placed into other programs and start generating recurring revenue streams.However, given that this is an emerging area of our business, involvingsignificant time and effort in connection with the development of new productsand distribution relationships, there are ongoing risks that these market areaswill not develop in the manner or along the timeline that we are projecting, orat all, resulting in significant costs and expenses without correspondingincreases in any revenues and profits.

*Our identification systems business expects to experience variabilityin gross margins*

Our DIDS business will likely experience variability in gross marginson its contracts due to numerous factors, including, among other things, thefollowing:

·        Pricing pressures in competitive bids,and contract renewals and contract extensions;

·        Variations in costs of materials andmanufacturing variances;

·        Varying levels of efficiency of ourworkforce in delivering, implementing, and servicing contracts;

·        Seasonality of issuance volumes;

12

----

·        Sales mix related to card issuancerevenues compared to product sales;

·        Sales mix related to domestic salescompared to international sales;

·        Sales mix related to adoption of newproducts compared to sales of current products;

·        Strategicdecisions on new business; and

·        Depreciationand amortization of capitalized project costs related to new or upgradedprograms.

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. Weare continually refining our predictive tools and increasing our understandingof what drives these various factors. However, we nevertheless expect toexperience fluctuations in our future operating results as a result of thevariability in margins on DIDS business contracts.

*Recent and ongoing leadership and staffing changes may result indisruptions and inefficiencies in our business during transition periods, mayrequire process changes in our business, and will likely cause additional coststo our business before benefits from such changes may be realized*

During the second quarter of 2004, we made significant changes in ourmanagement and staff as a result of a detailed review of our business processes.Many of these changes were initiated following the hiring of our new ChiefFinancial Officer in June 2004 and other senior managers, and inconjunction with the continuing implementation of our new accounting andmaterial requirements planning systems and work on Sarbanes-Oxley compliance.In addition, our Chief Operating Officer assumed direct control andresponsibility for our identification systems business on an interim basis inorder to make day-to-day improvements to the efficiency, effectiveness, andpredictability of its operations. Meanwhile, we are recruiting for a permanentpresident of the DIDS business. While we anticipate that these changes inleadership and staffing will improve operations, there is a risk that thesechanges may disrupt the operations of our business and, consequently, mayresult in some short-term inefficiencies as personnel complete theirtransitions and new leaders implement their new plans and procedures. We alsoexpect that these changes may require further modifications of our finance andbusiness processes and will likely cause additional costs to our business inthe short term before any benefits from such changes, if any, may be realized.

*We may encountersignificant employee turnover that could reduce our ability to sell, deliver,and support future commitments.*

Due to concerns related toour restatement, late SEC filings, possible delisting from the Nasdaq NationalMarket, shareholder litigation and the SEC’s informal inquiry, we couldencounter significant departures of key employees from the Company. While weare taking steps to support employee retention, there can be no assurances thatkey employees will not leave the Company for other jobs, thus impairing ourability to meet commitments and sustain revenue. In addition, these events mayhave a negative impact on the market price of our common stock, and employeesand prospective employees may factor in the uncertainties relating to ourstability and the value of any equity-based incentives in their decisionsregarding employment opportunities and decide to leave our employ. Theseuncertainties also could result in an erosion of morale, and affect the focusand productivity of our remaining employees, including those directlyresponsible for revenue generation, which in turn may affect our revenue in thefuture. Additionally, current employees may seek future employment with ourbusiness partners, customers or competitors. Although we generally attempt tocontrol access to and distribution of our proprietary information by our employees,there can be no assurances that the confidential nature of our proprietaryinformation will be maintained in the course of such future employment. Any ofthese events could have a material adverse effect on our financial and businessprospects. For more information about the shareholder litigation and the SEC’sinformal inquiry, see Item 3 of this Form 10-K.

13

----

*We depend on key employees for our future success due to the high levelof technical expertise that our industry requires and the loss of any of themcould delay projects or undermine customer relationships*

Our success depends to a significant extent on the performance andcontinued service of our senior management. Except for our Chief ExecutiveOfficer, our senior management do not have employment agreements. Although ouremployees generally have executed agreements containing non-competitionclauses, there is no assurance that a court would enforce all of the terms ofthese clauses or the clauses generally. If these clauses were not fullyenforced, our employees could be able to freely join our competitors. The lossof the services of any of our senior management or any of our other keyemployees could delay projects or undermine customer relationships.

*If we are not able to retain, hire or integrate qualified personnel, wemay not be able to deliver the products and services that our customers require*

Our ability to develop, market, sell and license successfully ourproducts, services, and intellectual property depends to a significant degreeupon the continued contributions of our key personnel in engineering, sales,marketing, operations, legal and licensing, many of whom would be difficult toreplace. Similarly, without the continued contributions of our key financepersonnel, we believe that our ability to meet our reporting obligations andoperate successfully as a public company may be limited. We believe our futuresuccess will depend in large part upon our ability to retain our current keyemployees and our ability to attract, integrate and retain such personnel inthe future. It may not be practical for us to match the compensation certain ofour employees could garner at other employment. Our business is also based inpart on patented technology, which is unique and not generally known. Newemployees require substantial training, involving significant resources andmanagement attention. Competition for experienced personnel in our business canbe intense. If we do not succeed in attracting new, qualified personnel or inintegrating, retaining and motivating our current personnel, our growth andability to deliver products and services that our customers require may behampered.

*We are engaged in litigation from time to time which is unpredictableand can lead to unplanned expenses*

From time to time we are engaged in litigation with third parties. Forexample, we currently are engaged in litigation relating to the initial publicoffering of our securities, one case involving an alleged improper grant of adriver license contract to a competitor, and various other routine actions, inaddition to the class actions filed against us in connection with our recentlyannounced accounting errors. Litigation typically is an expensive process and,due to its inherent uncertainties and because the settlement and trialpreparation processes are lengthy and potentially inconclusive, the ultimatecost and outcome of such matters cannot be predicted. As a result, while webelieve that litigation often is necessary to preserve the interests of ourcompany, it also can lead to additional expense and thus lower profits to ourbusiness without generating offsetting and lasting benefits.

*We may not be able to protect adequately our intellectual property, andwe may be subject to infringement claims and other litigation, which couldreduce the perceived valuation of the company and result in a lower stock price*

Our success depends inpart on licensing our proprietary technologies. To protect our growingintellectual property investments, we rely on a combination of patent,copyright, trademark and trade secret rights, confidentiality procedures andlicensing arrangements. Unlicensed copying and use of our intellectual propertyor illegal infringements of our intellectual property rights represent lossesof revenue to our company.

We face risksassociated with our patent position, including the potential and sometimesactual need from time to time to engage in significant legal proceedings toenforce our patents, the possibility that the 

14

----

validity or enforceability of our patents may be denied, thepossibility that third parties will be able to compete against us withoutinfringing our patents, and the possibility that our products may infringepatent rights of third parties. Budgetary concerns may cause us not to file, orcontinue, litigation against known infringers of our patent rights, or maycause us not to file for, or pursue, patent protection for all of our inventivetechnologies in jurisdictions where they may have value. Some governmentalentities that might infringe our intellectual property rights may enjoysovereign immunity from such claims. Failure to reliably enforce our patentrights against infringers may make licensing more difficult. If we fail toprotect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to ourinterests, or if we become involved in litigation relating to our intellectualproperty rights and proprietary technologies or relating to the intellectualproperty rights of others, our business could be seriously harmed because thevalue ascribed to our intellectual property could diminish and result in alower stock price.

As part of ourconfidentiality procedures, we generally enter into non-disclosure agreementswith our employees, directors, consultants and corporate partners, and attemptto control access to and distribution of our technologies, solutions,documentation and other proprietary information. Despite these procedures,third parties could copy or otherwise obtain and make unauthorized use of ourtechnologies, solutions or other proprietary information or independentlydevelop similar technologies, solutions or information. The steps that we havetaken to prevent misappropriation of our solutions, technologies or otherproprietary information may not prevent their misappropriation, particularlyoutside the United States where laws or law enforcement practices may notprotect our proprietary rights as fully as in the United States.

Effective protection ofintellectual property rights may be unavailable or limited, both in the UnitedStates and in other countries. Patent protection throughout the world isgenerally established on a country-by-country basis. We have applied forpatent protection both in the United States and in various other countries.However, we cannot assure you that pending patents will be issued or thatissued patents will be valid or enforceable. Failure to obtain such patents orfailure to enforce those patents that are obtained may result in a loss ofrevenue to us. We cannot assure you that the protection of our proprietaryrights will be adequate or that our competitors will not independently developsimilar technologies, duplicate our services or design around any of ourpatents or other intellectual property rights we hold.

Some of our contractsinclude provisions by which we assure non-infringement of third-partyintellectual property rights. If an infringement arose in a context governed bysuch a contract, we may have to refund to our customer amounts already paid tous or we may be sued by the party allegedly infringed upon, our exposure couldbe large, and we may incur significant litigation, settlement, or judgmentexpenses. Similarly, as we seek to broaden the number of companies licensedunder our patent portfolio, some may seek contractual assurances that we willpursue—by litigation if necessary—their competitors who use our patentedtechnology but are not licensed to do so. Compliance with any such contractprovisions may require that we pursue litigation where our costs exceed ourlikely damages award.

We are the exclusivelicensee under some third-party patents, and may need the assistance of theseparties if we choose to enforce any of these patent rights. The cooperation ofthese third parties cannot be assured even though we rely on some of thesetechnologies for our products.

We have registered “DIGIMARC”,“MARCSPIDER”, “MEDIABRIDGE”, “IMAGEBRIDGE”, “PICTUREMARC”, and the “D” logo,among other marks, as trademarks in the United States as well as othercountries. We are pursuing the registration of “DIGIMARC” in additional countries,and we are pursuing the registration of certain other trademarksincluding ”IDMARC”, “EXIAN” and “CENTRIAN”. However, our tradenames ortrademarks may be registered by third parties in other countries, impairing ourability to enter and compete in these markets. In the United States, thetrademark “Digimark” and the domain names “Digimark.com” and “Mediabridge.com”have been registered by 

15

----

unrelated companies. While we have put in place formal arrangements forco-existence with one of these unrelated companies, and while we haveco-existed successfully to date with the other, if we were forced to change ourname or were prevented from using our other brand names, we would lose asignificant amount of our brand equity.

As more companies engage in business activities relating to personalidentification technologies and digital watermarking, and develop correspondingintellectual property rights, it is increasingly likely that claims may arisewhich assert that some of our products or services infringe upon other parties’intellectual property rights. These claims could subject us to costlylitigation, divert management resources and result in the invalidation of ourintellectual property rights. These claims may require us to pay significantdamages, cease production of infringing products, terminate our use ofinfringing technologies or develop non-infringing technologies. In thesecircumstances, continued use of our technologies may require that we acquirelicenses to the intellectual property that is the subject of the allegedinfringement, and we might not be able to obtain these licenses on commerciallyreasonable terms or at all. Our use of protected technologies may result inliability that threatens our continuing operation. In addition, we offer indemnificationagainst intellectual property infringement for some contracts to which we are aparty. As deployment of our technology increases, and more companies enter ourmarkets, the likelihood of a third party lawsuit resulting from suchindemnification increases. If a claim were made under such an indemnityprovision, we could incur significant expense.

*The security systems used in our product and service offerings may becircumvented or sabotaged by third parties, which could result in the disclosureof sensitive government information or private personal information or causeother business interruptions that could damage our reputation and disrupt ourbusiness*

Our business relies oncomputers and other information technologies, both in-house and at customer andvendor locations. In addition, many of the systems we sell manage privatepersonal information and protect information involved in sensitive governmentfunctions. The protective measures that we use in these systems may not preventsecurity breaches, and failure to prevent security breaches may disrupt ourbusiness, damage our reputation, and expose us to litigation and liability. Aparty who is able to circumvent security measures used in these systems couldmisappropriate sensitive or proprietary information or materials or causeinterruptions or otherwise damage our products, services and reputation, andthe property of our customers. If unintended parties obtain sensitive data andinformation, or create bugs or viruses or otherwise sabotage the functionalityof our systems, we may receive negative publicity, incur liability to ourcustomers or lose the confidence of our customers, any of which may cause thetermination or modification of our contracts. Further, our insurance coveragemay be insufficient to cover losses and liabilities that may result from suchevents.

In addition, we may be required to expend significant capital and otherresources to protect ourselves against the threat of security breaches or toalleviate problems caused by these breaches. However, protection or remedialmeasures may not be available at a reasonable price or at all, or may not be entirelyeffective if commenced.

*Our products could have unknown defects or errors, which may give riseto claims against us or divert application of our resources from other purposes*

Products and systems ascomplex as those we offer or develop frequently contain undetected defects orerrors. Despite testing, defects or errors may occur in existing or newproducts, which could result in delays in the development and implementation ofproducts and systems, loss of revenue or market share, failure to achieve marketacceptance, diversion of development resources, injury to our reputation,increased insurance costs and increased service and warranty costs.Furthermore, we often provide implementation, integration, customization,consulting and other technical services in connection with the implementationand ongoing maintenance of our products. The performance of these productstypically 

16

----

involves working with sophisticated software, computing andcommunications systems. Our inability to meet customer expectations or projectmilestones in a timely manner could also result in a loss of, or delay in,revenue, loss of market share, failure to achieve market acceptance, injury toour reputation, increased costs and potential claims of breach of contract andcompensatory and/or liquidated damages.

Because many customersrely on our products for critical security applications, defects or errors inour products or services might discourage customers from purchasing futureproducts and services. These defects or errors could also result in productliability or warranty claims. Although we attempt to reduce the risk of lossesresulting from these claims through warranty disclaimers and liabilitylimitation clauses in our sales agreements when we can, these contractual provisionsare sometimes not included and may not be enforceable in every instance.Furthermore, although we maintain errors and omissions insurance, thisinsurance coverage may not adequately cover these claims. If a court refuses toenforce the liability-limiting provisions of our contracts for anyreason, or if liabilities arose that were not contractually limited oradequately covered by insurance, the expense associated with defending suchactions or paying the resultant claims could be significant and decrease ourprofits.

As our watermarking solutions are more broadly deployed by ourcustomers, our potential exposure to litigation may increase. For example, aswe provide technology solutions to customers, our offerings may face productliability or intellectual property infringement claims (as is the possibilitywith any technology), either alone or in conjunction with our customers.

*If our operating structure is not effective, or if we are required torestructure to address changes in our business, we may encounter higherexpenses and reduced margins*

As of December 31, 2004 we had 394 employees and 187 contractworkers. To effectively manage our operations, management must continue toimprove our operational and financial systems and train, improve and manage ouremployee base. As part of our goal to continue to improve operatingefficiencies, we organized our operations into a portfolio of peer-leveloperating units under a corporate umbrella, consisting of two units, the firstof which is Digital Watermarking and the second of which is ID Systems, both ofwhich are overseen by a corporate staff. While our management anticipates thatthis operating structure will facilitate effective management of the continuinggrowth and expansion of our business, we have had setbacks recently at theoperating-unit leadership level, and we cannot assure you that the operatingstructure will be effective or achieve the desired results. Additionally, lessthan optimal rates of growth of our product lines and areas of business mayrequire us to restructure our business from time to time, which, in turn, couldsignificantly strain our managerial and financial resources. If we cannotmanage our growth effectively, we may not be able to coordinate the activitiesof our technical, legal, accounting and marketing staffs and, as a result, wemay experience higher expenses and reduced margins.

*We may acquire other businesses or technologies and, if we do, we maybe unable to integrate them with our own business, or we may have reduced earningsfrom doing so and we may never achieve any of the benefits that we mightanticipate from such acquisitions*

From time to time we may acquire other businesses, assets andtechnologies. Such acquisitions involve certain risks. We may not be able to identify,negotiate or finance any future acquisition successfully. We may incuradditional or one-time charges related to the pursuit of acquisitions orrestructurings or other matters in connection with acquisitions. Other than theacquisition of LGP in 2001, we have limited experience in integrating anacquired business into our existing business. The process of integration mayproduce operating difficulties (like those experienced with the LGPacquisition) and may require significant attention of our management thatotherwise would be available for the ongoing development of our business. Inthe end, we may be unsuccessful in integrating an acquired business, technologyor other asset with our existing business. Moreover, if we make acquisitions,we may issue shares of our stock that would dilute the equity holdings of ourexisting stockholders, incur debt, assume contingent liabilities or 

17

----

create additional expenses related toamortizing intangible and other acquired assets. Any of these may result inreduced earnings and cause our stock price to decline. Our due diligence ofacquired companies may fail to reveal material risks or liabilities.Additionally, in order to take advantage of opportunities, we may find itnecessary to obtain additional equity financing, debt financing, or creditfacilities, and we may not be successful in doing so on satisfactory terms. Anyfinancing that we might need for future acquisitions may also placerestrictions on our business. Furthermore, we may never achieve any of thebenefits that we might anticipate from a future acquisition.

*As international customers have accounted for approximately 22% of ourtotal revenue during the year ended December 31, 2004, the loss of thesecustomers or the failure to find new customers may result in a decline in ourinternational revenue, which could lower our profitability and slow our growth*

We expect revenue from sales of products and services to governmentsand other customers outside the U.S. to represent a growing percentage of ourtotal revenue in the future. International sales and services are subject to anumber of risks, including the following:

·        changes in foreign government regulations and security requirements;

·        export license requirements, tariffs and taxes;

·        trade barriers;

·        difficulty in protecting intellectual property;

·        difficulty in collecting accounts receivable;

·        currency fluctuations;

·        difficulty in managing foreign operations; and

·        political and economic instability.

If our customers areaffected by currency devaluations or general economic downturns or persistenteconomic difficulties, their ability to purchase our products and subscriptionsand services could be reduced significantly. Payment cycles for internationalcustomers typically are longer than those for customers in the United States.Foreign customers may decide to terminate or delay the implementation of ourproducts and services. Any action like this by foreign customers, in particularforeign government authorities, could potentially delay or reduce ouranticipated revenue under our contracts with such customers, and we may havelimited recourse against them to recover any potential losses.

We generally do not invoice our foreign sales in U.S. dollars, and,consequently, we are materially exposed to currency exchange fluctuations. Wecurrently do not engage in foreign currency hedging transactions. We may in thefuture choose to limit our exposure by the purchase of forward foreign exchangecontracts, collared options, currency swap agreements or through similarhedging strategies. However, no currency hedging strategy can fully protectagainst exchange-related losses.

***Risks Related to theRestatement of Our Prior Financial Results and Internal Controls***

*We have identifiedcertain issues relating to our controls and procedures, which, if not remediedeffectively, could impede our ability to run and monitor our business*

Management concluded thatcertain problems in our internal controls and procedures****resultedin the restatement of financial statements and the inability to timely filereports with the SEC that constitute material weaknesses as of December 31,2004. We made this determination in consultation with the audit committee ofthe Company’s board of directors. We have acted promptly to address theseissues and are engaged in an ongoing design and implementation process of newand enhanced controls and procedures. 

18

----

If weare unable to identify and remedy all such issues promptly and effectively, itcould have a material adverse effect on our business, as well as impair ourability to meet our quarterly and annual reporting requirements in a timelymanner. While we are completing the design, implementation and testing of ourenhanced controls environment, the controls and procedures on which wecurrently rely may fail to be sufficiently effective, and such controls andprocedures may not be adequate to prevent or detect irregularities or ensurethe accuracy of our financial statements or reports filed with the SEC. Further,any system of controls, however well designed and operated, is based in part oncertain assumptions and can provide only reasonable, and not absolute,assurances that the objectives of the system are met. The failure orcircumvention of our controls, policies and procedures could have a materialadverse effect on our compliance with disclosure and listing requirements, andif they were to lead to a financial loss, could negatively affect the resultsof our operations and financial condition. For more information about thematerial weaknesses in our internal control over financial reporting, see Item9A of this Form 10-K.

*We were not successful in meeting the requirements under Section 404of the Sarbanes-Oxley Act of 2002 in a timely basis and the market price of ourcommon stock and our regulatory compliance may be adversely affected as aresult. Moreover, our assessmentof the effectiveness of our internal control over financial reporting asrequired by Section 404 has identified additional issues relating to ourinternal controls and will result in an attestation with an adverse ordisclaimed opinion from our independent registered public accounting firm,which may adversely affect the market price of our common stock.*

We are currently evaluating and testing our internalcontrol over financial reporting as required by Section 404 of theSarbanes-Oxley Act of 2002. In order for management to issue its report on ourinternal control over financial reporting, we must document both the design ofour internal control over financial reporting and the operating effectivenessof our controls and procedures. Our management has undertaken the necessaryprocesses and procedures for issuing its report. However, the focusedapplication of critical resources to our separate and on-going accountingreview and the preparation of filings with the SEC reflecting the restatementhave had a significant impact on our Section 404 compliance efforts. Moreover,our on-going accounting review has resulted in remediation efforts with respectto some of our accounting processes, in particular with regard to projectaccounting at DIDS. We cannot be certain at this time as to the timing of thecompletion of our evaluation, testing and remediation actions (as necessary orappropriate) or the impact these activities will have on our operations. Uponthe completion of our remaining testing and documentation, internal controlmatters that we discover may need or may require additional remediationefforts, which may require establishing, implementing and testing additionalcontrols, the time and cost of which are not presently known. As a result ofour failure to meet our compliance and reporting obligations, we may be subjectto sanctions or investigation by regulatory authorities, such as the SEC, andfurther review by The Nasdaq Stock Market, Inc. (“Nasdaq”), which mayresult in the delisting of our common stock from the Nasdaq National Market. Anysuch action could adversely affect the market price of our common stock.

Our internal controlassessment will confirm material weaknesses in our internal control overfinancial reporting that we have disclosed in this Form 10-K and mayidentify additional issues relating to our internal control over financialreporting. Consequently, we expect our assessment will result in an attestationreport with an adverse opinion, or a disclaimer of an opinion, from ourindependent registered public accounting firm as to the effectiveness of ourinternal control over financial reporting. Any such consequences of our Section 404assessment could have an adverse effect on investor perceptions of the Companyand cause a decline in the market price of our common stock.

19

----

*We are investing*significant time and resources to implement the requirements of Section 404 ofthe Sarbanes-Oxley Act of 2002, which may increase our operating expenses andreduce our profitability in the near future

Changes in the laws and regulations that have recently been enacted,including provisions of the Sarbanes-Oxley Act of 2002, are likely to continueto increase our expenses as we devote resources in response to them. Forexample, we already have deployed significant resources to document, implementand test our financial processes as part of our implementation of therequirements under Section 404 of the Sarbanes-Oxley Act of 2002, and weexpect to incur additional time and expenses as we meet the requirements under Section 404for our management to report on, and our independent registered publicaccounting firm to attest to, our internal control over financial reporting.Moreover, compliance with these rules could also cause us to furthermodify our existing review processes or divert our management’s time andattention away from otherwise running our business, either of which couldresult in our company experiencing additional costs and expenses withoutcorresponding increases in revenue. Consequently, as we take steps to furtherimprove and strengthen our financial management and controls, we anticipatecorresponding increases in our operating expenses that may reduce ourprofitability in the near future.

*We face risksrelated to securities litigation and investigations that could have a materialadverse effect on our business, financial condition and results of operations*

We announced in September 2004that we likely would be required to restate certain previously reportedfinancial statements and that such financial statements should no longer berelied upon until such time as we completed our review of certain possibleaccounting errors. Following this announcement, three class action lawsuitswere commenced against us and certain of our current and former officers bypersons claiming to have purchased or otherwise acquired our securities atspecified dates. In addition, two purported shareholder derivativelawsuits were filed against the Company and certain of our officers anddirectors, claiming that certain of our officers and directors breached theirfiduciary duties to the Company’s stockholders and to the Company. Moreover, aletter was mailed to the chairman of the Company’s board of directors by a lawfirm purporting to represent a shareholder of the Company demanding that theboard commence an investigation and civil action against designated current andformer directors and officers on behalf of the Company to recover for damagesalleged to have been incurred as a result of alleged breaches of fiduciary duties. Additional lawsuits may befiled against us. Finally, we have received a notice from the staff of the SECstating that it is conducting an informal inquiry relating to our previousannouncement that we were restating our prior financial results. The inquiry focuseson the errors made in the capitalization of certain software and otherproject costs. The staff has requested that we voluntarily produce documentsand information related to its inquiry, and we are cooperating with the staff’s request. Defendingagainst existing and potential litigation relating to the restatement of ourconsolidated financial statements, and cooperating with the SEC’s requests,will likely require significant time, attention and resources of management,which may adversely affect our business, results of operations and financialcondition.

Our response to theforegoing legal matters will likely result in significant future legalexpenses, some of which will not be covered by insurance. Predicting theresolution of legal claims is inherently uncertain. Accordingly, it is notpossible to state with certainty the remedies that may be sought or obtained inthe foregoing legal proceedings. There is a risk that these proceedings couldhave a material impact on the Company’s financial performance or its businessin the future.

*If a judgment wereto be entered against the company and our director and officer liabilityinsurance was inadequate or unavailable, the obligation to pay the judgment maymaterially harm our business and financial condition*

Our director and officerliability insurance policies provide liability protection relating to thesecurities class action and derivative lawsuits against us and certain of ourofficers and directors up to 

20

----

prescribedpolicy limits. If these policies do not adequately cover expenses and certainliabilities relating to these lawsuits, our financial condition could bematerially harmed. In addition, if this insurance coverage becomes unavailableto us or premiums increase significantly in the future, it could make it moredifficult for us to retain and attract officers and directors and could exposeus to potentially self-funding certain future liabilities ordinarily mitigatedby director and officer liability insurance.

*We could face adverseconsequences as a result of our late SEC filings and the restatement of ourhistorical financial statements*

We failed to timely file this Form 10-K andour Form 10-Q for the quarter ended September 30, 2004. In addition,this Form 10-K does not include the report on management’s assessmentof the effectiveness of internal control over financial reporting or therelated attestation reports of our independent registered public accountingfirm as required by Section 404 of the Sarbanes-Oxley Act. We intend tofile an amendment to the Form 10-K that includes such reports within45 days of the initial filing deadline for this Form 10-K. As aresult, we will not be eligible to use a “short form” registration statement onForm S-3 for a period of 12 months after becoming current in ourfilings. Our inability to use a shortform registration statement for a period of 12 months afterbecoming current in our SEC reporting obligations may impair our ability orincrease the costs and complexity of our efforts, to raise funds in the publicmarkets should we desire to do so during this one year period. In addition, ifwe are unable to remain current in our financial filings, we may faceadditional adverse consequences, including (1) an inability to have aregistration statement under the Securities Act of 1933 covering a publicoffering of securities declared effective by the SEC, (2) an inability tomake offerings pursuant to existing registration statements (includingregistration statements on Form S-8 covering employee stock plans) orpursuant to certain “private placement” rules of the SEC underRegulation D to any purchasers not qualifying as “accredited investors,” (3) thepossible delisting of our common stock from the Nasdaq National Market, and (4) limitationson the ability of our affiliates to sell our securities pursuant to Rule 144under the Securities Act. These restrictions may adversely affect our abilityto attract and retain key employees and may further impair our ability to raisefunds in the public markets should we desire to do so.

In addition, our futuresuccess depends largely upon the support of our customers, suppliers andinvestors. The restatement and late SEC filings have resulted in negativepublicity and a Nasdaq delisting proceeding, and may have a negative impact onthe market price of our common stock. The effects of the restatement and lateSEC filings could cause some of our customers or potential customers to refrainfrom purchasing or defer decisions to purchase our products and services.Additionally, current or potential suppliers may re-examine their willingnessto do business with us, to develop critical interfaces to our products or tosupply products and services if they lose confidence in our ability to fulfillour commitments. Any of these losses could have a material adverse effect onour financial and business prospects.

***Risks Related to OurIndustry***

*If we are unable to respond to regulatory or industry standardseffectively, or if we are unable to develop and integrate new technologieseffectively, our growth and the development of our products and services couldbe delayed*

Our future success willdepend in part on our ability to enhance and improve the responsiveness,functionality and features of our products and services in accordance withregulatory or industry standards. Our ability to remain competitive will dependin part on our ability to influence and respond to emerging industry andgovernmental standards, in a timely and cost-effective manner. If we are unableto influence these or other standards or respond to such standards effectively,our growth and the development of certain products and services could bedelayed.

21

----

Our market is characterized by new and evolving technologies. Thesuccess of our business will depend on our ability to develop and integrate newtechnologies effectively and address the increasingly sophisticatedtechnological needs of our customers in a timely and cost-effective manner. Ourability to remain competitive will depend in part on our ability to:

·        Enhance and improve the responsiveness, functionality and otherfeatures of the products and services we offer or plan to offer;

·        Continue to develop our technical expertise; and

·        Develop and introduce new services, applications and technologies tomeet changing customer needs and preferences and to integrate new technologies.

We cannot assure you that we will be successful in responding to thesetechnological and industry challenges in a timely and cost-effective manner. Ifwe are unable to develop or integrate new technologies effectively or respondto these changing needs, our margins could decrease and our release of newproducts and services could be slowed.

*If leading companies in our industry or standard-setting bodies orinstitutions downplay, minimize, or reject the use of digital watermarking, itsdeployment may be slowed and our revenue growth may be diminished*

Many of our business endeavors, such as our licensing of intellectualproperty in support of audio and video and copy-control applications, can beimpeded or frustrated by larger, more influential companies or bystandard-setting bodies or institutions downplaying, minimizing or rejectingthe value or use of watermarking technology or any of our other technologies.Such a negative position by these companies, bodies or institutions, if taken,may result in obstacles for us that we would be incapable of overcoming and maymake achieving our business objectives difficult or impossible, potentiallydiminishing our anticipated revenue growth as a result.

*The market for our products is highly competitive, and as a result,alternative technologies or larger companies may undermine, limit or eliminatethe market for our products’ technologies, which would decrease our revenue andprofits*

The markets in which we compete for business are intensely competitiveand rapidly evolving. We expect competition to continue from both existingcompetitors and new market entrants. We face competition from other companiesand from alternative technologies. As we expand the applications for our technologies,we will experience more competition from products and services that aresubstitutes for our applications. Because our digital watermarking business isnew and emerging, we also may face competition from unexpected sources.Alternative technologies that may directly or indirectly compete withparticular applications of our watermarking technologies include:

·        Encryption—securing data during distribution using a secret code so itcannot be accessed except by authorized users;

·        Containers—inserting a media object in an encrypted wrapper, whichprevents the media object from being duplicated and is used for contentdistribution and transaction management;

·        DataGlyphs®—a slightly visible modification of thecharacteristics of an image or document that is machine-readable;

·        Scrambled Indicia®—an optical refraction-based data-hidingtechnique that is inserted into an image and can be read with a lens;

22

----

·        Traditional anti-counterfeiting technologies—a number of solutions usedcurrently by many governments (and that compete for budgetary outlays) designedto deter counterfeiting, including optically sensitive ink, magnetic threadsand other materials used in the printing of currencies;

·        Radio frequency tags—embedding a chip that emits a signal when in closeproximity with a receiver, which is being used in photo identificationcredentials, labels and tags;

·        Internet technologies—numerous existing and potential Internet accessand search methods are competitive with the Digimarc MediaBridge system and thesearching capabilities of Digimarc ImageBridge;

·        Digital fingerprints and signatures—a metric, or metrics, computedsolely from a source image or audio or video track, that can be used touniquely identify an image or track, or authenticate the image or track;

·        Smart cards—badges and cards including a semiconductor memory and/orprocessor used for authentication and related purposes; and

·        Bar codes—a data-carrying code, typically visible in nature (butinvisible if printed in ultraviolet- or infrared-responsive inks).

In addition, as we morebroadly apply our digital watermarking technologies to the Internet through newcommercial solutions applications, we may begin to compete with a wide range ofother types of companies beyond those companies using digital watermarkingtechnologies and alternative technologies. Moreover, many of the companies thatcurrently compete with us for some of our business, as well as other companieswith whom we may compete in the future, are larger and national or internationalin scope and may have greater technical, financial, marketing, and politicalresources than we do. These resources could enable these companies to initiatesevere price cuts or take other measures in an effort to gain market share orotherwise impede our progress. We cannot assure you that digital watermarkingtechnologies, and our products and services using these technologies, will gainwidespread market acceptance.

New developments are expected to continue, and we cannot assure youthat discoveries by others, including current and potential competitors, willnot render our services and products noncompetitive. Moreover, because of rapidtechnological changes, we may be required to expend greater amounts of time andmoney than currently anticipated to develop new products and services, which inturn may necessitate us to require greater revenue streams on such products andservices to cover developmental costs. We cannot assure you that we will beable to compete successfully against current or future participants in ourmarket or against alternative technologies, nor can we assure you that thecompetitive pressures we face will not decrease our revenue and profits in thefuture.

*Terrorist attacks and threats of, or actual, war may negatively impactall aspects of our operations, revenue, costs and stock price*

Threats of terrorist attacks in the United States, as well as futureevents occurring in response to or in connection with them, including, withoutlimitation, future terrorist attacks or threats against United States targets,rumors or threats of war, actual conflicts involving the United States or itsallies, or military or trade disruptions, may impact our operations by leadingto deferred or cancelled projects, which may reduce our revenue and profits.While any of these terrorist-related events could result in an increased needfor new security features that may, as a result, favorably impact our revenuefrom our DIDS operations and our sales of product and subscription and servicein connection with our digital watermarking technology, any of these eventscould also, or alternatively, result in increased volatility in the UnitedStates and worldwide financial markets and economies, or drive up our research,development and engineering costs associated with attempting to achieveheightened effectiveness in new products. Also, any of these terrorist-relatedevents could result in economic recession in the United States or 

23

----

abroad. If such negative consequences were tooccur, they could reduce our revenue and profits without the effect of reducingcosts in the short-term and might result in the volatility of the future marketprice of our common stock.

***Risks Related to OurCommon Stock***

*Our future quarterly operating results may not meet our, our analysts’or our investors’ expectations or predictions and may fluctuate significantly,which could decrease our stock price or subject our stock price to volatility.*

Our quarterly operatingresults have fluctuated significantly in the past and may do so in the future.Our operating results are difficult to forecast because of our limitedoperating history and the nature and scale of our business. Accordingly, youshould not rely on quarter-to-quarter comparisons of our historical results asan indication of future performance or any trend in our performance. If ourquarterly operating results do not meet the expectations of analysts orinvestors, the market price of our common stock will likely decline.

Our quarterly results may fluctuate in the future as a result ofseveral factors, many of which are outside our control, including, among otherthings:

·        The timing, introduction and successful commercialization of our newproducts and services; 

·        The loss of or reduction in revenue from any large customer;

·        The market’s acceptance of ourproducts and services;

·        Our ability to establishand maintain strategic relationships;

·        The potential costs of litigation and intellectual propertyprotection;

·        The operating costs and capital expenditures related to theexpansion of our business operations and infrastructure, domestically andinternationally, including the hiring of key personnel and new employees;

·        The introduction of similar or substitute technologies byour competitors;

·        The unpredictability and irregularity of our revenue fromgovernment contracts due to political factors, budgetary appropriations,resident migrations, changes in driver license expiration periods, card renewalseasonal effects (particularly in the fourth quarter of each year when licenserenewals are lower), purchasing and delivery constraints, potential costoverruns, or delays in contract implementation or performance resulting in anddamages having to be paid for such delays; 

·        The timing of future licensing revenue;

·        The costs associated with marketing arrangements that weenter into during early market development;

·        The manufacturing yield losses that we may incur as wedevelop new products;

·        Excess and obsolete inventory adjustments and charges thatwe determine may be appropriate at the termination of government contracts orduring the course of those contracts; and,

·        The failure of or delay in efforts to establish industrystandards involving watermarking.

Inaddition, because the market demand for certain of our products and services isnew and rapidly evolving, it is difficult for us to predict certain aspects ofour future financial results. Much of our research and development, sales andmarketing efforts and business expenditures are based in part on ourpredictions regarding developments involving counterfeiting and piracy, as wellas other security and 

24

----

intelligence needs, and on ourestimates as to the use of digital watermarking as a solution to thoseproblems. To the extent that these predictions and estimates prove inaccurate,our actual revenue and operating results will fluctuate from our anticipatedresults, which could decrease our stock price or increase the volatility of ourstock price.

*Our common stock may be delisted from the Nasdaq NationalMarket, which may, among other things, reduce the price of our common stock andthe levels of liquidity available to our stockholders*

OnNovember 10, 2004, we were advised byNasdaq that our common stock may be delisted from the Nasdaq National Marketbecause we were no longer in compliance with Nasdaq’scontinued listing requirements as a result of our failure to timely file ourForm 10-Q for the quarter endedSeptember 30, 2004. The Nasdaq ListingQualifications Panel hasd determined to continue the listing of our common stockon the Nasdaq National Market provided that we filed our Form 10-Qfor the quarter ended September 30, 2004 and this Form 10-Kon or before March 31, 2005, and that we timelyfile periodic reports with the SEC and Nasdaq for all reporting periods endingon or before December 31, 2005. We did not filed ourForm 10-Q and this Form 10-Kuntil April 7, 2005. In addition, our Form 10-Kdoes not include the report on management’s assessment of theeffectiveness of internal control over financial reporting or the relatedattestation reports of our independent registered public accounting firm asrequired by Section 404 of the Sarbanes-Oxley Act.Although we have requested that Nasdaq continue the listing of our common stockbecause we believe we are now in substantial compliance with Nasdaq’sconditions for continued listing on the Nasdaq National Market, there can be noassurance that Nasdaq will grant our request. If Nasdaq does not grant ourrequest or we fail to timely file such other reports and our common stock isdelisted from the Nasdaq National Market, our common stock would be listed onsome other quotation medium, such as the “pink sheets,”depending upon our ability to meet the specific listing requirements of thosequotation systems. In the event our common stock is delisted from the NasdaqNational Market, the visibility, liquidity and price of our common stock may bereduced, and our stockholders may find it more difficult to dispose of, or toobtain accurate price quotations for, our shares. In addition, if our commonstock is delisted from the Nasdaq National Market, it may also result in othernegative implications, including the potential loss of confidence by suppliers,customers and employees, the loss of institutional investor interest and fewerbusiness development opportunities.

*Anti-takeover provisions in our charter documents could preventor delay transactions that could be profitable for our stockholders*

Theanti-takeover provisions of Delaware law and our certificate of incorporationand bylaws may make a change of control of us more difficult, even if a changeof control would be beneficial to our stockholders. These provisions may allowour board of directors to prevent changes in management and control of theCompany. Under Delaware law, our board may adopt additional anti-takeovermeasures in the future.

We have the following anti-takeover provisions in ourcharter documents:

·   Our board of directors is divided into threeclasses of directors, with a separate class of directors being elected at eachsuccessive annual meeting for a term of three years;

·   Special meetings of the stockholders may becalled only by our president or our secretary, or at the discretion of ourboard of directors;

·   Vacancies on our board of directors may be filled by a majority ofdirectors in office, without the approval of the stockholders; and

25

----

·   Our board of directors may issue preferred stock anddetermine the price, designations, rights and preferences as well asqualifications, limitations, and restrictions of those shares without any voteor further action by the stockholders.

In addition, onNovember 16, 2004, our board ofdirectors authorized and declared a dividend of one right for each outstandingshare of our common stock to stockholders of record at the close of business onNovember 29, 2004, and authorized theissuance of one right for each share of common stock issued by us under certaincircumstances in the future. Each right entitles the registered holder, subjectto the terms of the Rights Agreement between us and the rights agent, topurchase from us one one-hundredth of a share (a unit) of Series APreferred Stock, par value $0.001 per share, at a purchase price of $100.00 perunit, under circumstances described in the Rights Agreement. The purchaseprice, the number of units of preferred stock and the type of securitiesissuable upon exercise of the rights are subject to adjustment. The rights willexpire at the close of business November 16, 2014 unless earlierredeemed or exchanged. Until a right is exercised, the holder thereof, as such,will have no rights as one of our stockholders, including the right to vote orto receive dividends. The rights are not immediately exercisable. Subject tothe terms and conditions of the Rights Agreement, they will become exercisableten business days after a person or group acquires, or commences a tender orexchange offer which would lead to the acquisition of, beneficial ownership of15% or more of our outstanding common stock, subject to prior redemption orexchange and subject to exceptions specified in the Rights Agreement, includingan exception for certain existing large shareholders that have historicallyheld ownership positions in excess of 15 percent. Subject to these exceptions,once a person or group acquires beneficial ownership of 15% or more of ouroutstanding common stock, each right not owned by that person or group orcertain related parties will entitle its holder to purchase, at the right’sthen-current purchase price, units of Series A preferred stock or, at ouroption, shares of common stock or cash, property or other securities of ourcompany having a market value equal to twice the then-current purchase price,subject to terms and conditions of the Rights Agreement. 

Ouranti-takeover provisions as well as our Rights Agreement could have the effectof discouraging a third party from making a tender offer or otherwiseattempting to gain control of us, even though the transactions could beprofitable for our stockholders. In addition, these provisions could limit theprice that investors might be willing to pay in the future for shares of ourcommon stock.

**Safe Harbor Statement under thePrivate Securities Litigation Reform Act of 1995**

Becausethis Annual Report on Form 10-K contains forward-lookingstatements within the meaning of the Private Securities Litigation Reform Act of1995, any of the risk factors set forth above or elsewhere in this AnnualReport on Form 10-K or incorporated herein byreference could cause our actual results to differ materially from thoseresults projected or suggested in such forward-looking statements. Statementsthat are not historical facts are hereby identified as “forward-lookingstatements” for the purpose of the safe harbor provided by Section 21Eof the Securities Exchange Act of 1934 and Section 27Aof the Securities Act of 1933. Such forward-looking statements include but arenot limited to statements relating to trends and expectations in revenuegrowth, including with regard to programs in Florida, Ohio, Alabama and Mexico,statements regarding anticipated expenses, costs, margins and investmentactivities in the foreseeable future, statements regarding anticipated revenueto be generated from current contracts and as a result of new programs,statements regarding our profitability in future periods, statements regardingthird parties and their inclusion of certain technology in their products,statements regarding business opportunities that could require that we seekadditional financing, statements regarding the existence of internationalgrowth opportunities and our future investment in such opportunities,statements regarding the continuance of operational pressures on ouridentification systems business in future quarters, statements regarding thesource of a majority of our future revenue, statements regarding thecontribution of new sales channels to our future results, statements regardingfuture effects on our 

26

----

business in connection with thecontinuing implementation of our new accounting and material requirementsplanning systems and modifications to our inventory management and controlssystems and procedures or other review processes, statements regarding thetiming of the completion of the design and implementation of new and enhancedcontrols and procedures, statements regarding the anticipated improvement inoperations as a result of recent changes in leadership and staffing, statementsregarding the impact on the Company of our restatement, late SEC filings,possible delisting from Nasdaq, shareholder litigation and the informal inquiryby the SEC, statements regarding our expected short-term and long-termliquidity positions, statements relating to the anticipated filing date of theCompany’s Form 10-K/Athat includes management’s report on internal controlover financial reporting and the related attestation reports of the Company’sindependent registered public accounting firm, statements relating to theCompany’s compliance with Nasdaq’s conditions for continuedlisting on the Nasdaq National Market, and other statements containing wordssuch as “anticipate,”“estimate,”“expect,”“managementbelieves,”“we believe,”“we intend” and similar words or phrases,which are intended to identify forward-looking statements. Actual results mayvary materially due to, among other things, inherent limitations in all controlsystems and related procedures, risks as to litigation and related matters inconnection with our restatement of financial results, the actual timing andimpact of our compliance with Section 404 of the Sarbanes-Oxley Actof 2002, changes resulting from any key personnel additions or changes, theactual filing date of the Company’s Form 10-K/A, as well aschanges in economic, business, competitive, technology and/or regulatoryfactors and trends. All forward-looking statements are necessarily onlyestimates of future results and there can be no assurance that actual resultswill not differ materially from expectations, and, therefore, investors arecautioned not to place undue reliance on such statements. Investors shouldunderstand that it is not possible to predict or identify all risk factors andthat the risks discussed above should not be considered a complete statement ofall potential risks and uncertainties. We undertake no obligation to update anyforward-looking statements as a result of future events or developments.

**ITEM 2:**   PROPERTIES

Our principal administrative, sales,marketing, support, research, development and engineering facility is currentlylocated in Beaverton, Oregon. Our personal identification systems business isheadquartered in Burlington, Massachusetts, with additional space in FortWayne, Indiana for certain administrative and customer support functions.Information about our office leases is set forth below.
| ** **                | ** ** | **Square Feet** | ** ** | **Expires**       |
|---------------------------|------------|-----------------|------------|-------------------|
| Beaverton, Oregon         |       | 46,000          |       | August 2011  |
| Burlington, Massachusetts |       | 60,000          |       | October 2010 |
| Ft. Wayne,  Indiana       |       | 48,000          |       | January 2007 |

 

Inaddition, we leased approximately 8,000 square feet of office space inTualatin, Oregon until February 2005, which we vacated as partof the relocation of our principal offices to Beaverton, Oregon in September 2004.We also lease sales and support offices in multiple locations throughout theUnited States and internationally.

**ITEM 3:**   LEGAL PROCEEDINGS

Beginning in September 2004,three purported class action lawsuits were commenced against us and certain ofour current and former directors and officers by or on behalf of personsclaiming to have purchased or otherwise acquired our securities during theperiod from April 17, 2002 to July 28, 2004. These lawsuits werefiled in the United States DistrictCourt for the District of Oregon and were consolidated into one action for allpurposes on December 16, 2004. The complaints assert claimsunder the federal securities laws, specifically Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934, 

27

----

relating to ourannouncement that we had discovered errors in our accounting for software development costs andproject capitalization and other project cost capitalization accountingpractices at our DIDS business unit, and that we likely would be required torestate our previously reported financial statements for full fiscal year 2003and the first two quarters of 2004. Specifically, these actions allegethat we issued false andmisleading financial statements in order to inflate the value of Digimarcstock, which resulted in insider sales of personal holdings at inflated values,and that we maintained insufficient accounting controls, which created anenvironment where improper accounting could be used to manipulate financialresults. The complaints seek unspecified damages. We believe that wehave substantial legal and factual defenses to the claims, which we intend topursue vigorously. Due to the inherent uncertainties of litigation and becausethe lawsuits are still at a preliminary stage, the ultimate outcome of thematter cannot be predicted.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of our officers anddirectors, naming the Company as a nominal defendant, in the Superior Court ofthe State of California for the County of San Luis Obispo. The suits claim thatthese officers and directors breached their fiduciary duties to ourshareholders and to the Company. The complaints are derivative in nature and donot seek relief from the Company. On November 8, 2004, a letter was mailedto the chairman of our board of directors by a law firm purporting to representa shareholder of the Company, demanding that the board commence a civil actionagainst each of the directors and officers on behalf of the Company to recoverfor damages alleged to have been incurred as a result of alleged breaches offiduciary duties.The Company has appointed a committee to investigate the claims asserted in thedemand letter and in the derivative lawsuits. 

We have received a notice from the staff of the SECstating that it is conducting an informal inquiry relating to our previousannouncement that we were restating our prior financial results. The inquiryfocuses on the errors made in the capitalization of certain software and otherproject costs. The staff has requested that we voluntarily produce documentsand information related to the SEC’s inquiry. We are cooperating with the staff’srequest. It is not possible to predict whether this inquiry will have any impacton the Company or its financial results.

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including the Company, certainof its officers and directors, and certain underwriters of the Company’sinitial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensation arrangements(such as undisclosed commissions or stock stabilization practices) in theCompany’s initial public offering registration statement and by engaging inmanipulative practices to artificially inflate the price of the Company’s stockin the after-market subsequent to the Company’s initial public offering. TheCompany and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. Theindividual officer and director defendants entered into tolling agreements and,pursuant to a court order dated October 9, 2002, were dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, acommittee of the Company’s board of directors conditionally approved a proposedpartial settlement with the plaintiffs in this matter. In June 2004, anagreement of 

28

----

settlement was submittedto the court for preliminary approval. The settlement would provide, amongother things, a release of the Company and of the individual defendants for theconduct alleged in the amended complaint to be wrongful. The Company wouldagree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. The parties are directed to report backto the court regarding the modifications. If the parties are able to agree uponthe required modifications, and such modifications are acceptable to the court,notice will be given to all class members of the settlement, a “fairness”hearing will be held and if the court determines that the settlement is fair tothe class members, the settlement will be approved. There can be no assurancethat this proposed settlement would be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation, the ultimateoutcome of the matter cannot be predicted.

Digimarc is subject fromtime to time to other legal proceedings and claims arising in the ordinarycourse of business. Although the ultimate outcome of these matters cannot bedetermined, management believes that the final disposition of these proceedingswill not have a material adverse effect on the consolidated financial position,results of operations, or liquidity of the Company.

**ITEM 4:   SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

None.

29

----

**PART II**

**ITEM5:**   MARKET FOR REGISTRANT’S COMMON EQUITYAND RELATED STOCKHOLDER MATTERS

Our common stock is traded on TheNasdaq National Market under the symbol “DMRCE.” As previously disclosed, wehave been subject to a delisting proceeding by the Nasdaq Stock Marketas a result of our failure to timely file our Form 10-Q for the quarterlyperiod ended September 30, 2004 and this Form 10-K. The NasdaqListing Qualifications Panel had determined to continue the listing of theCompany’s common stock on the Nasdaq National Market provided that we filed ourForm 10-Q for the quarter ended September 30, 2004 and thisForm 10-K on or before March 31, 2005, and that we timely file allperiodic reports with the Securities and Exchange Commission and Nasdaq for allreporting periods ending on or before December 31, 2005. We did not fileour Form 10-Q for the quarter ended September 30, 2004 and thisForm 10-K until April 7, 2005. Although we have requested thatNasdaq continue the listing of our common stock because we believe we are nowin substantial compliance with Nasdaq’s conditions for continued listing on theNasdaq National Market, there can be no assurance that Nasdaq will grant ourrequest. The fifth character “E” will remain appended to our trading symbolpending a determination by the Nasdaq Panel that we are compliant with Nasdaq’sfiling requirement and have evidenced compliance with all other requirementsfor continued listing on the Nasdaq National Market.

Theclosing price of our common stock on The Nasdaq National Market was $6.15 as ofMarch 31, 2005. The following table lists the high and low sales prices ofour common stock for the periods indicated, as reported by The Nasdaq NationalMarket.
| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **     | ** ** | **High**                                   | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                          | 15.45      |   | $ | 11.02 |   | $ | 14.44 |   | $ | 9.65 |   |
| Second quarter |       | $                                          | 13.91      |   | $ | 9.90 |   | $ | 16.55 |   | $ | 9.94 |   |
| Third quarter  |       | $                                          | 13.81      |   | $ | 7.45 |   | $ | 17.48 |   | $ | 14.11 |   |
| Fourth quarter |       | $                                          | 10.01      |   | $ | 8.42 |   | $ | 17.25 |   | $ | 12.74 |   |

 

At February 28, 2005, there were 124 stockholdersof record of our common stock, as shown in the records of our transfer agent.

We have never declared or paid cash dividends on ourcapital stock and we do not anticipate paying any cash dividends in theforeseeable future. We currently intend to retain future earnings, if any, tofinance the future growth of our business.

Information relating tothe securities authorized for issuance under equity compensation plans will beset forth in the section with the caption “Equity Compensation PlanInformation” in the Proxy Statement. This information is incorporated herein byreference.

30

----

**ITEM 6:   SELECTEDFINANCIAL DATA**

Thefollowing selected financial data reflects the restatement of our consolidatedfinancial statements as of and for the year ended December 31, 2003. Theselected financial data set forth below should be read in conjunction with theconsolidated financial statements and the notes to the consolidated financialstatements and “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” which are included elsewhere in this report. Theconsolidated statement of operations and balance sheet data as of and for eachof the five years in the period ended December 31, 2004, are derived fromour audited consolidated financial statements.
| ** **                                       | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                       | ** ** | ** **                                                         | ** ** | **Restated(1)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of Operations Data:**   |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                                          |       | $                                                                  | 92,947     |   |   | $ | 85,591 |   |   | $ | 86,617 |   | $ | 14,878 |   | $ | 11,850 |   |
| Cost of revenue                                  |       | 57,447                                                             |       |   | 46,936 |   |   | 51,950 |   | 7,197 |   | 6,637 |   |
| Gross profit                                     |       | 35,500                                                             |       |   | 38,655 |   |   | 34,667 |   | 7,681 |   | 5,213 |   |
| Operating expenses:                              |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       | 11,919                                                             |       |   | 11,854 |   |   | 14,235 |   | 11,290 |   | 10,878 |   |
| Research, development and  engineering           |       | 7,229                                                              |       |   | 7,137 |   |   | 10,391 |   | 7,980 |   | 4,911 |   |
| General and  administrative                      |       | 25,863                                                             |       |   | 19,733 |   |   | 19,277 |   | 12,566 |   | 11,135 |   |
| Restructuring charges,  net                      |       | —                                                             |       |   | — |   |   | 493 |   | 574 |   | — |   |
| Total operating expenses                         |       | 45,011                                                             |       |   | 38,724 |   |   | 44,396 |   | 32,410 |   | 26,924 |   |
| Operating loss                                   |       | (9,511                                                             | )          |   | (69 | ) |   | (9,729 | ) | (24,729 | ) | (21,711 | ) |
| Other income, net                                |       | 854                                                                |       |   | 567 |   |   | 1,040 |   | 5,571 |   | 5,866 |   |
| Income (loss) before  provision for income taxes |       | (8,657                                                             | )          |   | 498 |   |   | (8,689 | ) | (19,158 | ) | (15,845 | ) |
| Provision for income  taxes                      |       | (365                                                               | )          |   | (323 | ) |   | — |   | — |   | — |   |
| Net income (loss)                                |       | $                                                                  | (9,022     | ) |   | $ | 175 |   |   | $ | (8,689 | ) | $ | (19,158 | ) | $ | (15,845 | ) |
| Net income (loss) per  share—basic          |       | $                                                                  | (0.44      | ) |   | $ | 0.01 |   |   | $ | (0.50 | ) | $ | (1.15 | ) | $ | (1.17 | ) |
| Net income (loss) per  share—diluted        |       | $                                                                  | (0.44      | ) |   | $ | 0.01 |   |   | $ | (0.50 | ) | $ | (1.15 | ) | $ | (1.17 | ) |
| Weighted average  shares—basic              |       | 20,326                                                             |       |   | 18,572 |   |   | 17,361 |   | 16,704 |   | 13,567 |   |
| Weighted average  shares—diluted            |       | 20,326                                                             |       |   | 19,351 |   |   | 17,361 |   | 16,704 |   | 13,567 |   |

 
| ** **                                                           | ** ** | **December 31,**   | ** ** |
|----------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                           | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                           | ** ** | ** **              | ** ** | **Restated(1)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | **(in thousands)** | ** ** |
| **Consolidated Balance Sheet  Data:**                                |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Cash, cash equivalents,  restricted cash, and short-term investments |       | $                       | 51,836     |   |   | $ | 78,633 |   |   | $ | 53,174 |   | $ | 61,605 |   | $ | 135,872 |   |
| Working capital                                                      |       | 48,937                  |       |   | 89,310 |   |   | 63,309 |   | 79,203 |   | 135,203 |   |
| Total assets                                                         |       | 163,287                 |       |   | 161,153 |   |   | 132,467 |   | 129,367 |   | 142,479 |   |
| Long-term  obligations, net of current portion                       |       | 1,112                   |       |   | 1,286 |   |   | 7 |   | 33 |   | 30 |   |
| Total stockholders’ equity                                      |       | 142,244                 |       |   | 148,750 |   |   | 119,264 |   | 123,474 |   | 138,727 |   |
|                                                                      |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)    See Notes 2 and 13 to the consolidated financialstatements for information regarding the restatement of our 2003 financialstatements.

In December 2001, we acquired the assets andassumed certain liabilities of the U.S. large government programsidentification systems and international digital identification systemsbusinesses of Polaroid Corporation and certain other affiliated entities ofPolaroid Corporation (collectively known as the Large Government ProgramIdentification Business or “LGP”). LGP provided secure personal identificationcard systems to the majority of state departments of motor vehicles in theUnited States, as well as to various non-U.S. government agencies. Followingthe acquisition of LGP, the personal identification systems business has becomeour dominant source of revenue.

31

----

**ITEM7:   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

*The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements relating to future events orthe future financial performance of Digimarc, which involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of certainfactors, including those set forth under “Risks Factors” under Item 1 above andelsewhere in the Annual Report on Form 10-K. We assume no obligation toupdate this information. This discussion and analysis should be read inconjunction with our consolidated financial statements and related notesincluded elsewhere herein.*Please see the discussion regarding forward-looking statements includedin this Form 10-K under the caption “Safe Harbor Statement under thePrivate Securities Litigation Reform Act of 1995.”

*This Annual Report on Form 10-K amends our AnnualReport on Form 10-K previously filed for the fiscal year ended December 31,2003 and our previously filed Form 10-Qs for the quarterly periods ended March 31,2004 and June 30, 2004, to reflect the restatement of our consolidatedfinancial statements for all such previously reported periods, as describedelsewhere in this Annual Report on Form 10-K.*

**Overview**

We are one of the leading suppliers of secure personalidentification systems. We supply the issuance systems for the majority ofdriver licenses produced in the United States (“U.S.”) and provide all or partof the issuance systems for national identifications, voter identifications,and driver licenses in more than 20 international programs. We estimate thatour next-closest competitor with regard to driver license issuance systemsholds contracts with approximately 13 driver license issuing authorities in theUnited States as of December 31, 2004. We are developing and marketingenhanced security for personal identification documents enabled by ourproprietary digital watermarking technology.

We also are one of the leading providers of patenteddigital watermarking technologies that allow imperceptible digital codes to beembedded in all forms of media content, including personal identificationdocuments, financial instruments, photographs, movies, music, and productpackages. The embedded codes within various types of media content can bedetected and read by software or hardware detectors in personal computers andother digital processing devices. We provide solutions based on this technologydirectly and through our licensees. We believe we have the broadestintellectual property patent portfolio and commercial deployment ofwatermarking-based applications amongst entities of which we are aware,including use of such intellectual property by more than four thousandenterprises and individuals.

Our principal administrative, sales, marketing,support, research, development and engineering facility is currently located inBeaverton, Oregon. Our personal identification systems business isheadquartered in Burlington, Massachusetts, with additional space in FortWayne, Indiana for certain administrative and customer support functions.

The majority of our revenue comes from multi-yearcontracts with government agencies, including U.S. state departments of motorvehicles and central banks. We intend to increase our revenue throughincreasing adoption of our products and services, marketing new digitalwatermarking applications, and licensing our intellectual property. We expectto target, among other sources of revenue, government agencies, commercialprinters, packaging companies, publishers, advertisers, proprietors of largeimage collections, and other producers of printed materials. Our aim is tolicense our technologies to those content producers so that they may embed ourdigital watermarks in their printed media, such as identification documents,magazine advertisements and articles, direct mail coupons, catalogs, stationeryand envelopes, product packaging, labels and tags, trading cards, credit cards,and business cards. Our current and anticipated products are intended to enablecontent producers to control reproduction and alteration of their content, aswell as to enable their printed materials to provide a link to relevant network

32

----

services. Revenue from ournew applications may include one-time license fees, time-based or volume-basedfees, subscription fees, royalties and revenue-sharing arrangements. Weanticipate that the calculation of revenue and royalties for these newapplications will be based at least in part on the size of the installed baseof personal computers, cameras, scanners, digital image capture and outputdevices, and software carrying our patented reader technology, as well as thenature of the use of, and the nature and amount of licensed content carrying,our digital watermarks.

Since inception, we haveinvested a significant portion of our resources and capital in attracting topsenior management, in developing our products and technology, and in buildingour sales and marketing organizations. We incurred significant losses frominception through the fiscal year ended December 31, 2002 and during 2004,and as of December 31, 2004, we had an accumulated deficit of$64.9 million. We intend to continue to expend significant financial andmanagement resources on developing additional products and services, improvingsales and marketing activities, advancing our technologies and expanding ouroperations. Our revenue may not increase or even continue at its current levelsand we may not maintain profitability or generate cash from operations infuture periods.

**Restatement of Financial Statements**

*Summary*.   We have restated our consolidated financialstatements as of and for the fiscal year ended December 31, 2003, and thequarterly periods ended March 31, 2004 and June 30, 2004 primarily asa result of certain errors in the capitalization of costs related to internaluse software and project accounting cost tracking and cost deferrals at DIDS. 

Concurrently with this Form 10-K,we are filing our Quarterly Report on Form 10-Q for the quarterly periodended September 30, 2004, which we delayed filing as a result of therestatement. 

We have not amended our 2003 Annual Report on Form 10-Kor Quarterly Reports on Form 10-Q for periods affected by the restatement,and the financial statements and any independent registered public accountingfirm’s report and related financial information for the affected periodscontained in such reports should no longer be relied upon. Any disclosures thatwould be provided in any such amendments to our Form 10-K or Form 10-Qfor periods affected by the restatement would in large part repeat thedisclosures contained in this report.

*Background*.   On September 13, 2004 weannounced that we were reviewing certain accounting practices andpreviously reported financial statements as a result of possible errorsdiscovered by our management in the accounting for software development costsand project capitalization and other project cost capitalization accountingpractices at our DIDS business unit. On November 8, 2004, we announcedthat we were delaying the filing of our Form 10-Q for the third quarterended September 30, 2004 due to our ongoing evaluation of certainaccounting issues relating to transactions entered into in prior periods. Duringthe course of our review, we determined that errors in the accounting forsoftware development costs, project accounting, revenue recognition, and taxaccruals among other areas with respect to certain prior periods had been madeand required adjustment. We have restated our consolidated financial statementsto correct these errors.

We identified these errors as a result of our reviewof our accounting and our review of our internal control over financialreporting in preparation for compliance with Section 404 of theSarbanes-Oxley Act of 2002 and its implementing regulations. In connection withour restatement, we identified and reported to our audit committee materialweaknesses in our internal control over financial reporting. Please see Item 9Abelow for a description of these matters and certain measures that we haveimplemented during 2004 and to date, as well as additional steps we plan totake to strengthen our controls.

33

----

*Effect of Adjustments*.   Thekey impacts of the restatement adjustments for each period affected by therestatement are to:

·        decrease net income from $0.00 per share to a net loss of $0.01 per share for the quarter ended March 31,2003;

·        decrease net income from$0.02 per share to net income of $0.01per share for the quarter ended June 30, 2003;

·        decrease net income from $0.07 per share to net income of $0.04per share for the quarter ended September 30,2003; 

·        increasenet loss from $0.00 per share to net loss of $0.03 per share and decreaserevenues by $27,000 for the quarter ended December 31, 2003;

·        decrease net income from$0.08 per share to net income of $0.01per share and decrease revenues by$27,000 for the year ended December 31, 2003;

·        decrease net income from $0.03 per share to anet loss of $0.04 per share and increase revenues by $168,000 for the quarter ended March 31,2004; and

·        decrease net loss from $0.10 per share to anet loss of $0.06 per share anddecrease revenues by $199,000 for the quarter ended June 30, 2004.

*Description ofAdjustments.*

*Capitalizedsoftware development costs*.   We produce software that isused internally, and as such have costs that qualify under the AmericanInstitute of Certified Public Accountants’ Statement of Position (SOP) 98-1, *Accounting for the Costs of Computer Software Developed or Obtained forInternal Use*. The Company’s policy requires expensing of activitiesrelated to the preliminary stage of a software project (such as the conceptualformulation of alternatives), allows capitalization of activities related tothe application development stage of a software project (such as coding,installation, and testing), and requires expensing of activities related to thepost-implementation stage (such as training, maintenance, and support). Underthese rules we capitalize costs in the application development stage of asoftware project. In connection with the restatement, we determined thatcertain costs had been erroneously capitalized because either a portion of suchcosts did not qualify for capitalization (e.g., costs related to thepreliminary or post-implementation stages) or the project itself did notqualify as internal-use software (e.g., costs related to a non-softwareproject).

*Projectaccounting cost tracking and cost deferrals*.   Weerroneously tracked costs for various projects as a result of certaindifficulties we had implementing a new accounting system in late 2003 and early2004. As a result, certain costs that should have been recognized as expensesin the period incurred were erroneously recorded as inventory or as fixedassets.

*Taxaccrual timing*.   We identified certain international taxexpenses that had not been properly accrued in the period incurred.

*Revenueaccrual based on estimated production*.   We recognize revenue on long-termidentification and driver license production contracts using a price-per-cardmethod. We use actual monthly volume amounts, if available. Otherwise, weestimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, prior to publicly reporting results, our practice is tocompare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. However, for the first and second quartersof 2004, this practice was not followed and, as a result, we understatedrevenues during the first quarter of 2004 and overstated revenues for the secondquarter of 2004.

34

----

*Other Adjustments.  *Anumber of other adjustments were made in the restatement, including adjustmentsto (i) correctly record inventory receipts in the proper period, (ii) correctthe timing of revenue recognized for a maintenance contract, (iii) correctcommission liability relating to a long-term card product contract, (iv) correctVAT payables and expenses, (v) correct revenue recognized on a milestonebased contract to match revenue recognized when the milestones were completed,and (vi) correct intercompany allocations which were not properly recorded.While the amounts associated with these other adjustments are relatively small,we believe that it is appropriate to record them as part of this restatement.

The decrease in net incomerelates primarily to the errors in software capitalization and projectaccounting. These errors were partially offset by the net impact of incometaxes and other adjustments.

The following tables setforth the restatement adjustments to our financial statements for December 31,2003. The amounts in the tables are expressed in thousands. The restatedquarterly periods are contained in Note 13 of our consolidated financialstatements included herewith.

***As of and for theyear ended December 31, 2003:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|-----------|------------|------------------|------------|
| Revenue                                                       |       | $          | 85,618     |                         |       | —                       |       |                    |       | —            |       |      | —     |             | $          | (27 | ) | $ | 85,591 |   |
| Cost of revenue                                               |       | 46,283     |       |                         | $          | 341                          |       |                    |       | $                 | 360        |      |       | —           |       | (48 | ) | 46,936 |   |
| Gross profit                                                  |       | 39,335     |       |                         | (341       | )                            |       |                    | (360       | )                 |       | —    |       | 21               |       | 38,655 |   |
| Operating expense                                             |       | 38,169     |       |                         | 596        |                         |       |                    | 93         |              |       | (82       | )          | (52              | )          | 38,724 |   |
| Operating income (loss)                                       |       | 1,166      |       |                         | (937       | )                            |       |                    | (453       | )                 |       | 82        |       | 73               |       | (69 | ) |
| Other income                                                  |       | 567        |       |                         | —     |                         |       |                    | —     |              |       | —    |       | —           |       | 567 |   |
| Provision for income  taxes                                   |       | (203       | )          |                         | —     |                         |       |                    | —     |              |       | $         | (120       | )                | —     |   | (323 | ) |
| Net income (loss)                                             |       | $          | 1,530      |                         |       | $                            | (937       | )                       |       |              | $          | (453      | )          |             | $          | (38 | ) | $ | 73 |   | $ | 175 |   |

 
| **Balance Sheet Data**                | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  Taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|-----------|------------|------------------|------------|
| **Assets:**                                     |       |       |       |                         |       |                         |       |                    |       |              |       |      |       |             |       |   |   |   |   |
| Trade accounts receivable, net                  |       | $          | 9,195      |                         |       | —                       |       |                    |       | —            |       |      |       | —           |       |   | $ | (27 | ) | $ | 9,168 |   |
| Inventory, net                                  |       | 5,739      |       |                         | —     |                         |       |                    | $          | 514               |       |      |       | —           |       |   | — |   | 6,253 |   |
| Other current assets                            |       | 2,227      |       |                         | —     |                         |       |                    | (357       | )                 |       |      | 82         |             |       | 100 |   | 2,052 |   |
| Total current assets                            |       | 100,115    |       |                         | —     |                         |       |                    | 157        |              |       |      | 82         |             |       | 73 |   | 100,427 |   |
| Property and equipment, net                     |       | 37,755     |       |                         | $          | (937                         | )          |                    |       | (967              | )          |      |       | —           |       |   | (38 | ) | 35,813 |   |
| Other assets, net                               |       | 858        |       |                         | —     |                         |       |                    | 357        |              |       |      | —     |             |       | — |   | 1,215 |   |
| Total assets                                    |       | $          | 162,426    |                         |       | $                            | (937       | )                       |       |              | $          | (453      | )          |             |       | 82 |   |   | $ | 35 |   | $ | 161,153 |   |
| **Liabilities and Stockholders’ Equity:**  |       |       |       |                         |       |                         |       |                    |       |              |       |      |       |             |       |   |   |   |   |
| Accounts payable                                |       | $          | 6,671      |                         |       | —                       |       |                    |       | —            |       |      |       | —           |       |   | $ | (87 | ) | $ | 6,584 |   |
| Accrued payroll and related costs               |       | 969        |       |                         | —     |                         |       |                    | —     |              |       |      | —     |             |       | 100 |   | 1,069 |   |
| Other current liabilities                       |       | 235        |       |                         | —     |                         |       |                    | —     |              |       |      | $          | 120              |       |   | (51 | ) | 304 |   |
| Total current liabilities                       |       | 11,035     |       |                         | —     |                         |       |                    | —     |              |       |      | 120        |             |       | (38 | ) | 11,117 |   |
| Total liabilities                               |       | 12,321     |       |                         | —     |                         |       |                    | —     |              |       |      | 120        |             |       | (38 | ) | 12,403 |   |
| Total stockholders’ equity                 |       | 150,105    |       |                         | $          | (937                         | )          |                    |       | $                 | (453       | )         |       |             | $          | (38 | ) |   | 73 |   | 148,750 |   |
| Total liabilities and stockholders’ equity |       | $          | 162,426    |                         |       | $                            | (937       | )                       |       |              | $          | (453      | )          |             |       | $ | 82 |   |   | $ | 35 |   | $ | 161,153 |   |

 

35

----

**Cash Flow Changes**
| ** **                                   | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Tax  accrual** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|------------------|------------|-----------|------------|------------------|------------|
| Cash flows from  operating activities:       |       |                         |       |                         |       |                    |       |             |       |      |       |             |       |   |   |   |   |
| Net income                                   |       | $                            | 1,530      |                         |       | $                       | (937       | )                |       |      | $          | (453             | )          |   | $ | (38 | ) | $ | 73 |   | $ | 175 |   |
| Depreciation and amortization                |       | 10,756                       |       |                         | 24         |                    |       |             | —     |      |       | —           |       | — |   | 10,780 |   |
| Trade and unbilled accounts receivable,  net |       | 1,788                        |       |                         | —     |                    |       |             | —     |      |       | —           |       | 27 |   | 1,815 |   |
| Inventory                                    |       | (648                         | )          |                         | —     |                    |       |             | (514       | )         |       | —           |       | — |   | (1,162 | ) |
| Other current assets                         |       | 880                          |       |                         | —     |                    |       |             | 357        |      |       | (82              | )          | (100 | ) | 1,055 |   |
| Other assets, net                            |       | 32                           |       |                         | 16         |                    |       |             | (357       | )         |       | —           |       | — |   | (309 | ) |
| Accounts payable                             |       | (1,337                       | )          |                         | —     |                    |       |             | —     |      |       | —           |       | (87 | ) | (1,424 | ) |
| Accrued payroll and related costs            |       | (418                         | )          |                         | —     |                    |       |             | —     |      |       | —           |       | 100 |   | (318 | ) |
| Other liabilities                            |       | (12                          | )          |                         | —     |                    |       |             | —     |      |       | 120              |       | (51 | ) | 57 |   |
| Net cash provided by operating activities    |       | 27,224                       |       |                         | (897       | )                       |       |             | (967       | )         |       | —           |       | (38 | ) | 25,322 |   |
| Cash flows from  investing activities:       |       |                         |       |                         |       |                    |       |             |       |      |       |             |       |   |   |   |   |
| Purchase of property and equipment           |       | (8,367                       | )          |                         | (40        | )                       |       |             | 967        |      |       | —           |       | 38 |   | (7,402 | ) |
| Capitalization of labor costs                |       | (7,546                       | )          |                         | 937        |                    |       |             | —     |      |       | —           |       | — |   | (6,609 | ) |
| Net cash used in investing activities        |       | (39,154                      | )          |                         | 897        |                    |       |             | 967        |      |       | —           |       | 38 |   | (37,252 | ) |
|                                              |            |                              |            |                              |            |                         |            |                  |            |           |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

**Major New Contractsfor DIDS**

During 2004, DIDS generated revenue growth,particularly in the international sector. Although revenue increased as aresult of international revenues reaching the revenue recognition phase for anumber of large domestic contracts, gross margins decreased because of voteridentification projects delivered during 2004, which typically have lowermargins, as well as the initial deployment of several large domestic contractsthat came on line in 2004, which typically have smaller margins in the earlieryears of the contract as compared to the later, extension years of thecontract.

In the domestic market, we competed effectively,gaining extensions and upgrades from a number of customers and increasing our overallmarket share on a card-production basis, including long term contracts withsubstantial upgrades in Iowa and Wyoming, and contract term extensions inIndiana, Virginia, Georgia, and Minnesota. We also received new contract awardsin Minnesota and Ohio in connection with competitive bidding processes. Thecontract in Ohio had previously been the contract of one of our competitors. InFlorida, we started live central issue production in July, generating newrevenue for DIDS, and were poised at year end to pilot the Floridaover-the-counter system for hundreds of sites. We also recieved short termextensions in West Virginia and Hawaii, but those contracts have or will betransitioned to other providers.

In foreign markets, wecontinued to deliver consumable supplies on ongoing projects such as the UK andRussian driver license programs, as well as a number of other, smallerprojects. We grew our 2004 revenue by closing a $9 million order to build asystem to produce a driver license system for Latvia, started production ofsuch system, and initiated production of the Mexican voter identification card.

**DigitalWatermarking Strategy on Track; New and Enhanced Products Developed**

Our digital watermarking business consists of twoprongs: digital watermarking solutions that we provide directly to customers,and intellectual property licensing that enables other companies to providewatermarking solutions to their customers while paying patent and technologylicense fees to Digimarc. 

36

----

Revenue for thewatermarking business was up $1.9 million or 20% compared to the prior yeardriven by increased acceptance of our watermarking technologies.

The current Digimarc solutions business consists of ananti-counterfeiting system, ImageBridge, MyPictureMarc and IDMarc product lines.We have developed the anti-counterfeiting system for a consortium of centralbanks, which has, and continues to, account for a substantial majority of ourdigital watermarking revenue. ImageBridge provides image asset tracking andidentification to enterprise and stock photo agencies. MyPictureMarc providescopyright protection services to creative professionals. IDMarc, a securityenhancement for driver licenses, is the latest addition to our digitalwatermarking mix providing cross-jurisdictional authentication of identitydocuments such as driver licenses.

IDMarc is offered tosystems integrators and document issuers on a per-document fee basis. In somecases during early market development these fees may be discounted in exchangefor accelerated market adoption. Our intent is to minimize barriers to adoptionand encourage broad-based deployment of the technology, and then monetize theembedded feature in a variety of aftermarket applications, including DMV andborder crossing identity verification, law enforcement, airport security, andpoint of sale document authentication applications. After successfully provingthe model in driver licenses, we intend to license similar embedding andreading applications in the broader secure personal identification documentmarket.

**EncouragingSigns of Industry-Wide Adoption of Digital Watermarking in Entertainment**

Licensing of our digitalwatermarking patents is a critical element of our long-term shareholder valueproposition. The greatest near-term interest in digital watermarking is in theentertainment field. Digital watermarking is increasingly being employed fortracking and monitoring of music, movies, and television programs. The majorityof the major music labels are using digital watermarking solutions for forensictracking of pre-release music. They are obtaining the tracking solutionsdirectly from Digimarc and from our licensees. Motion picture studios havebegun following suit, using forensic tracking based on digital watermarking aspart of increased piracy deterrence measures in the Academy Award screenerprogram. In the television business, three companies have licensed our patentseither directly or through sublicenses and deployed monitoring systems to trackradio and television programs and advertisements in major media markets aroundthe world.

**RenewedInterest in Print-to-Internet Applications, Fueled by Innovation in MobileImaging**

Certain other marketdevelopments are encouraging for our strategy as well. The influx of imaging inmobile devices—mainly cell phones and PDAs—is inspiring a renewed interest indigital watermarking as the means of linking printed materials to Internetservices that we launched in 2000. We believe that a highly supportive changein market dynamics is underway. A number of companies, ranging from start-upsto industry leaders like Intel, Microsoft, and NTT have announced initiativesaimed at using various signaling means, including bar codes, RFID, and digitalwatermarking to simplify the user interface for mobile device access toInternet services.

**Looking Ahead**

With the restatementbehind us, the Company anticipates strong revenue growth and improvement insupporting business and financial processes. Digital watermarking momentum isbuilding in both commercial solutions and licensing businesses. The broadeningadoption of digital watermarking for pre-release movies and music and bymajor U.S. broadcasters for syndicated programming and promotions is veryencouraging. Our newest digital watermarking product initiative is IDMarc, asecurity enhancement for driver licenses that has been adopted by 12 U.S.states and one foreign country to date. The U.S. Department of Transportationhas provided funding for pilot programs to demonstrate the utility of the 

37

----

embeddeddata in a number of transportation safety scenarios. Elsewhere in our securepersonal identification business, the new system installations in Florida,Alabama, and Ohio should fuel growth in U.S. driver license issuance revenues. Whilewe may face competitive bids for a number of our major accounts in 2005including California, Texas, Indiana, and Georgia, there are also a number ofopportunities for competitive wins in jurisdictions, such as Arkansas, SouthCarolina and Ontario, Canada. The U.S. legislative environment also isfavorable to our growth as a result of increasing recognition of the broadsecurity value of the driver license for America. The global market for securepersonal identification continues to take shape, providing numerousopportunities for continuing growth in international and channel sales forDigimarc.

**CriticalAccounting Policies and Estimates**

The preparation of consolidated financial statementsin accordance with U.S. generally accepted accounting principles requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenue and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to bad debts, inventories, intangible assets, income taxes,restructuring, long-term service contracts, warranties, investments, andcontingencies and litigation. We base our estimates on historical experienceand on various other assumptions we believe to be reasonable under thecircumstances. Actual results may differ from these estimates under differentassumptions or conditions.

Certain of ouraccounting policies require higher degrees of judgment than others in theirapplication. These include revenue recognition on long-term service contracts,impairments and estimation of useful lives of long-lived assets, inventoryvaluation, reserves for uncollectible accounts receivable, and contingenciesand litigation. We believe the following critical accounting policies affect ourmore significant judgments and estimates used in the preparation of ourconsolidated financial statements:

**Revenue recognition on long-termservice contracts:****  **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.These amounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting results, our practice isto compare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Revisions to our estimates have been lessthan 0.5% of total revenue in every period reported in 2004, 2003 and 2002(since the LGP transaction). Any estimated amounts are included in unbilledreceivables on the balance sheet until the actual production information isavailable and the billing occurs. Any estimation process involves inherentrisk. We reduce the inherent risk relating to production estimation through ourapproval and monitoring processes related to accounting estimates.

38

----

Revenue fromprofessional services arrangements is generally determined based on time andmaterial or a cost plus a profit margin measure. Revenue for professionalservices is recognized as the services are performed. Losses on contracts, ifany, are provided for in the period in which the loss becomes determinable.Billing for services rendered generally occurs within one month following whenthe services are provided. Revenue earned which has not been invoiced isclassified as unbilled trade receivables in the consolidated balance sheets.

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically assess long-livedassets for impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable, in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets.* This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values,depending on the nature of the asset. If our estimates of projected future cashflows were too high by 10%, we believe there would be no material impact on thereported value of intangible assets on our Consolidated Balance Sheet. Also, weperiodically review the useful lives of long-lived assets whenever events orchanges in circumstances indicate that the useful life may have changed. If theestimated useful lives of such assets do change, we adjust the depreciation oramortization period to a shorter or longer period, based on the circumstancesidentified.

**Inventoryvaluation:****  **Inventory consistsprimarily of consumable supplies that are used in the production of driverlicenses and products held for resale to customers. We value inventory at thelower of cost or market value (which lower amount is the net realizable value).We reduce the value of our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.

**Reservesfor uncollectible accounts receivable:****  **We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust whenappropriate, our allowance for doubtful accounts on at least a quarterly basis.If the financial condition of our customers were to deteriorate, resulting inan impairment of their ability to make payments, additional allowances may berequired. If our estimate of uncollectible accounts were too low by 10%, therewould be no material impact on the reported value of accounts receivable on ourconsolidated balance sheets.

**Contingenciesand Litigation**:   We periodically evaluate all pending or threatened contingencies orcommitments, if any, that are reasonably likely to have a material adverseeffect on our operations or financial position. We assess the probability of anadverse outcome and determine if it is remote, reasonably possible or probableas defined in accordance with the provisions of SFAS No. 5, *Accounting for Contingencies*. If information available priorto the issuance of our financial statements indicates that it is probable thatan asset has been impaired or a liability has been incurred at the date of ourfinancial statements, and the amount of the loss, or the range of probable losscan be reasonably estimated, then such loss is accrued and charged tooperations. If no accrual is made for a loss contingency because one or both ofthe conditions pursuant to SFAS No. 5 are not met, but the probability ofan adverse outcome is at least reasonably possible, we will disclose the natureof the 

39

----

contingency and provide an estimate of the possible loss or range ofloss, or state that such an estimate cannot be made.

**Results of Operations**

During the year ended December 31, 2004, we investedin capital equipment and software development for several new programs,including programs based in Florida, Mexico, and Alabama which caused ourworking capital to decrease for the period. Two of these three programs beganto contribute revenue in the second half of 2004 and all of these programs areexpected to be fully deployed in 2005. Operating results were negativelyimpacted by lower margins (resulting from sales mix, depreciation expense as ahigher percentage of revenue, competitive bidding, inventory reserves, andlower yields on new products) as well as charges for Sarbanes-Oxley compliance,increased spending on our restatement activities, litigation settlementcharges, and impairment charges.

Thefollowing table presents our consolidated statement of operations data for theperiods indicated as a percentage of total revenue.
| ** **                                      | ** ** | **Year Ended December 31,**   | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **   2004   ** | ** ** | **   2003   ** | ** ** | **   2002   ** | ** ** |
| ** **                                      | ** ** | **(Restated)**                               | ** ** |
| Revenue:                                        |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Service                                         |       |                                         | 80         | % |   |   | 84 | % |   |   | 78 | % |   |
| Product and subscription                        |       |                                         | 20         |   |   |   | 16 |   |   |   | 22 |   |   |
| Total revenue                                   |       |                                         | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Service                                         |       |                                         | 49         |   |   |   | 46 |   |   |   | 46 |   |   |
| Product and subscription                        |       |                                         | 13         |   |   |   | 9 |   |   |   | 14 |   |   |
| Total cost of revenue                           |       |                                         | 62         |   |   |   | 55 |   |   |   | 60 |   |   |
| Gross profit                                    |       |                                         | 38         |   |   |   | 45 |   |   |   | 40 |   |   |
| Operating  expenses:                            |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                             |       |                                         | 13         |   |   |   | 14 |   |   |   | 16 |   |   |
| Research, development and engineering           |       |                                         | 8          |   |   |   | 8 |   |   |   | 12 |   |   |
| General and administrative                      |       |                                         | 28         |   |   |   | 23 |   |   |   | 22 |   |   |
| Restructuring charges, net                      |       |                                         | —     |   |   |   | — |   |   |   | 1 |   |   |
| Total operating expenses                        |       |                                         | 49         |   |   |   | 45 |   |   |   | 51 |   |   |
| Operating income (loss)                         |       |                                         | (11        | ) |   |   | — |   |   |   | (11 | ) |   |
| Other income  (expense):                        |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                 |       |                                         | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                |       |                                         | —     |   |   |   | — |   |   |   | — |   |   |
| Other                                           |       |                                         | —     |   |   |   | — |   |   |   | — |   |   |
| Total other income, net                         |       |                                         | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss) before provision for income taxes |       |                                         | (10        | ) |   |   | 1 |   |   |   | (10 | ) |   |
| Provision for  income taxes                     |       |                                         | —     |   |   |   | (1 | ) |   |   | — |   |   |
| Net income (loss)                               |       |                                         | (10        | )% |   |   | — | % |   |   | (10 | )% |   |

 

**Years Ended December 31, 2004 and 2003**

Revenue for 2004 was up from the prior year. Thisresulted from an increase of $5.5 million in ID systems revenue, goingfrom $76.3 million in 2003 to $81.8 million in 2004, and an increaseof $1.9 million 

40

----

in watermarking revenue,going from $9.3 million in 2003 to $11.2 million in 2004. Revenuerelated to services, which include the issuance of driver licenses, increasedby approximately 3% while revenue related to product and subscription salesincreased approximately 36% because of delivery of a large, internationalfilm-based system to a customer, the sale of equipment to a domestic customer,and the license and related revenues for intellectual property rights tointernational customers.

Operating expenses in total increased by$6.3 million or 16% for the year ended December 31, 2004 compared tothe year ended December 31, 2003. The majority of the increase came fromthe general and administrative function as a result of several factors. Onesuch factor is the cost related to the restatement activities we areundertaking, which include legal, accounting, and consulting fees. A secondfactor is the increased cost of our efforts to document, evaluate, and test ourinternal controls in accordance with the Sarbanes-Oxley Act of 2002. We alsohad increased costs related to impairment charges, litigation settlementcharges, increased bad debt expense, charges for vacating our old building, andincreased costs related to higher financial staffing and consulting fees. Oursales and marketing and research, development, and engineering costs increasedonly slightly. As of the end of 2004, we increased the number of our full timeemployees by 20 and increased the number of our contractors by 92 since the endof 2003. The increased workforce resulted from the high demand of deliveryprograms during the year and increased resources for our finance group.

We had a net loss of $9.0 million compared to our netincome of $175,000 in 2003. The decrease in net income came as a result of a decreasein margins of $3.2 million and an increase in operating expenses of $6.3million, as described above.

Based on projected driverlicense production volumes and other commitments we have for the periods undercontract with our respective customers, including driver license issuingauthority customers, we anticipate our current contracts as of December 31,2004 to generate more than $260 million in revenue during the life of suchcontracts, currently expected to be up to eight years. We consider as backlogproduction volumes reasonably expected to be achieved under currently existingcontractual terms, government orders that are firm but not yet funded, andgovernment contracts awarded but not yet signed. However, there can be noassurance that our backlog will result in actual revenue in any particularperiod, because our backlog includes contracts that extend for several years,during which time they could be cancelled or suspended. Anticipated revenuesfrom long-term contracts may cover periods as long as eight years, and in manyinstances such contracts may be terminated by the customer throughout theperiod. We may never realize revenue on contracts included in our backlog orthe timing of such recognition may change because the contract could bereduced, modified, or terminated early or the project schedule could bechanged.

*Revenue*

Total revenue was $92.9 million and$85.6 million for the years ended December 31, 2004 and 2003, respectively.The $7.4 million or 9% increase in total revenue resulted primarily from anincrease****in our product and subscriptionrevenues.

In international markets, where we provide driverlicenses, national identification, and voter identification systems, services,and components in partnership with local card producers, security printers,system integrators, and others, we may serve as prime contractor orsub-contractor, depending on the circumstances. As a sub-contractor, we areresponsible for delivering hardware, software, or consumables to the primecontractor and, as a prime contractor, we are responsible for integrating thecomponents of the system to the customer’s specifications. In internationalmarkets, revenue from international customers was $20.8 million and$14.0 million for 2004 and 2003, respectively. International sales for ushave typically taken the form of an outright sale of equipment and/orconsumables to international government agencies or their prime contractors.These sales often can be large, one-time events. Due to the nature of the 

41

----

international customers,the timing of these sales is somewhat less predictable than in the context ofservice revenues provided to us by domestic customers and, consequently,international sales can occur unevenly during the course of a year. We believethat international growth opportunities exist for us and we expect to continueto invest in personnel and resources to support our potential revenue growthoutside of the United States.

We had no customer that accounted for more than 10% ofour revenue in 2004, 2003 or 2002.

*Service.  *Servicerevenue consists primarily of card production on a price-per-card basis,software development services and hardware and software maintenance. Themajority of service revenue arrangements are typically structured asprice-per-card product agreements, time and materials consulting agreements, orfixed price consulting agreements. Service revenue is an umbrella categoryconsisting of both service revenue and contract-based service revenue. Thedistinction between these two subcategories is that service revenue isgenerated from long-term identification and driver license productioncontracts, while contract-based service revenue is generated from otherlong-term, time-and-materials service contracts. Service revenue was$73.9 million and $71.6 million for the years ended December 31,2004 and 2003, respectively. The $2.3 million or 3% increase was theresult of increased issuance revenue from program transitions (the addition ofprograms based in Mexico, Florida, and Latvia offset by the loss of programsbased in Oklahoma, Alaska and Maryland), in addition to****increasedservices provided under our long-term contract with the internationalconsortium of central banks.

*Productand subscription.  *Product and subscription revenueconsists primarily of the sale of equipment and consumables related toidentification card production systems, software license sales, andsubscriptions related to the ImageBridge product. Product and subscriptionrevenue was $19.0 million and $14.0 million for the years ended December 31,2004 and 2003, respectively. The $5.0 million or 36% increase was primarilyrelated to the delivery of a large, international film-based system to acustomer, the sale of equipment to a domestic customer, and the license andrelated revenues for intellectual property rights to international customers.Prices for product and subscription offerings by the company are generallyconsistent with prior periods.

*Cost of Revenue*

*Service.  *Costof service revenue primarily includes compensation for software developers,quality assurance personnel, product managers, field operations personnel, andbusiness development personnel, outside contractors, costs of consumables usedin delivering a service, depreciation charges for machinery used specificallyfor service delivery, amortization of capitalized internal-use software costs,and travel costs directly attributable to service and development contracts.Cost of service revenue was $45.7 million and $39.4 million for theyears ended December 31, 2004 and 2003, respectively. The$6.3 million or 16% increase was primarily the result of increasedinternational operations costs of $2.0 million, an increase of program-relateddepreciation costs of $3.7 million, and an increase of $1.8 million in domesticfield operations costs, and inventory and program asset charges of $1.1 millionrelated to excess, obsolete, and slow-moving inventory, partially offset by adecrease of $2.2 million related to costs of consumables related to issuances.We have begun to outsource much of our field operations and maintenanceactivities on new contracts to third parties, and therefore the increase inspending is not the result of the increase in the total number of our full-timeemployees during 2004. We have been active in negotiating volume discounts,decreasing storage costs, and consolidating operations when necessary amongother actions. Field operations employees totaled 142 and 147 at December 31,2004 and 2003, respectively.

42

----

*Productand subscription.  *Cost of product and subscriptionrevenue primarily includes compensation for operations personnel, costs ofconsumables sold to third parties, costs of machinery sold to third parties,Internet service provider connectivity charges and image search data fees tosupport the services offered to our subscription customers. Cost of product andsubscription revenue was $11.8 million and $7.5 million for the yearsended December 31, 2004 and 2003, respectively. The $4.3 million or57% increase was primarily the result of increased material costs in connectionwith the delivery of the large international film based system to one customerduring the year ended December 31, 2004. This large delivery hadparticularly low margins. We also sold quantities of older or expiring film andequipment to a domestic customer at low margins or no margin during the yearwhich drove up costs and reduced margins for the period.

*Gross Profit*

Overall grossprofit as a percentage of revenue for the years ended December 31, 2004and 2003 was 38% and 45%, respectively. The $3.2 million or 8% decrease ingross profit for the year ended December 31, 2004 compared to the prioryear was primarily related to the following factors:

·        Inventoryand program asset charges of $1.1 million related to excess, obsolete, andslow-moving inventory;

·        Increasedinternational operations costs of $3.6 million related to the ramp up of twolarge new programs;

·        Increaseddomestic field operations costs of $1.8 million;

·        Anunfavorable revenue mix during the first half of the year, including low marginrevenues from follow-on film sales into an international voter identificationproject and some domestic equipment sales;

·        Costoverruns related to the sale of a driver license issuance system in the firsthalf of the year; and

·        Higherdepreciation charges of $2.0 million originating from the capitalized costsrelated to hardware, software, and delivery activities in the deployment of newcontracts and upgrades to existing contracts.

·  These items were partially offset by adecrease of $2.2 million related to costs on consumables related to issuances. 

In particular, the highlevel of new programs, while indicative of our continuing marketing successesand anticipated to be a precursor to significant growth in revenues, exertedoperational pressures on our identification systems business during the year asthe organization incurred higher expenses as part of the upfront implementationcosts associated with making these new programs operational. We believe thatthese operational pressures on our identification systems business will likelycontinue for the next few quarters, resulting in continued margin pressures aswe continue to incur significant expenses without corresponding revenueincreases, until the new programs are fully implemented and producing revenuesin timing and amount that offset such increased expenses in connection withtheir implementation.

*Operating Expenses*

*Sales and marketing.  *Salesand marketing expenses consist primarily of compensation, benefits and relatedcosts of sales and marketing personnel, product managers and sales engineers,as well as recruiting, travel, market research, and costs associated withmarketing programs, such as trade shows, public relations and new productlaunches. Sales and marketing expenses were $11.9 million for each of theyears ended December 31, 2004 and 2003. The spending remained relativelyflat for the year due primarily to lower headcount for sales and marketingemployees and spending controls offset by increased impairment charges ofapproximately $0.5 million related to investments in private,technology-related companies. 

43

----

Starting in 2003, wereduced many of the overhead and variable costs within sales and marketing byconsciously making strategic spending decisions. These efforts have resulted intargeted spending for critical areas, yielding lower overall spending withinthe function. Sales and marketing employees totaled 50 and 55 as of December 31,2004 and 2003, respectively. We anticipate that we will continue to invest ator slightly above the current run rate in sales and marketing for theforeseeable future.

*Research,development and engineering.  *Research, development andengineering expenses consist primarily of compensation, benefits and relatedcosts of software developers and quality assurance personnel and payments tooutside contractors. Research, development and engineering expenses were$7.2 million and $7.1 million for the years ended December 31,2004 and 2003, respectively. The overall increase in research, development andengineering expenses of $0.1 million or 1% resulted from higher headcounts,partially offset by cost control measures taken by us during the previous andcurrent year, such as restructuring the business, consolidating operations,centralizing certain services, and standardizing products. Research,development and engineering personnel totaled 137 and 115 as of December 31,2004 and 2003, respectively. We anticipate that we will continue to invest atthe current run rate in product research, development and engineering for theforeseeable future.

*Generaland administrative.  *General and administrative expensesconsist primarily of compensation, benefits and related costs of executive,finance and administrative personnel, facilities costs, legal, human resourcesand other professional fees, and depreciation and amortization expense,including intangibles. General and administrative expenses were$25.9 million and $19.7 million for the years ended December 31,2004 and 2003, respectively. The overall increase in general and administrativeexpenses of $6.1 million or 31% primarily resulted from:

·        Incrementalthird party legal and accounting costs related to our restatement activities of$1.4 million;

·        Incrementalcosts related to third party services in support of our efforts to comply withthe Sarbanes-Oxley Act of 2002 of $0.7 million;

·        Incrementalcharges related to the provision for uncollectible accounts receivable anduncollectible notes receivable of $0.5 million;

·        Incrementalcharges related to the settlement of litigation of $0.4 million;

·        Incrementalfacility costs of $0.3 million due to dual rent costs for four months inaddition to increased amortization and depreciation on the facility build out; offsetby

·        Adecrease by $1.0 million in amortization charges related to intangible assetscompared to the prior year.

The remaining $3.8 millionof the increase in general and administrative expenses is primarily the resultof increases in headcount, consulting fees and other general costs related tocompliance and administrative activities.

In addition, we addedheadcount and consulting resources to our infrastructure, including our financeand information technology groups, in order to meet the normal responsibilitiesof these functions in addition to the increased demands of our restatement andongoing compliance activities. General and administrative employees totaled 65and 57 as of December 31, 2004 and 2003, respectively.

We expect general andadministrative expenses will remain at increased levels in future periodsprimarily due to the legal and other professional fees related to the foregoingmatters, as well as the recently filed shareholder derivative lawsuits, and theanticipated higher insurance costs and increased accounting, audit and legalfees related to our compliance with Section 404. We also expect suchexpenses to increase in future quarters because we anticipate that we willcontinue to invest in our finance and information technologies organizationsand the operational infrastructure at our identification systems business.

44

----

*Amortization of intangible assets*.   Weaccount for intangible assets resulting from acquisitions in accordance withFinancial Accounting Standards Board (“FASB”) Statement Nos. 141, *Business Combinations* and 142, *Goodwill andOther Intangible Assets*. These statements require the recording ofintangible assets under purchase accounting rules, and require the amortizationof such intangible assets over their expected useful life. As a result, in December 2001we recorded $29.5 million of intangible assets related to the acquisition ofcertain assets and certain liabilities from Polaroid and affiliates. Theseintangible assets were set up to amortize over a 12-year period, representingthe expected useful life. Changes in contract status and customer relationshipsmay lengthen or shorten the expected useful life of such intangible assets, orcause an impairment charge related to the intangible asset, so some variabilityis expected to exist related to intangibles depending on internal and externalfactors. Amortization of intangible assets is included in general andadministrative expenses in our statements of operations. The estimated amortizationof intangibles over the next five years is as follows:
| ** **                   | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Amortization of  intangibles |       | $        | 3,200      |     | $          | 2,000    |       | $        | 2,000      |     | $          | 2,000 |   | $ | 2,000 |   |
|                              |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

*Stock-basedcompensation.  *Stock-based compensation expense includescosts relating to stock-based employee compensation arrangements. Stock-basedcompensation expense is based on the difference between the fair market valueof our common stock and the exercise price of options to purchase that stock onthe date of grant, and is being recognized over the vesting periods of therelated options, usually four years. No stock-based compensation expense wasrecorded in 2004 while $1.3 million was recorded for the year ended December 31,2003, and is included in the respective statements of operations expensecategories for the employees to which it applies, as set forth in the tablebelow.
| ** **                             | ** ** | **Twelve Months Ended**            | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|
| ** **                             | ** ** | **December 31,**                        | ** ** |
| ** **                             | ** ** | **   2004   ** | ** ** | **2003** | ** ** |
| Sales and  marketing                   |       |                                         | $          | — |   |   | $ | 277,000 |   |
| Research,  development and engineering |       |                                         | —     |   |   | 254,000 |   |
| General and  administrative            |       |                                         | —     |   |   | 760,000 |   |
|                                   |       |                                         | $          | — |   |   | $ | 1,291,000 |   |

 

On December 16, 2004, the FASB issued Statement No. 123(R),*Share Based Payment*, which is a revisionof Statement No. 123 and supersedes APB Opinion No. 25. StatementNo. 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be valued at fair value on the date ofgrant, and to be expensed over the applicable vesting period. Pro formadisclosure of the income statement effects of share-based payments is no longeran alternative. Statement No. 123(R) is effective for all stock-basedawards granted on or after July 2005. In addition, companies must recognizecompensation expense related to any awards that are not fully vested as of theeffective date. Compensation expense for the unvested awards will be measuredbased on the fair value of the awards previously calculated in developing thepro forma disclosures in accordance with the provisions of StatementNo. 123. Digimarc is currently assessing the impact of adopting StatementNo. 123(R) to its consolidated results of operations.

On December 21, 2004, the Audit, Compensation andCorporate Governance Committees of the Board of Directors of the Companyapproved the acceleration of vesting of the Company’s outstanding stock optionswith option exercise prices greater than $15.00. The acceleration applies toall options outstanding under the Company’s Restated 1999 Stock Incentive Planand 2000 Non-Officer Employee Stock Incentive Plan that would not haveotherwise vested in full by June 30, 2005 in accordance with their terms. Theeffective date of the vesting acceleration is December 31, 2004. TheCompany has disclosed the value associated with these options in the pro formanet income calculation for the year ended 

45

----

December 31, 2004included in Note 1 to the Company’s financial statements. The $15.00 exerciseprice was selected because it was higher than (i) the price at which theCompany’s stock had traded during the period prior to the announcement of therestatement of prior financial results, (ii) the average trading price ofthe Company’s common stock for the last two years, and (iii) the purchaseprice per share of the Company’s common stock in the Company’s privateplacement in August 2003. Options to purchase 310,057 shares of theCompany’s common stock, or 5% of the total number of options of the Companyoutstanding as of December 31, 2004 with remaining vesting schedules, wereaccelerated. Accelerating the vesting of the Company’s options prior to thetime at which these new accounting changes become effective accelerates therecognition of any remaining expense associated with these options. Noadditional compensation expense was recorded in the statement of operations asthe options that were accelerated had an exercise price greater than the fairmarket value of the shares underlying the options on the date of themodification. The incremental pro forma expense shown in Note 1 to theconsolidated financial statements was $1.1 million as a result of thisacceleration. Of these 310,057 options, approximately 50,000 options are heldby the Company’s executive officers. Other than the Company’s chairman andchief executive officer, no director of the Company holds any options subjectto the acceleration.

*Total other income (expense), net.  *Otherincome (expense), net consists primarily of interest received and paid. Otherincome (expense) was $0.9 million and $0.6 million for the yearsended December 31, 2004 and 2003, respectively. The $0.3 million or51% increase came as a result of higher average cash balances that originatedfrom the private placement offering in the third quarter of 2003 and higherinterest rates during the majority of fiscal 2004.

*Provisionfor income taxes.  *Due to the Company’s domestic lossesbefore the provision for income taxes for the year ended December 31, 2002,there was no provision for federal, foreign, or state taxes. However, for theyears ended December 31, 2004 and 2003, the Company was profitable in someforeign jurisdictions. Therefore, during 2004 and 2003 we provided for incometaxes expected to be paid on our international operations. As of December 31,2004, we had net operating loss carryforwards for federal, state and foreign incometax reporting purposes of approximately $82 million and research andexperimentation credits of approximately $3.0 million which expire through 2024if not utilized. Under the Tax Reform Act of 1986, the amounts of and benefitsfrom net operating loss carryforwards may be impaired or limited in certaincircumstances, including a change of more than 50% in ownership. Such a changein ownership occurred with the sales of preferred stock in June 1996, July 1996,and July 1999 and in connection with the initial public offering of ourcommon stock in December 1999. Accordingly, we estimate that approximately$9.0 million of net operating loss carryforwards are subject to theutilization limitation.

**Years Ended December 31, 2003 and 2002**

*Revenue*

Total revenue was $85.6 million and$86.6 million for the years ended December 31, 2003 and 2002,respectively. The $1.0 million or 1% decrease in total revenue resultedfrom an increase in our overall services revenue related to higher averageprice-per-card fees that we collect offset by a greater decrease in our productand subscription revenue due to an unusually large order shipped in the thirdquarter of 2002. In non-U.S. markets, revenue from international customers was$14.0 million and $17.8 million for 2003 and 2002, respectively. Wehad no customer that accounted for more than 10% of our revenue in 2003 or2002.

*Service.  *Servicerevenue was $71.6 million and $67.1 million for the years ended December 31,2003 and 2002, respectively. The $4.4 million or 7% increase was primarilythe result of higher average price-per-card payments that we receive from ourcustomers. The higher prices came as a result of several factors, includingsecurity upgrades for existing programs, new programs starting that aregenerally higher 

46

----

in price due to thefeatures requested and level of security included, and existing contracts thathave price increases built into the agreement. The increases in price vary fromarrangement to arrangement. The volumes remained relatively consistent fromyear to year. Revenue from the consortium of central banks was less than 10%for both 2003 and 2002.

*Productand subscription.  *Product and subscription revenue was$14.0 million and $19.5 million for the years ended December 31,2003 and 2002, respectively. The $5.5 million or 28% decrease wasprimarily related to an unusually large international order we received anddelivered in the third quarter of 2002 in the amount of $5.1 million. Wedid not have a similar order in 2003, and consequently experienced a decreasein product and subscription revenue in 2003.

*Cost of Revenue*

*Service.  *Costof service revenue was $39.4 million and $39.6 million for the yearsended December 31, 2003 and 2002, respectively. The $0.2 million orzero percent decrease was primarily the result of efforts made by the companyto reduce the costs associated with delivering these services offset by certainproject overruns recorded during the year. Field operations employees totaled151 and 146 at December 31, 2003 and 2002, respectively.

*Productand subscription.  *Cost of product and subscriptionrevenue was $7.5 million and $12.4 million for the years ended December 31,2003 and 2002, respectively. The $4.8 million or 39% decrease wasprimarily the result of the associated decrease in product and subscription revenue.The large order mentioned above, fulfilled in the third quarter of 2002, hadvery low margins. As a result, the majority of the decrease in cost of revenuerelated to costs associated with the $5.1 million of revenue recognized in2002.

*Operating Expenses*

*Sales and marketing.  *Salesand marketing expenses were $11.9 million and $14.2 million for theyears ended December 31, 2003 and 2002, respectively. The overall decreasein sales and marketing expenses of $2.4 million or 17% resulted frommanaging costs effectively within the group. We reduced many of the overheadand variable costs within sales and marketing by improving our purchasingprocess, identifying improved or alternative options, and consciously makingstrategic spending decisions. Specifically, the decrease resulted fromdecreased salaries and other employee related costs of approximately$1.3 million due to lower headcount, decreased administrative costs ofapproximately $0.8 million related to sales and marketing activities,decreased spending for marketing materials and promotional activities of$0.3 million, and decreased use of outside consulting services of$0.1 million, and a decrease of approximately $0.2 million indeferred stock compensation related to sales and marketing personnel, partiallyoffset by increased costs of $0.4 million due to the decreased use ofsales and marketing personnel to provide services for our revenue generatingcontracts that would have been included in cost of service revenue. Sales andmarketing employees totaled 55 and 59 as of December 31, 2003 and 2002,respectively.

*Research, development andengineering.  *Research, development and engineeringexpenses were $7.1 million and $10.4 million for the years ended December 31,2003 and 2002, respectively. The overall decrease in research, development andengineering expenses of $3.3 million or 31% resulted from the generalshift we made as a company from a research, development, and engineeringdominated company to a sales and marketing organization, in addition to a focuson managing discretionary spending appropriately. The shift was evidenced bythe decrease of 37 employees within this group. The net decrease in spendingwas also attributed to cost control measures taken by us during the year, suchas restructuring the business, consolidating operations, centralizing certainservices, and standardizing products. The decrease resulted from decreasedsalaries and other employee related costs of $0.8 million, decreased costsrelated to outside consultants of approximately $3.2 million associatedmainly with decreased use of 

47

----

contractors, decreasedadministrative costs of $0.4 million associated with research, developmentand engineering activities, and a decrease of approximately $0.2 millionof deferred stock compensation charges related to research, development, andengineering personnel, partially offset by $1.2 million related todecreased use of research, development and engineering personnel to provideservices for our revenue generating contracts and to develop internal-use software.Research, development and engineering personnel totaled 111 and 148 as of December 31,2003 and 2002, respectively.

*General and administrative.  *Generaland administrative expenses were $19.7 million and $19.3 million forthe years ended December 31, 2003 and 2002, respectively. The overallincrease in general and administrative expenses of $0.5 million or 2% wasrelatively flat from year to year. Specifically, the increase resulted fromincreased costs of $0.3 million related to administrative costs, whichincludes depreciation and amortization, and $1.2 million related toincreased use of general and administrative personnel to provide services forother groups within the company, partially offset by a decrease of$0.1 million related to salaries and other employee related costs,including travel expenses, decreased spending on consulting and professionalfees of $0.6 million, and a decrease of approximately $0.1 million ofdeferred stock compensation charges related to general and administrativepersonnel. General and administrative employees totaled 57 and 49 as of December 31,2003 and 2002, respectively.

*Stock-based compensation.  *Stock-basedcompensation expense of $1.3 million and $1.8 million was recordedfor the years ended December 31, 2003 and 2002, respectively, and isincluded in the respective statements of operations expense categories for theemployees to which it applies. At December 31, 2003, no stock-basedcompensation remains deferred.

*Total other income (expense), net.  *Otherincome (expense), net consists primarily of interest received and paid. Otherincome (expense) was $0.6 million and $1.0 million for the yearsended December 31, 2003 and 2002, respectively. The $0.5 million or45% decrease came as a result of lower average cash balances and interest ratesduring the majority of fiscal 2003.

*Provisionfor income taxes.  *During 2003 and 2002 we provided forincome taxes expected to be paid on our international operations.

**Liquidity and Capital Resources**

As of December 31, 2004, we had cash and cashequivalents, restricted cash, and short-term investments of $51.8** **million, representing a decrease of $26.8****million from****$78.6** **million at December 31, 2003. As of December 31,2004, $8.3** **million of cash and cashequivalents is restricted as a result of the requirements of performance bondsthat we are obligated to maintain in connection with some of our long-termcontracts in our personal identification systems business. We support theperformance bonds with letters of credit, which may or may not requirerestricted cash. Due to the losses incurred through the second quarter and thelosses that were expected for the year at that time, we were required toincrease our restricted cash during the fourth quarter. The letters of creditmust be renewed yearly if they are expected to continue, and therefore the needfor restricted cash is renewed yearly. However, our banks have required us torestrict this cash until we return to profitability for one year. Accordingly,restricted cash is classified as a non-current asset. Working capital at December 31,2004 was****$48.9** **million,compared to working capital of $89.3** **million****at December 31, 2003. The majority of the decrease incash and working capital primarily relates to investments made in the newFlorida, Mexico, and Alabama programs that we anticipate will contribute torevenue growth in 2005 and beyond.

*Operating Cash Flow*.   The $4.7 millionof cash provided by operations for the year ended December 31, 2004resulted from net loss of $9.0 million which includes non cash items related todepreciation and amortization of $13.5 million. Items positively impactingoperating cash flow were increases in accounts payable of $4.8 million,deferred revenue of $1.7 million and accrued payroll and related costs of$1.1 million. Negatively impacting operating cash flow was an increase in restrictedcash of 

48

----

$6.3 million, anincrease in inventory of $2.6 million and an increase in trade and unbilledaccounts receivable, net of $1.4 million. The $25.3 million of cashprovided by operations for the year ended December 31, 2003 resulted fromnet income of $0.2 million which includes non cash items related todepreciation, amortization, and stock-based compensation of $12.1 million,along with a decrease of $13.7 million of restricted cash as the Companyrenegotiated the terms of its performance bonds during the year, and $1.6million related to decreased accounts receivable. Cash provided by operationswas negatively impacted by a decrease in accounts payable of $1.4 million.

*Investing Cash Flow*.   The $21.7 millionof cash used in investing activities for the year ended December 31, 2004primarily related to $39.7 million for the purchase of property andequipment, including capitalized labor costs, partially offset by $18.0 in netsales of short-term investments. We also acquired approximately$0.1 million of fixed assets during 2004 through capital leasearrangements. The $37.2 million of cash used in investing activities forthe year ended December 31, 2003 primarily related to $23.2 millionin net purchases of short-term investments, and $14.0 million for thepurchase of property and equipment, including capitalized labor costs. We alsoacquired approximately $1.5 million of fixed assets during 2003 throughcapital lease arrangements.

*Financing Cash Flow*.   The $1.9 millionof cash provided by financing activities for the year ended December 31,2004 primarily related to the issuance of stock for $2.1 million related to theemployee stock option and employee stock purchase plans, offset by $0.2 millionof principal payments under capital leases. The $27.9 million of cash providedby financing activities for the year ended December 31, 2003 resultedprimarily from the sale of common stock. In August 2003 we sold 1,785,996units, each of which consisted of one share of common stock and a warrant topurchase 0.15 of a share of common stock, to sixteen institutional andaccredited investors, in a private placement transaction that resulted in $23.5million of net proceeds to the company and $4.4 million related to the issuanceof common stock through the employee stock option and employee stock purchaseplans.

*Commitmentsand Contingencies*.   Our significant commitments consistof obligations under non-cancelable operating leases, which totaled $10.4** **million as of December 31, 2004, and are payablein monthly installments through October 2010. Our obligations undernon-cancelable capital leases, which totaled $1.5****millionas of December 31, 2004, are payable in monthly installments through 2007.We are contractually obligated to make the following payments as of December 31,2004:

**Known ContractualObligations** 
| ** **                     | ** ** | **Payment Due by Period (in 000’s)** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                                         | ** ** | **Less  than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| ** **                     | ** ** | **Total**                                                          | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **5 years** | ** ** |
| Capital leases                 |       | $                                                                  | 1,457      |   | $ | 551 |   |   | $ | 906 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating leases               |       | 10,421                                                             |       | 2,190 |   |   | 3,867 |   |   |   | 2,914 |   |   |   | 1,450 |   |   |
| Total contractual  obligations |       | $                                                                  | 11,878     |   | $ | 2,741 |   |   | $ | 4,773 |   |   |   | $ | 2,914 |   |   |   | $ | 1,450 |   |   |

 

We have driver licensecontracts with various states that are not yet fully deployed for which we haveestimated the amounts to complete. In order to complete these contracts, weestimate we will incur approximately $15 million of expenditures. The estimatesare derived from information known to the Company at the time the estimateswere prepared. Actual expenditures may vary from our estimates. The majority ofthe expenditures will occur in the first half of 2005, and none are expected tobe incurred in 2006. These expenditures are recouped through receipts from thelong-term price-per-card agreements.

Our planned operatingexpenses and capital expenditures may constitute a material use of our cashresources. In addition, we expect that we will continue to utilize cash in theupcoming few quarters as we complete our program implementations in Florida,Alabama and Ohio and build inventory levels for these 

49

----

programsand the Mexico program as such programs reach full production. We may utilizecash resources to fund acquisitions or investments in complementary businesses,technologies or product lines.

Customers have asserted, and may in the future assert, compensatory orliquidated damages, breach of contract, or other claims alleging that we havefailed to meet timing or other delivery requirements and milestones pursuant tothe terms of such contracts. From time to time, customers have givennotice of their intention to assert claims for liquidated damages. For example,in the fourth quarter of 2004 and in the first quarter of 2005, customersprovided notice that they may elect to assert liquidated damages under theterms of their respective contracts. Management believes that these assertionsare part of the resolution process involving commercial disagreements over thedelivery terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. To date, we have not paid liquidated damages in connectionwith a dispute with a domestic customer. We recently elected to pay a minoramount in settlement of a liquidated damages claim in connection with ourMexican contract. While there is always risk that liquidated damages could beassessed in the future, management does not believe that it is probable thatmaterial amounts will be paid, nor can we predict what the amount of any suchdamages would be if they were to be imposed. However, our failure to meet contractualmilestones or other performance requirements as promised could result in ourhaving to incur increased costs, lower margins, or compensatory obligations inaddition to other losses, such as harm to our reputation. Such unexpectedincreases in costs to meet our contractual obligations or any otherrequirements necessary to address claims and damages with regard to ourcustomer contracts could have a material adverse effect on our business andfinancial results, although prior assertions of such claims have not had suchan effect. We anticipate that future contracts will continue to have suchprovisions unless and until industry practices change.

*Future Cash Expectations*.   Webelieve that our current cash, cash equivalents, and short-term investmentbalances will satisfy our projected working capital and capital expenditurerequirements for at least the next 12 months. Thereafter, we anticipatecontinuing to use cash, cash equivalents, and short-term investment balances tosatisfy our projected working capital and capital expenditure requirements. Wehave taken and continue to take steps to limit our expenses and align our coststructure to our revenues. These steps include, among other things, consideringand/or taking steps, as needed, to restructure our business, consolidating ouroperations, negotiating volume pricing with vendors, centralizing certainservices, and standardizing products. We recognize that our operating expenselevels, including research, development, engineering, selling, marketing,general and administrative expenses, depend on anticipated business activitylevels. While research, development, engineering and marketing expenses arebased on anticipated investment levels in technology development, productdevelopment and market development activities, the appropriate expense levelsin selling, general and administrative expenses are dependent on the level ofinfrastructure required to support our anticipated business volume. We reviewour business plans periodically to determine the appropriate level of suchexpenses based on various business factors. In the past we have takenappropriate measures to control our expenses based on business circumstances.In the future we will continue to review our business plans from time to timeand make appropriate changes to our expense levels, as we have in the past, toreduce operating expenses where it is advantageous to do so to improveoperational efficiencies.

In order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities although we do not believe atthis time that our long-term working capital and capital expenditures will beof such a nature that we would be required to take steps presently to remedyany such potential deficiency. As an example, in the event that we were to wincontracts requiring significant capital investment, we may need to seekadditional financing. If it were necessary to obtain additional financings orcredit facilities, we may not be able to do so, or if these funds areavailable, they may not be available on satisfactory terms.

50

----

**Off-Balance SheetArrangements**

We do not have anyoff-balance sheet arrangements, as such term is defined in recently enacted rules bythe SEC, that have or are reasonably likely to have a current or future effecton our financial condition, changes in financial condition, revenue orexpenses, results of operations, liquidity, capital expenditures or capitalresources that are material to investors.

**RecentAccounting Pronouncements**

In November 2004, theFASB issued SFAS No. 151, *Inventory Costs, anamendment of ARB No. 43, Chapter 4* (FAS 151). FAS 151 clarifiesthat abnormal inventory costs such as costs of idle facilities, excess freightand handling costs, and wasted materials (spoilage) are required to berecognized as current period charges. The Company is currently evaluating theprovisions of FAS 151 and does not expect that the adoption will have amaterial impact on its consolidated financial position or results ofoperations.

On December 16, 2004,the FASB issued Statement No. 123(R) *Share-BasedPayment*, which is a revision of Statement No. 123 andsupersedes APB Opinion No. 25. Statement No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be valued at fair value on the date of grant, and to be expensed over theapplicable vesting period. Pro forma disclosure of the income statement effectsof share-based payments is no longer an alternative. Statement No. 123(R) iseffective for all stock-based awards granted on or after July 2005. Inaddition, companies must also recognize compensation expense related to anyawards that are not fully vested as of the effective date. Compensation expensefor the unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123. The Company is currentlyassessing the impact of adopting SFAS 123(R) to its consolidated resultsof operations.

**ITEM7A:   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Our exposure to marketrisk for changes in interest rates relates primarily to the increase ordecrease in the amount of interest income we can earn on our investmentportfolio and on the increase or decrease in the amount of any interest expensewe must pay with respect to outstanding debt instruments. The risk associatedwith fluctuating interest expense is limited, however, to the exposure relatedto those debt instruments and credit facilities that are tied to market rates.We do not plan to use derivative financial instruments in our investmentportfolio. We plan to ensure the safety and preservation of our investedprincipal funds by limiting default risk, market risk and investment risk. Weplan to mitigate default risk by investing in low-risk securities. At December 31,2004, we had an investment portfolio of money market funds, commercialsecurities and U.S. Government securities, including those classified as cashand cash equivalents, restricted cash, and short-term investments, of$45.0 million. The original maturities of our investment portfolio rangefrom 29 to 366 days with an average interest rate of 1.9%. We had capitallease obligations of approximately $1.5****million at December 31,2004. If market interest rates were to increase immediately and uniformly by10% from levels as of December 31, 2004, the decline of the fair marketvalue of the fixed income portfolio and loans outstanding would not bematerial.

**ITEM8:   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

The consolidated financialstatements and notes thereto of Digimarc Corporation and its subsidiaries as ofDecember 31, 2004 and 2003 and for the three year period ended December 31,2004 and the independent registered public accounting firm report thereon are setforth on the F pages of this Annual Report on Form 10-K and areincorporated herein by reference.

51

----

**ITEM9:   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

None.

**ITEM 9A:   CONTROLSAND PROCEDURES**

As described elsewhere inthis Form 10-K, we identified during the third quarter of 2004 certainerrors in the accounting for software development costs and projectcapitalization at DIDS, and we postponed the release of our financial resultsfor the quarter ended September 30, 2004 pending the completion of ourreview of these accounting errors. We identified these errors as a result ofour review of our accounting and our review of our internal control overfinancial reporting in preparation for compliance with Section 404 of theSarbanes-Oxley Act of 2002 and its implementing regulations. This reviewinvolves a detailed analysis and documentation of the processes that impact thepreparation of our financial statements, an assessment of the risks that couldadversely affect the accurate and timely preparation of those financialstatements and the identification of the controls that are in place to mitigatethe risks of untimely or inaccurate preparation of those financial statements. Duringthe course of our review, we determined that certain prior period financialstatements required restatement. As a result, this Form 10-K includes restatedconsolidated financial statements as of and for (1) the fiscal year ended December 31,2003, including each of the quarterly periods in the fiscal year ended December 31,2003, and (2) the quarterly periods ended March 31, 2004 and June 30,2004.

Inconnection with our restatement, we identified and reported to our auditcommittee the following areas for improvement in our internal control overfinancial reporting. These matters constitute “material weaknesses” as definedunder standards established by the Public Company Accounting Oversight Board or“PCAOB”.

·        *Inadequate supervision and technical accounting expertise within theaccounting and finance department.  *There was not adequatesupervision and technical accounting expertise within our accounting andfinance department. The personnel resources and technical accounting expertisein the accounting and finance department were not sufficient to adequatelyresolve non-routine matters or complex accounting processes, such as thosematters and processes relating to the recording of software capitalization,standard costing, and revenue recognition in accordance with U.S. generallyaccepted accounting principles (“U.S. GAAP”).

·        *Inadequate design and implementation of newaccounting system.  *The new accounting system we began toimplement in the second quarter of 2002, and which was placed in service duringthe fourth quarter of 2003, was not designed or implemented properly. There wasa lack of accounting expertise within our accounting and finance department; asa result our internally developed guidelines were not properly implementedduring the setup and configuration of the new accounting system. Implementationof the new accounting system also was flawed because some of our accounting andfinance employees were not properly trained in the use of the new accountingsystem. In addition, the new and old accounting systems were not operated inparallel prior to the Company’s reliance on the new system. Running new and oldaccounting systems in parallel helps validate that the new system is correctlyrecording accounting entries. These implementation issues resulted in errorswith respect to fixed assets and inventory, including the duplicate recordingof purchases, the capitalization of assets that should have been expensed and theexpensing of assets that should have been capitalized.

·        *Inadequate quarterly and year-end financial statement close and reviewprocess.  *For each quarterly and fiscal year-end period, afinancial statement close and review process occurs. Our staffing for thequarterly and year-end financial statement close process was not sufficient,and in some instances, we failed to have adequate management review andsupervision over the financial 

52

----

statement close andreview process, including timely reconciliation of inventory, tax and accountspayable accounts to ensure our financial statements were prepared in accordancewith U.S. GAAP.

·        *Insufficient controls both for determining the nature and types ofcosts that should be capitalized and for ensuring allocation of costs toparticular projects are appropriate.*   Controls for determiningthe nature and types of costs that should be capitalized in accordance withU.S. GAAP, and for ensuring that costs were allocated to appropriate projects,were inadequate, which affected our fixed asset and research and developmentaccounts. We lacked enough personnel with sufficient expertise in complexsoftware capitalization and project accounting rules under U.S. GAAP andthere was not a clear understanding regarding the application of our internalpolicies in these areas. Some of our employees who performed accountingfunctions were not adequately trained and supervised, and there weredeficiencies in communication between functional departments within the Company.Such controls also were insufficient because the documentary support for thehistorical capitalization of certain software development costs and the systemfor tracking costs that qualify for capitalization needed improvement, and thedetective controls related to the capitalization of internally developedsoftware were not adequate.

·        *Insufficient controls to ensure that variousinternational tax exposures were quantified and properly accrued on a timelybasis*.   Internal controls related to the quantification andaccrual of international taxes incurred by the Company were insufficient. Therewas not sufficient staff to properly quantify, accrue, and record such taxes ona timely basis in accordance with U.S. GAAP. This affected our income taxpayable and income tax expense accounts.

·        *Insufficient training and inadequate reconciliation processes forcomplex revenue recognition requirements primarily related to internationaltransactions.*   Training and reconciliation processes related tocomplex revenue recognition requirements regarding distributor discounts,partial deliveries of goods and the acceptance criteria for shipped goods wereinsufficient to ensure these transactions were recorded in accordance with U.S.GAAP. This affected our revenue and our deferred revenue accounts.

·        *Insufficient controls related to system access andsegregation of duties.  *Insufficient internal controls resultedin a lack of segregation of duties among employees. Users of our new accountingsystem had access to multiple accounting processes within the system instead ofonly those processes that were the responsibility of such user. In the absenceof such controls, inappropriate or unauthorized journal entries could beentered into the system.

·        *Inadequacies related to entity-level controls.  *Managementhas concluded that there are deficiencies in the design and execution of ourentity-level controls relating to training, job descriptions, managing ofemployee turnover, application of U.S. GAAP, and communication betweendepartments that constitute “material weaknesses” in our internal control overfinancial reporting. These deficiencies contributed to the restatement of ourpreviously issued financial statements as discussed herein, delays incompliance efforts with Section 404 of the Sarbanes-Oxley Act of 2002 andthe rules issued thereunder, and the delayed filing of this Form 10-K.

53

----

**RemediationActivities**

Digimarcplaces the highest priority on addressing these matters. Under the direction ofour senior management and the participation and oversight of our auditcommittee, we have implemented significant changes to our infrastructure andrelated processes over the past eight months, and continue to address thesematters and will make changes as appropriate. The numbers set forth oppositeeach identified area for improvement in the chart below correspond to thenumbered descriptions of the changes we have implemented, or are in the processof implementing, to improve such areas of our internal controls which appearimmediately following the chart.
| Identified Areas for  Improvement in Internal Controls                                                                                                                       | ** ** | ** **              | ** ** | **Changes Implemented** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|
| Inadequate supervision and technical accounting  expertise within the accounting and finance department                                                                      |       | 1,  2, 3, 4, 8          |
| Inadequate design and implementation of new  accounting systems                                                                                                              |       | 1,  2, 3, 4, 6, 9       |
| Inadequate quarterly and year-end financial  statement close and review process                                                                                              |       | 1,  2, 3, 4, 5, 6, 7, 8 |
| Insufficient controls for determining the nature and  types of costs that should be capitalized and for ensuring allocation of  costs to particular projects are appropriate |       | 1,  2, 3, 4, 8          |
| Insufficient controls to ensure that various  international tax exposures were quantified and accrued on a timely basis                                                      |       | 1,  2, 4, 7             |
| Insufficient training and inadequate reconciliation  processes for complex revenue recognition requirements primarily related to international  transactions                 |       | 1,  2, 4, 7             |
| Insufficient controls related to system access and  segregation of duties                                                                                                    |       | 1,  2, 9                |
| Inadequacies related to entity-level controls                                                                                                                                |       | 1,  2, 4, 5             |

 

*Description ofChanges Implemented to Improve Internal Controls*

1.                 We hired a newChief Financial Officer in June 2004 and a number of other personnel andconsultants who have expertise in financial controls or accounting, and we areactively recruiting other senior level members of the finance and accountingorganization to improve the overall quality and level of experience in ourfinance and accounting organization.

2.                 We have made, andwill continue to make, changes in our finance and accounting organization to provideclearer segregation of responsibilities and supervision with regard to, amongothers, documentation supporting our quarterly and annual financial statements.

3.                 We have initiatedadditional training of our management and other employees at DIDS regardingtimekeeping practices and other best practices.

4.                 We areimplementing an enhanced quarterly and annual financial review close process toinclude additional analysis and support for the financial accounts.

5.                 We have deployedsignificant internal and external resources directed at documenting and testingour internal control over financial reporting as contemplated by Section 404of Sarbanes-Oxley, and such efforts have been helpful in improving our overallprocess and control environment.

6.                 We have strengthenedour inventory management and controls systems and procedures, including thosegoverning the usability and disposition of slow-moving or excess inventories,by performing 

54

----

timely physical inventorycounts that reconcile to the general ledger, analyzing historical and expectedusage levels, and reviewing manufacturing standard costs.

7.                 We have enhancedour review and documentation of accounting estimates. This includes changes inpeople, processes, and documentation in areas such as inventory reserves,allowance for bad debt, long-lived asset impairment analyses, estimated revenueamounts, estimated international taxes, and estimates related to percentage ofcompletion contracts.

8.                 We have continuedto implement steps, including changes to our processes and systems, to improvethe information flow among the various personnel that have a role in thedetermination of proper cost capitalization as well as to improve the reviewand approval process relating to such determination, and we are implementingprocesses to improve communication among our various functional groups, whichinclude sales, manufacturing, customer support, engineering, accounting, andlegal, during the contract negotiation, implementation and fulfillment phases.

9.                 We have establisheda staff position to implement preventive control procedures related to systemaccess and to monitor and control access to system modules in accordance withappropriate guidelines in order to ensure safeguarding of assets, and are inthe process of implementing such preventative controls at the system andprocedural levels. In addition, we have implemented detective controls such asthe enhanced review of accounting transactions and financial statements.

We continue to take remedial steps to strengthen ourinternal controls and enhance our reporting processes. We will also addressitems that have been or may be identified through our internal controlsassessment under Section 404 of the Sarbanes-Oxley Act of 2002 and relatedwork, which is continuing.

In connection with the requirements of Section 404of the Sarbanes-Oxley Act of 2002, we continue the process of documenting andtesting our systems of internal controls over financial reporting in order toprovide the basis for our evaluation and report on our system of internalcontrol over financial reporting as of the end of our fiscal year. However, thefocused application of critical resources on our separate and on-goingaccounting review in connection with the restatement of our financialstatements is havinga significant impact on our Section 404 compliance efforts. Moreover, ouron-going accounting review has resulted in some, and may result in further,remediation efforts with respect to some of our accounting processes, inparticular with regard to cost capitalization and project accounting.

This Form 10-Kdoes not include the report on management’s assessment of theeffectiveness of internal control over financial reporting or the relatedattestation reports of our independent registered public accounting firm, KPMGLLP, as required by Section 404 of the Sarbanes-Oxley Act.We intend to file an amendment to the Form 10-K that includes suchreports within 45 days of the initial filingdeadline for this Form 10-K. We currently expect that on or before May 2,2005 we will file an amendment to our Form 10-K to include bothmanagement’s assessment of internal controls over financial reporting and therelated attestation reports of our independent registered public accountants. Giventhe time requirements necessary to test our processes, there can be noassurance that there will be sufficient time and resources available for us tobe fully compliant with the requirements relating to internal controls overfinancial reporting and other aspects of Section 404 by May 2, 2005.Additionally, due to the nature of and the time necessary to effectivelyremediate the deficiencies identified, these issues were not being effectivelyremediated as of December 31, 2004, the date of our assessment of internalcontrol over financial reporting. As a result, based on the material weaknessesidentified, it is currently anticipated that management’s assessment and KPMG’sReport will conclude that the Company’s internal control over financialreporting was not effective as of December 31, 2004.

Our current management,with the participation of our principal executive officer and principalfinancial officer, carried out a separate evaluation of the effectiveness ofour disclosure controls and procedures (as defined in Rules 240.13a-15(e) and240.15d-15(e) of the Securities Exchange Act of 1934) 

55

----

as of December 31, 2004, which included an evaluation ofdisclosure controls and procedures applicable to the period covered by thefiling of this periodic report. As noted above, we have identified a number ofareas for improvement in our internal controls and procedures, as they existedas of December 31, 2004. Based on the evaluation of the effectiveness ofour disclosure controls and procedures as of December 31, 2004, andsubject to the information set forth in this Item 9A, our principal executiveofficer and principal financial officer have concluded that our disclosurecontrols and procedures were not effective based on the matters described inthis Item 9A. However, subsequent to December 31, 2004, and up to thefiling date of this report, we implemented a detailed review and analysis ofour accounting records, including a reconstruction of certain accountingrecords,****in support of thefinancial statements contained herein utilizing consultants with expertise inaccounting under the direction of new financial management. As internal controlissues have been identified, management has taken steps to remediate suchmatters. If additional internal control issues come to light, managementintends to address them promptly.

Other than as describedabove, since the evaluation date by our management of its internal controls,management does not believe there have been any changes in the internal controlover financial reporting that have materially affected or are reasonably likelyto materially affect our internal control over financial reporting.

As described above, wecurrently are designing and implementing new controls to address the weaknessesidentified in our internal controls and procedures. Notwithstanding theseimprovements, our internal controls and procedures may not be capable ofpreventing all instances of error or fraud. Any control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are knowledge andresource constraints in any such system, and a large number of complexpermutations of facts, circumstances, accounting policies, proceduralimplications and business practices that must be considered. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and breakdowns can occur because ofsimple error or mistake. Additionally, controls can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the controls. The design of any system of controls alsois based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Over time, the controlsystems we develop may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

The certifications ofour principal executive officer and the principal financial officer required inaccordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attachedas exhibits to this Form 10-K. The disclosures set forth in thisItem 9A contain information concerning the evaluation of our disclosurecontrols and procedures, and changes in internal control over financialreporting, referred to in paragraph 4 of the certifications. This Item 9Ashould be read in conjunction with the officer certifications for a morecomplete understanding of the topics presented.

56

----

**PART III**

Certain informationrequired by Part III is omitted from this Annual Report on Form 10-Kin that we will file the Proxy Statement no later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K, andcertain information included therein is incorporated by reference into Part IIIof this Annual Report on Form 10-K.

**ITEM 10:   DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the captions “Election of Directors,” “Meetings andCommittees of the Board of Directors,” “Relationships Among Directors orExecutive Officers,” “Management,” “Report of the Nominating Committee of theBoard of Directors,” “Report of the Corporate Governance Committee of the Boardof Directors,” and “Section 16(a) Beneficial Ownership ReportingCompliance.”

**ITEM 11:   EXECUTIVE COMPENSATION**

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the captions “Director Compensation,” “CompensationCommittee Interlocks and Insider Participation,” and “Executive Compensation.”

**ITEM 12:   SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the captions “Security Ownership of Certain BeneficialOwners and Management” and “Equity Compensation Plan Information.”

**ITEM 13:   CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the caption “Certain Relationships and RelatedTransactions.”

**ITEM 14:   PRINCIPAL ACCOUNTING FEES AND SERVICES**

The information requiredby this item is incorporated herein by reference to the information in theProxy Statement under the caption “Audit Fees and Non-Audit Fees.”

**ITEM 15:   EXHIBITS, FINANCIAL STATEMENTSCHEDULES, AND REPORTS ON FORM 8-K**

**(a)(1) Financial Statements**

The followingfinancial statements are set forth on pages F-1 to F-36 attached to theAnnual Report on Form 10-K filed with Securities and Exchange Commissionon March 31, 2005:

(i)             Report of Independent Registered PublicAccounting Firm

(ii)         Consolidated BalanceSheets as of December 31, 2004 and 2003 (restated)

(iii)     Consolidated Statements ofOperations for the years ended December 31, 2004, 2003 (restated) and 2002

(iv)       Consolidated Statements ofStockholders’ Equity for the years ended December 31, 2004, 2003(restated) and 2002

(v)           Consolidated Statementsof Cash Flows for the years ended December 31, 2004, 2003 (restated) and2002

57

----

(vi)       Notes to ConsolidatedFinancial Statements

**(a)(2) FinancialStatement Schedules**

All schedules havebeen omitted since they are not required or are not applicable or the requiredinformation is shown in the financial statements or related notes.

**(a)(3) Exhibits**
| Exhibit   Number       | ** ** | **Document**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     2.1 |       | Asset Purchase Agreement among Polaroid Corporation,  Polaroid ID Systems, Inc. and Digimarc Corporation (incorporated by  reference to Exhibit 2.1 to the Registrant’s Current Report on  Form 8-K, as filed with the Securities and Exchange Commission on  January 3, 2002)                                                                                                                                                                                                                                                                                |
|     3.1 |       | Second Amended and  Restated Certificate of Incorporation of the Registrant (incorporated by  reference to Exhibit 3.1 to the Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on November 14,  2000)                                                                                                                                                                                                                                                                                                             |
|     3.2 |       | Certificate of Amendment  of Second Amended and Restated Certificate of Incorporation of the Registrant  (incorporated by reference to Exhibit 3.2 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on November 14, 2000)                                                                                                                                                                                                                                                                                 |
|     3.3 |       | Amended and Restated  Bylaws of the Registrant, as amended (incorporated by reference to  Exhibit 3.3 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 15, 2004)                                                                                                                                                                                                                                                                                                                                     |
|     3.4 |       | Certificate of  Designation of the Series A Preferred Stock of Digimarc Corporation  (incorporated by reference to Exhibit 3.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on November 17, 2004)                                                                                                                                                                                                                                                                                                   |
|     4.1 |       | Reference is made to  Exhibits 3.1, 3.2 and 3.3                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|     4.2 |       | Second Amended and  Restated Investor Rights Agreement, dated as of November 2, 1999,  between the Registrant and the holders of the Registrant’s preferred stock  (incorporated by reference to Exhibit 4.2 to the Registrant’s  Registration Statement on Form S-1 (Commission File No. 333-87501)  which became effective on December 2, 1999)                                                                                                                                                                                                   |
|     4.3 |       | Rights Agreement, dated  as of November 16, 2004, between Digimarc Corporation and EquiServe  Trust Company, N.A. together with: Exhibit A Form of Rights  Certificate; Exhibit B Form of Summary of Rights to Purchase  Preferred Stock; and Exhibit C Form of Certificate of Designation  of the Series A Preferred Stock of Digimarc Corporation (incorporated by reference to Exhibit 4.1  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on November 17, 2004) |
|   10.1            |       | Form of  Indemnification Agreement between the Registrant and each of its executive  officers and directors (incorporated by reference to Exhibit 10.1 to the  Registrant’s Registration Statement on Form S-1 (Commission File  No. 333-87501) which became effective on December 2, 1999)                                                                                                                                                                                                                                                              |
|   10.2            |       | Registrant’s 1995 Stock  Incentive Plan, as amended (incorporated by reference to Exhibit 99.1 to  the Registrant’s Registration Statement on Form S-8 (Commission  File No. 333-31114) which became effective on February 25,  2000)                                                                                                                                                                                                                                                                                                                    |
|   10.3            |       | Registrant’s Restated  1999 Stock Incentive Plan, as amended and restated on April 17, 2003  (incorporated by reference to Exhibit 10.3 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 15, 2004)                                                                                                                                                                                                                                                                                        |

58

----

 
|   10.4  |   | Form of Notice of  Stock Option Award and Stock Option Award Agreement for the Digimarc  Corporation 1999 Stock Incentive Plan (incorporated by reference to  Exhibit 99(d)(2) of the Company’s Schedule TO, as filed with the  Securities and Exchange Commission on February 16, 2001)                                                                                                 |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.5  |   | Registrant’s 1999  Employee Stock Purchase Plan, as amended and restated on February 19,  2004, including forms of agreements thereunder (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-115074) which became effective on  April 30, 2004)                                                       |
|   10.6  |   | Lease Agreement, dated  as of June 25, 1999, between the Registrant and Southplace Associates  LLC (incorporated by reference to Exhibit 10.8 to the Registrant’s  Registration Statement on Form S-1 (Commission File No. 333-87501)  which became effective on December 2, 1999)                                                                                                  |
|   10.7  |   | First Amendment to Lease  Agreement, dated as of February 17, 2000, between the Registrant and  Southplace Associates LLC (incorporated by reference to Exhibit 10.10 to  the Registrant’s Registration Statement on Form S-1 (Commission  File No. 333-32778) which was filed with the Securities and  Exchange Commission on March 17, 2000 and withdrawn on July 31,  2000) |
|   10.8  |   | CityPlex Towers Lease  Agreement, dated as of January 4, 2000, between the Registrant and Oral  Roberts University (incorporated by reference to Exhibit 10.11 to the  Registrant’s Registration Statement on Form S-1 (Commission File  No. 333-32778) which was filed with the Securities and Exchange  Commission on March 17, 2000 and withdrawn on July 31, 2000)         |
|   10.9  |   | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Macrovision Corporation (incorporated by reference to Exhibit 10.12 to  the Registrant’s Quarterly Report on Form 10-Q, as filed with the  Securities and Exchange Commission on November 14, 2000)                                                                                         |
|   10.10 |   | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Koninklijke Philips Electronics N.V. (incorporated by reference to  Exhibit 10.13 to the Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on November 14,  2000)                                                                           |
|   10.11 |   | Registrant’s 2000 Non-Officer  Employee Stock Incentive Plan, as amended and restated on February 19,  2004 (incorporated by reference to Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q, as filed with the Securities and  Exchange Commission on May 10, 2004)                                                                                                   |
|   10.12 |   | Registrant’s 1999 Non-Employee  Director Option Program, as amended and restated on March 10, 2004  (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on May 10, 2004)                                                                                                           |
|   10.13 |   | First Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.16 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                       |
|   10.14 |   | Second Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.17 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                      |
|   10.15 |   | Employment Agreement,  dated as of July 16, 2001, between the Registrant and Bruce Davis  (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on May 15, 2003)                                                                                                                          |
|   10.16 |   | Form of Warrant  (incorporated by reference to Exhibit 4.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on August 27, 2003)                                                                                                                                                                                                    |

59

----

 
|   10.17 |   | Purchase Agreement by and between the Registrant and  each of the purchasers whose names are set forth on the signature  pages thereof (incorporated by reference to Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on August 27, 2003)                  |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   10.18 |   | Form of  Notice of Stock Option Award and Stock Option Award Agreement for employees  under the Digimarc Corporation 1999 Stock Incentive Plan (incorporated by  reference to Exhibit 99(d)(2) of the Company’s Schedule TO, as  filed with the Securities and Exchange Commission on February 16, 2001)                      |
|   10.19 |   | Form of Restricted  Stock Agreement for the Digimarc Corporation 1999 Stock Incentive Plan  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on March 1, 2005)                                                               |
|   10.20 |   | Form of Stock  Option Award Agreement for the 1999 Non-Employee Director Option Program  adopted under the Digimarc Corporation 1999 Stock Incentive Plan (incorporated by reference to Exhibit 10.2  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on March 1, 2005) |
|   10.21 |   | Forms of Notice of Stock  Option Award and Stock Option Award Agreement for officers under the Digimarc  Corporation 1999 Stock Incentive Plan                                                                                                                                                                                                         |
|   10.22 |   | Full Service Lease,  dated March 22, 2004, by and between PS Business Parks, L.P., and the  Registrant                                                                                                                                                                                                                                                 |
|   21.1  |   | List of Subsidiaries  (incorporated by reference to Exhibit 21.1 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                                         |
|   23.1  |   | Consent of KPMG LLP,  Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                                    |
|   24.1  |   | Power of Attorney  (included on the signature page of this report)                                                                                                                                                                                                                                                                                |
|   31.1  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                                                           |
|   31.2  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                                                           |
|   32.1  |   | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                            |
|   32.2  |   | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                            |

 

60

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                          | DIGIMARC CORPORATION                                                                                                        |
|--------------------------|-----------------------------------------------------------------------------------------------------------------------------|
|                     | /s/  Michael McConnell                                                                                                      |
| Date: April 7, 2005 | Michael McConnell*Title: Chief Financial Officer (Duly Authorized Officer and Principal  Financial and Accounting Officer)* |

 

**POWER OF ATTORNEY**

KNOW ALL THESE PERSONS BY THESE PRESENTS, that eachperson whose signature appears below constitutes and appoints Bruce Davis andMichael McConnell and each of them, jointly and severally, hisattorneys-in-fact, each with full power of substitution, for him in any and allcapacities, to sign any and all amendments to this Form 10-K, and to filethe same, with exhibits thereto and other documents in connection therewith,with the Securities and Exchange Commission, hereby ratifying and confirmingall that each said attorneys-in-fact or his substitute or substitutes, may door cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Form 10-Khas been signed below by the following persons on behalf of the registrant andin the capacities and on the dates indicated:
|                          | **Signature** | ** **                                            | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|-------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  Bruce Davis         |          | Chief Executive Officer  and Chairman of              |       | April 7,  2005 |
| Bruce Davis              |          | the Board of Directors (Principal  Executive Officer) |       |                |
| /s/  Paul Gifford        |          | President and Chief Operating  Officer                |       | April 7,  2005 |
| Paul Gifford             |          |                                                  |       |                |
| /s/  Michael McConnell   |          | Chief Financial Officer  and Treasurer                |       | April 7,  2005 |
| Michael McConnell        |          | (Principal Financial and Accounting Officer)          |       |                |
| /s/  Robert Chamness     |          | Chief Legal Officer and  Secretary                    |       | April 7,  2005 |
| Robert Chamness          |          |                                                  |       |                |
| /s/  Philip Monego, Sr.  |          | Director                                              |       | April 7,  2005 |
| Philip  Monego, Sr. |          |                                                  |       |                |
| /s/  Brian J. Grossi     |          | Director                                              |       | April 7,  2005 |
| Brian J. Grossi          |          |                                                  |       |                |

61

----

 
| /s/ Peter Smith       |   | Director |   | April 7,  2005 |
|-----------------------|--------|----------|--------|---------------------|
| Peter Smith           |   |     |   |                |
| /s/  Alty van Luijt   |   | Director |   | April 7,  2005 |
| Alty van Luijt        |   |     |   |                |
| /s/  Jim Roth         |   | Director |   | April 7,  2005 |
| Jim Roth              |   |     |   |                |
| /s/  James Richardson |   | Director |   | April 7,  2005 |
| James Richardson      |   |     |   |                |

 

 

62

----

 

**DIGIMARCCORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**
|                                                                 | ** ** | **Page** |
|-----------------------------------------------------------------|------------|----------|
| Report  of Independent Registered Public Accounting Firm        |       | F-2      |
| Consolidated  Balance Sheets                                    |       | F-3      |
| Consolidated  Statements of Operations                          |       | F-4      |
| Consolidated  Statements of Stockholders’ Equity (Deficit) |       | F-5      |
| Consolidated  Statements of Cash Flows                          |       | F-6      |
| Notes  to Consolidated Financial Statements                     |       | F-7      |

 

F-1

----

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of DirectorsandStockholders of Digimarc Corporation:

We have audited the accompanying consolidated balancesheets of Digimarc Corporation and subsidiaries as of December 31, 2004and 2003, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2004. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Digimarc Corporation and subsidiaries as of December 31, 2004and 2003, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2004 in conformitywith U.S. generally accepted accounting principles.

As indicated in Note 2 to the consolidated financialstatements, the Company has restated its consolidated financial statements asof and for the year ended December 31, 2003.

DigimarcCorporation has not reported on, and we have not audited the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2004.  Accordingly, we do not express anopinion or any other form of assurance on the effectiveness of DigimarcCorporation’s internal control over financial reporting as of December 31,2004.

/s/ KPMG LLP

Portland, OregonApril 6, 2005

 

F-2

----

**DIGIMARCCORPORATIONCONSOLIDATED BALANCE SHEETS(In thousands, except share and per share data)**
| ** **                                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | ** **            | ** ** | **Restated**          | ** ** |
| **ASSETS**                                                                                                                                                                                                    |       |                  |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                                                               |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                     |       |                  | $          | 18,489                |       |   |   | $ | 33,626 |   |   |
| Restricted cash                                                                                                                                                                                               |       |                  | —     |                  |       |   | 1,976 |   |   |
| Short-term investments                                                                                                                                                                                        |       |                  | 25,068     |                  |       |   | 43,031 |   |   |
| Trade accounts receivable, net                                                                                                                                                                                |       |                  | 9,666      |                  |       |   | 9,168 |   |   |
| Unbilled trade receivables                                                                                                                                                                                    |       |                  | 5,008      |                  |       |   | 4,321 |   |   |
| Inventory, net                                                                                                                                                                                                |       |                  | 8,858      |                  |       |   | 6,253 |   |   |
| Other current assets                                                                                                                                                                                          |       |                  | 1,779      |                  |       |   | 2,052 |   |   |
| Total current assets                                                                                                                                                                                          |       |                  | 68,868     |                  |       |   | 100,427 |   |   |
| Restricted cash                                                                                                                                                                                               |       |                  | 8,279      |                  |       |   | — |   |   |
| Property and  equipment, net                                                                                                                                                                                  |       |                  | 63,975     |                  |       |   | 35,813 |   |   |
| Intangibles                                                                                                                                                                                                   |       |                  | 21,162     |                  |       |   | 23,698 |   |   |
| Other assets, net                                                                                                                                                                                             |       |                  | 1,003      |                  |       |   | 1,215 |   |   |
| Total assets                                                                                                                                                                                                  |       |                  | $          | 163,287               |       |   |   | $ | 161,153 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                 |       |                  |       |                  |       |   |   |   |   |
| Current  liabilities:                                                                                                                                                                                         |       |                  |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                              |       |                  | $          | 11,424                |       |   |   | $ | 6,584 |   |   |
| Accrued payroll and related costs                                                                                                                                                                             |       |                  | 2,161      |                  |       |   | 1,069 |   |   |
| Deferred revenue                                                                                                                                                                                              |       |                  | 4,854      |                  |       |   | 3,160 |   |   |
| Other current liabilities                                                                                                                                                                                     |       |                  | 1,492      |                  |       |   | 304 |   |   |
| Total current liabilities                                                                                                                                                                                     |       |                  | 19,931     |                  |       |   | 11,117 |   |   |
| Other long-term  liabilities                                                                                                                                                                                  |       |                  | 1,112      |                  |       |   | 1,286 |   |   |
| Total liabilities                                                                                                                                                                                             |       |                  | 21,043     |                  |       |   | 12,403 |   |   |
| Commitments and  contingencies (Note 9)                                                                                                                                                                       |       |                  |       |                  |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                                                                                   |       |                  |       |                  |       |   |   |   |   |
| Common stock,  $0.001 par value; 100,000,000 shares authorized at December 31, 2004 and  2003; issued and outstanding 20,453,429 and 20,129,846 shares at December 31,  2004 and 2003, respectively |       |                  | 21         |                  |       |   | 20 |   |   |
| Additional  paid-in capital                                                                                                                                                                                   |       |                  | 206,979    |                  |       |   | 203,634 |   |   |
| Warrant                                                                                                                                                                                                       |       |                  | —     |                  |       |   | 881 |   |   |
| Accumulated other  comprehensive income                                                                                                                                                                       |       |                  | 147        |                  |       |   | 96 |   |   |
| Accumulated  deficit                                                                                                                                                                                          |       |                  | (64,903    | )                     |       |   | (55,881 | ) |   |
| Total stockholders’ equity                                                                                                                                                                               |       |                  | 142,244    |                  |       |   | 148,750 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                              |       |                  | $          | 163,287               |       |   |   | $ | 161,153 |   |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**DIGIMARCCORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)**
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                        | ** ** | ** **                                 | ** ** | **Restated** | ** ** | ** ** | ** ** |
| Revenue:                                          |       |                                       |       |   |   |   |   |   |   |
| Service                                           |       | $                                          | 73,919     |   |   | $ | 71,588 |   |   | $ | 67,149 |   |
| Product and subscription                          |       | 19,028                                     |       |   | 14,003 |   |   | 19,468 |   |
| Total revenue                                     |       | 92,947                                     |       |   | 85,591 |   |   | 86,617 |   |
| Cost of revenue:                                  |       |                                       |       |   |   |   |   |   |   |
| Service                                           |       | 45,663                                     |       |   | 39,412 |   |   | 39,596 |   |
| Product and subscription                          |       | 11,784                                     |       |   | 7,524 |   |   | 12,354 |   |
| Total cost of revenue                             |       | 57,447                                     |       |   | 46,936 |   |   | 51,950 |   |
| Gross profit                                      |       | 35,500                                     |       |   | 38,655 |   |   | 34,667 |   |
| Operating  expenses:                              |       |                                       |       |   |   |   |   |   |   |
| Sales and marketing                               |       | 11,919                                     |       |   | 11,854 |   |   | 14,235 |   |
| Research, development and engineering             |       | 7,229                                      |       |   | 7,137 |   |   | 10,391 |   |
| General and administrative                        |       | 25,863                                     |       |   | 19,733 |   |   | 19,277 |   |
| Restructuring charges, net                        |       | —                                     |       |   | — |   |   | 493 |   |
| Total operating expenses                          |       | 45,011                                     |       |   | 38,724 |   |   | 44,396 |   |
| Operating loss                                    |       | (9,511                                     | )          |   | (69 | ) |   | (9,729 | ) |
| Other income  (expense):                          |       |                                       |       |   |   |   |   |   |   |
| Interest income                                   |       | 905                                        |       |   | 687 |   |   | 1,035 |   |
| Interest expense                                  |       | (104                                       | )          |   | (14 | ) |   | (51 | ) |
| Other                                             |       | 53                                         |       |   | (106 | ) |   | 56 |   |
| Total other income, net                           |       | 854                                        |       |   | 567 |   |   | 1,040 |   |
| Income (loss)  before provision for income taxes  |       | (8,657                                     | )          |   | 498 |   |   | (8,689 | ) |
| Provision for  income taxes                       |       | (365                                       | )          |   | (323 | ) |   | — |   |
| Net income (loss)                                 |       | $                                          | (9,022     | ) |   | $ | 175 |   |   | $ | (8,689 | ) |
| Net income (loss) per share—basic            |       | $                                          | (0.44      | ) |   | $ | 0.01 |   |   | $ | (0.50 | ) |
| Net income (loss)  per share—diluted         |       | $                                          | (0.44      | ) |   | $ | 0.01 |   |   | $ | (0.50 | ) |
| Weighted average shares outstanding—basic    |       | 20,326                                     |       |   | 18,572 |   |   | 17,361 |   |
| Weighted average  shares outstanding—diluted |       | 20,326                                     |       |   | 19,351 |   |   | 17,361 |   |

 

See accompanying notes to consolidated financial statements.

F-4

----

**DIGIMARCCORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**
| ** **                                                                      | ** ** | **Common stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred  stock** | ** ** | ** **       | ** ** | **Accumulated** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Total  stockholders’** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------|------------|------------------|------------|-----------------|------------|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**         | ** ** | **compensation** | ** ** | **Warrant**     | ** ** | **Deficit**                                   | ** ** | **(loss)**                    | ** ** | **equity** | ** ** |
| **BALANCE AT DECEMBER 31, 2001**                                           |       | 17,020,818            |       |                    | $          | 17                  |       |             |       | $               | 173,443    |                                          |       |                          | $          | (3,294 | ) |   |   | $ | 675 |   |   |   | $ | (47,367 | ) |   |   | $ | — |   |   |   | $ | 123,474 |   |   |
| Exercise of stock options                                                       |       | 535,526               |       |                    | 1          |                |       |             | 1,796      |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,797 |   |   |
| Purchase of employee stock purchase plan shares                                 |       | 84,354                |       |                    | —     |                |       |             | 897        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 897 |   |   |
| Stock-based compensation expense                                                |       | —                |       |                    | —     |                |       |             | (134       | )               |       |                                          | 1,962      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,828 |   |   |
| Foreign currency translation loss                                          |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | (43 | ) |   |   | (43 | ) |   |
| Net loss                                                                        |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | (8,689 | ) |   |   | — |   |   |   | (8,689 | ) |   |
| **BALANCE AT DECEMBER 31, 2002**                                           |       | 17,640,698            |       |                    | 18         |                |       |             | 176,002    |            |       |                                          | (1,332     | )                             |       |   | 675 |   |   |   | (56,056 | ) |   |   | (43 | ) |   |   | 119,264 |   |   |
| Exercise of stock options                                                       |       | 622,108               |       |                    | —     |                |       |             | 3,567      |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 3,567 |   |   |
| Purchase of employee stock purchase plan shares                                 |       | 81,044                |       |                    | —     |                |       |             | 862        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 862 |   |   |
| Issuance of common stock and warrants through  private placement, net |       | 1,785,996             |       |                    | 2          |                |       |             | 22,569     |            |       |                                          | —     |                          |       |   | 881 |   |   |   | — |   |   |   | — |   |   |   | 23,452 |   |   |
| Expired warrants and options issued to non-employees                            |       | —                |       |                    | —     |                |       |             | 675        |            |       |                                          | —     |                          |       |   | (675 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock-based compensation expense                                                |       | —                |       |                    | —     |                |       |             | (41        | )               |       |                                          | 1,332      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,291 |   |   |
| Foreign currency translation gain                                          |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | 139 |   |   |   | 139 |   |   |
| Net income (restated)                                                           |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | 175 |   |   |   | — |   |   |   | 175 |   |   |
| **BALANCE AT DECEMBER 31, 2003 (restated)**                                |       | 20,129,846            |       |                    | 20         |                |       |             | 203,634    |            |       |                                          | —     |                          |       |   | 881 |   |   |   | (55,881 | ) |   |   | 96 |   |   |   | 148,750 |   |   |
| Exercise of stock options                                                       |       | 160,622               |       |                    | 1          |                |       |             | 679        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 680 |   |   |
| Purchase of employee stock purchase plan shares                                 |       | 48,455                |       |                    | —     |                |       |             | 468        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 468 |   |   |
| Issuance of common stock and warrants through  private placement, net |       | 74,506                |       |                    | —     |                |       |             | 969        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 969 |   |   |
| Issuance of common stock for litigation settlement                              |       | 40,000                |       |                    | —     |                |       |             | 348        |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 348 |   |   |
| Conversion and expiration of warrants                                           |       | —                |       |                    | —     |                |       |             | 881        |            |       |                                          | —     |                          |       |   | (881 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Foreign currency translation gain                                          |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | 51 |   |   |   | 51 |   |   |
| Net loss                                                                        |       | —                |       |                    | —     |                |       |             | —     |            |       |                                          | —     |                          |       |   | — |   |   |   | (9,022 | ) |   |   | — |   |   |   | (9,022 | ) |   |
| **BALANCE  AT DECEMBER 31, 2004**                                          |       | 20,453,429            |       |                    | $          | 21                  |       |             |       | $               | 206,979    |                                          |       |                          | $          | — |   |   |   | $ | — |   |   |   | $ | (64,903 | ) |   |   | $ | 147 |   |   |   | $ | 142,244 |   |   |

 

See accompanying notes to consolidated financial statements.

F-5

----

**DIGIMARCCORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands, except share and per share data)**
| ** **                                                                                           | ** ** | **Twelve Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                           | ** ** | **December 31,  2004**       | ** ** | **December 31,  2003** | ** ** | **December 31,  2002** | ** ** |
| ** **                                                                                           | ** ** | **Restated**                      | ** ** |
| Cash flows from operating  activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                                    |       |                              | $          | (9,022 | ) |   |   | $ | 175 |   |   |   | $ | (8,689 | ) |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                                        |       |                              | 13,490     |   |   |   | 10,780 |   |   |   | 9,058 |   |   |
| Stock-based compensation expense                                                                     |       |                              | —     |   |   |   | 1,291 |   |   |   | 1,828 |   |   |
| Impairment of investments                                                                            |       |                              | 465        |   |   |   | — |   |   |   | — |   |   |
| Issuance of common stock for litigation settlement                                                   |       |                              | 348        |   |   |   | — |   |   |   | — |   |   |
| Increase (decrease) in allowance for doubtful  accounts                                              |       |                              | 263        |   |   |   | (171 | ) |   |   | (654 | ) |   |
| Other non-cash charges                                                                               |       |                              | 703        |   |   |   | 379 |   |   |   | 261 |   |   |
| Changes  in operating assets and liabilities:                                                        |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Restricted cash                                                                                      |       |                              | (6,303     | ) |   |   | 13,726 |   |   |   | (15,702 | ) |   |
| Trade and unbilled accounts receivable, net                                                          |       |                              | (1,448     | ) |   |   | 1,815 |   |   |   | 1,021 |   |   |
| Inventory, net                                                                                       |       |                              | (2,605     | ) |   |   | (1,162 | ) |   |   | 587 |   |   |
| Other current assets                                                                                 |       |                              | 273        |   |   |   | 1,055 |   |   |   | (827 | ) |   |
| Other assets, net                                                                                    |       |                              | (253       | ) |   |   | (309 | ) |   |   | (651 | ) |   |
| Accounts payable                                                                                     |       |                              | 4,840      |   |   |   | (1,424 | ) |   |   | 4,604 |   |   |
| Accrued payroll and related costs                                                                    |       |                              | 1,092      |   |   |   | (318 | ) |   |   | 222 |   |   |
| Deferred revenue                                                                                     |       |                              | 1,694      |   |   |   | (572 | ) |   |   | 3,241 |   |   |
| Other liabilities                                                                                    |       |                              | 1,142      |   |   |   | 57 |   |   |   | (221 | ) |   |
| Net cash provided by (used in) operating activities                                                  |       |                              | 4,679      |   |   |   | 25,322 |   |   |   | (5,922 | ) |   |
| Cash flows from investing  activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Purchase of property and equipment                                                                   |       |                              | (27,247    | ) |   |   | (7,402 | ) |   |   | (12,277 | ) |   |
| Capitalization of labor costs                                                                        |       |                              | (12,444    | ) |   |   | (6,609 | ) |   |   | (7,792 | ) |   |
| Long-term investments                                                                                |       |                              | —     |   |   |   | — |   |   |   | (300 | ) |   |
| Sale or maturity of short-term investments                                                           |       |                              | 193,355    |   |   |   | 39,786 |   |   |   | 43,655 |   |   |
| Purchase of short-term investments                                                                   |       |                              | (175,392   | ) |   |   | (63,027 | ) |   |   | (15,064 | ) |   |
| Net cash provided by (used in) investing activities                                                  |       |                              | (21,728    | ) |   |   | (37,252 | ) |   |   | 8,222 |   |   |
| Cash flows from financing  activities:                                                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Net proceeds from issuance of common stock                                                           |       |                              | 2,117      |   |   |   | 27,881 |   |   |   | 2,694 |   |   |
| Principal payments under capital lease obligations                                                   |       |                              | (205       | ) |   |   | (7 | ) |   |   | (536 | ) |   |
| Net cash provided by financing activities                                                            |       |                              | 1,912      |   |   |   | 27,874 |   |   |   | 2,158 |   |   |
| Net increase (decrease) in cash and cash equivalents                                                 |       |                              | (15,137    | ) |   |   | 15,944 |   |   |   | 4,458 |   |   |
| Cash and cash equivalents at beginning of year                                                       |       |                              | 33,626     |   |   |   | 17,682 |   |   |   | 13,224 |   |   |
| Cash and cash equivalents at end of year                                                             |       |                              | $          | 18,489 |   |   |   | $ | 33,626 |   |   |   | $ | 17,682 |   |   |
| Supplemental  disclosure of cash flow information:                                                   |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Cash paid for interest                                                                               |       |                              | $          | 104 |   |   |   | $ | 14 |   |   |   | $ | 51 |   |   |
| Cash paid for income taxes                                                                           |       |                              | $          | 400 |   |   |   | $ | 136 |   |   |   | $ | — |   |   |
| Summary of non-cash  investing and financing activities:                                             |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Equipment acquired  or exchanged under capital lease obligations                                |       |                              | $          | 77 |   |   |   | $ | 1,464 |   |   |   | $ | — |   |   |

 

See accompanying notes to consolidated financial statements.

F-6

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share data)**

**(1)**   Description of Business and Summary ofSignificant Accounting Policies

*Description ofBusiness*

Digimarc Corporation (“Digimarc” or the “Company”) isa leading supplier of secure personal identification systems. The Company andits affiliates supply the issuance systems for the majority of driver licensesproduced in the United States and provide all or part of the issuance systemsfor national identifications, voter identifications, and driver licenses inmore than 20 non-U.S. countries.

The Company is also a leading provider of patenteddigital watermarking technologies that allow imperceptible digital codes to beembedded in all forms of media content, including photographs, movies, music,financial instruments, personal identification documents, and product packages.The embedded codes within various types of media content can be detected andread by software or hardware detectors in personal computers and other digitalprocessing devices.

In December, 2001, theCompany, through its wholly-owned subsidiary, Digimarc ID Systems, LLC andcertain of that subsidiary’s wholly-owned subsidiaries, acquired the assets andassumed certain redundant liabilities of the U.S. large government programsidentification systems and international digital identification systemsbusinesses of Polaroid Corporation and certain other affiliated entities ofPolaroid Corporation (collectively known as the Large Government ProgramIdentification Business, or “LGP”). The acquisition was accounted for using thepurchase method of accounting.

*Use of Estimates*

The preparation ofconsolidated financial statements in accordance with U.S. generally acceptedaccounting principles requires Digimarc to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenue and expenses, andrelated disclosure of contingent assets and liabilities. Certain of the Company’saccounting policies require higher degrees of judgment than others in theirapplication. These include revenue recognition on long-term service contracts,impairments and estimation of useful lives of long-lived assets, inventoryvaluation, reserves for uncollectible accounts receivable, and contingenciesand litigation. Digimarc bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

*Reclassifications*

Certain prior year amountsin the accompanying consolidated financial statements and notes thereon havebeen reclassified to conform to current year presentation. Thesereclassifications had no material effect on the results of operations orfinancial position for any year presented. These reclassifications include the reclassificationof market auction preferred investments from cash equivalents to short-terminvestments.

*Principles ofConsolidation*

The consolidated financialstatements include the accounts of Digimarc and its wholly-owned subsidiaries.All significant intercompany transactions and balances have been eliminated.

F-7

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

*Cash Equivalents*

The Company considers allhighly liquid investments with original maturities of 90 days or less atthe date of acquisition to be cash equivalents. Cash equivalents include moneymarket funds, certificates of deposit, commercial paper, and investments ingovernment bonds totaling $11,606 and $29,509 at December 31, 2004 and2003, respectively. Cash equivalents are carried at cost or amortized cost,which approximates market.

*Restricted Cash*

Restricted cash of $8,279and $1,976 at December 31, 2004 and 2003, respectively, consists of cashand cash equivalents that are held as a guarantee for certain performance bondobligations that the Company is obligated to maintain in connection with someof the Company’s long-term contracts in the Company’s personal identificationsystems business. The Company supports the performance bonds with letters ofcredit, which may or may not require restricted cash. Due to the lossesincurred through the second quarter and the losses that were expected for theyear at that time, the Company was required to increase its restricted cashduring the fourth quarter. The letters of credit must be renewed yearly if theyare expected to continue, and therefore the need for restricted cash is renewedyearly. However, the Company’s banks have required the Company to restrict thiscash until it returns to profitability for one year. Accordingly, restrictedcash is classified as a non-current asset.

*Investments*

The Company considers all investments with originalmaturities over 90 days that mature in less than one year to be short-terminvestments. Short-term investments include federal agency notes, company notes,and commercial paper. The Company’s marketable securities are generallyclassified as held-to-maturity as of the balance sheet date and are reported atamortized cost, which approximates market. The Company also holds marketauction preferred investments in its portfolio, which are classified asavailable-for-sale. The book value of these investments approximates fairmarket value and, accordingly, no amounts have been recorded to othercomprehensive income.

A decline in the market value of any security belowcost that is deemed to be other-than-temporary results in a reduction incarrying amount to fair value. The impairment is charged to earnings and a newcost basis for the security is established. To determine whether an impairmentis other-than-temporary, the Company considers whether it has the ability andintent to hold the investment until a market price recovery and considerswhether evidence indicating the cost of the investment is recoverable outweighsevidence to the contrary. There have been no other-than-temporary impairmentsidentified or recorded by the Company.

Premiums and discounts areamortized or accreted over the life of the related security as an adjustment toyield using a method that approximates the effective-interest method. Dividendand interest income are recognized when earned.

F-8

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

*Fair Value ofFinancial Instruments*

The carrying amounts ofcash and cash equivalents, short-term investments, trade accounts receivable,accounts payable and accrued payroll approximate fair value due to theshort-term nature of these instruments. The carrying amounts of capital leasesapproximate fair value as the stated interest rates approximate current marketrates. Fair value estimates are made at a specific point in time, based onrelevant market information about the financial instrument when available.These estimates are subjective in nature and involve uncertainties and mattersof significant judgment and, therefore, cannot be determined with precision.Changes in assumptions could significantly affect the estimates.

*Concentrations ofBusiness and Credit Risk*

A significant portion of the Company’s business dependson a limited number of large public sector contracts, typically departments ofmotor vehicles for various states within the United States. Governmentcontracts are generally subject to termination for convenience or lack ofappropriation at the determination of the subject agency.

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of cash and cashequivalents, restricted cash, investments, trade and unbilled accountsreceivables. The Company places its cash and cash equivalents with major banksand financial institutions. The Company’s investment policy limits its creditexposure to any one financial institution or type of financial instrument. As aresult, the credit risk associated with cash and investments is minimal. TheCompany had no customer which accounted for more than 10% of trade and unbilledaccounts receivable at December 31, 2004 or 2003.

The Company is dependenton a limited number of third parties to produce systems or components necessaryfor the Company to produce some of its products. While the Company strives tohave alternative suppliers provide it with many of its products, a loss of oneor more of such suppliers could have a material adverse effect on the Company’sability to perform effectively, if at all, for some of its long-term contracts.

*Trade AccountsReceivable*

Trade accounts receivableare recorded at the invoiced amount and do not bear interest. Revenue earnedwhich has not been invoiced is classified as unbilled trade receivables in theconsolidated balance sheets. The allowance for doubtful accounts is the Company’sbest estimate of the amount of probable credit losses in the Company’s existingaccounts receivable. The Company determines the allowance based on historicalwrite-off experience and current information. The Company reviews its allowancefor doubtful accounts monthly. Account balances are charged off against theallowance after all means of collection have been exhausted and the potentialfor recovery is considered remote. The Company does 

F-9

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description of Business and Summary of Significant AccountingPolicies (Continued)

not have anoff-balance sheet credit exposure related to its customers. The amount of theallowance and the charges were as follows:
| ** **                        | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Balance—beginning  of period |       | $          | 53         |     | $          | 224      |       | $ | 878 |   |
| Provision  (recovery)             |       | 263        |       | (96      | )          | (154     | )          |
| Charge offs                       | ** ** | **—** |       | (75      | )          | (500     | )          |
| Balance—end of  period       |       | $          | 316        |     | $          | 53       |       | $ | 224 |   |

 

*Inventories*

Inventoriesconsist of consumable materials which may be sold or held for future consumptionin long-term identification and driver license production contracts using aprice-per-card method and equipment and other deferred contract costs pursuantto specific identification and driver license production contracts which areexpected to be fulfilled in the next twelve months.
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Equipment and  deferred contract costs |       | 1,033    |       | 849      |       |
| Consumable  materials                  |       | 7,825    |       | 5,404    |       |
| Inventory, net                         |       | 8,858    |       | 6,253    |       |

 

Inventoriesare valued on a first-in, first-out basis at the lower of cost or market value(net realizable value). The Company’s policy for valuation of inventory,including the determination of obsolete or excess inventory and lower of costor market reserves, requires it to estimate the future demand for its products,either for sale or consumption in long-term production contracts. Ifinventories are considered to be in excess of or unsuitable for thoserequirements, the Company estimates market value based on potential sales valueor alternative uses in production. The reserve for slow moving and obsoleteitems was $271 and $70 at December 31, 2004 and December 31, 2003respectively. Changes in contract requirements, technology, or marketconditions could significantly affect these estimates and result in additionalinventory allowances, which could have an adverse effect on our results ofoperations. During 2004 the Company recorded a provision for excess andobsolete inventory based on changes in market conditions, sales orders,expected sales volumes, and technology advances. The provision was recorded inthe period the circumstances occurred or were identified. The activity in the inventoryreserve is as follows:
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  Beginning of Period        |       | $        | 70         |     | $          | 330      |       | $ | — |   |
| Charges to Provision  for Obsolescence |       | 726      |       | 75       |       | 330      |       |
| Deductions  against Balance            |       | (525     | )          | (335     | )          | —   |       |
| Balance at End of  Period              |       | $        | 271        |     | $          | 70       |       | $ | 330 |   |

 

F-10

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

*Property andEquipment*

Property and equipment are stated at cost. Propertyand equipment under capital lease obligations are stated at the lower of thepresent value of minimum lease payments at the beginning of the lease term orfair value of the leased assets at the inception of the lease. Repairs andmaintenance are charged to expense when incurred.

Depreciation on propertyand equipment is calculated by the straight-line method over the estimateduseful lives of the assets, generally two to five years. Property and equipmentheld under capital leases are amortized by the straight-line method over theshorter of the lease term or the estimated useful life. Amortization ofproperty and equipment under capital lease is included in depreciation expense.Assets specifically used to provide services under long-term contracts aredepreciated over the shorter of the contract term or estimated useful life.

*Pre-contract Costs*

Costs related topre-contract activity are expensed as incurred in accordance with the AmericanInstitute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”)No. 98-5, *Reporting on the Costs ofStart-Up Activities*. The Company begins capitalizing costs when itreceives notification that a contract will be awarded.

*SoftwareDevelopment Costs*

Under Statement of Financial Accounting Standards (“SFAS”)No. 86, *Accounting for the Cost ofComputer Software to Be Sold, Leased, or Otherwise Marketed,*softwaredevelopment costs are to be capitalized beginning when a product’stechnological feasibility has been established and ending when a product ismade available for general release to customers. To date, the establishment oftechnological feasibility of the Company’s products has occurred shortly beforegeneral release and, therefore, software development costs qualifying forcapitalization have been immaterial. Accordingly, the Company has notcapitalized any software development costs and has charged all such costs toresearch and development expense.

Internal use softwaredevelopment costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred inthe preliminary project stage are expensed as incurred and costs incurred inthe application development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. Costs incurred in thepost-implementation stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to cardmanufacturing and control systems software.

*Intangible Assets*

Intangible assets relateto the value of customer relationships acquired when the Company purchased theassets of LGP and other technology and intellectual property rights. Customerrelationships are generally being amortized on a straight-line basis over anestimated useful life of 12 years and the other 

F-11

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

technology and intellectual property rights are beingamortized over an estimated useful life of five years. The useful life of the individualasset is evaluated and adjusted when warranted by changes in the contractualarrangement or other evidence indicates a change in useful life. The grossassets and accumulated amortization for intangibles are as follows:
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Gross intangible assets  |       | $        | 29,869     |     | $          | 29,869 |   |
| Accumulated amortization |       | (8,707   | )          | (6,171   | )          |
| Intangible assets,  net  |       | $        | 21,162     |     | $          | 23,698 |   |

 

Intangible assets arereviewed for impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable. The estimatedamortization of intangibles over the next five years is as follows:
| ** **                   | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Amortization of  intangibles |       | $        | 3,200      |     | $          | 2,000    |       | $        | 2,000      |     | $          | 2,000 |   | $ | 2,000 |   |
|                              |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

*Impairment ofLong-Lived Assets*

The Company accounts forlong-lived assets in accordance with the provisions of SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values,depending on the nature of the asset. Assets to be disposed of are reported atthe lower of the carrying amount or fair value less costs to sell. During 2004,the Company recorded impairment charges of $465 related to investments inearly-stage technology companies. These charges are reflected as sales andmarketing expenses in the consolidated statement of operations.

*Contingencies andFactors that Could Affect Future Results*

A portion of the Company’s revenue each year isgenerated from licensing of technology. In the competitive environment in whichthe Company operates, product generation, development and marketing processesrelating to technology are uncertain and complex, requiring accurate predictionof demand as well as successful management of various development risksinherent in technology development. In light of these dependencies, it ispossible that failure to successfully manage future changes in technology withrespect to the Company’s technology could have a long-term impact on theCompany’s growth and results of operations.

Our contracts fordriver license and other identification issuance systems and their relatedproducts typically include terms relating to supplier dependencies, time-basedperformance, development and 

F-12

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description of Business andSummary of Significant Accounting Policies (Continued)

delivery schedules and milestones, and other contract terms that maycreate situations where a customer may assert that we are late in meeting ourdelivery obligations and that we owe them late penalties, charges or otherdamages. Such provisions are common in large scale government contracts at thestate and federal levels. These contracts include installation, customeracceptance and testing, and other delivery and related procedures. Becauseprocedures often require compliance over extended periods of time, they giverise to an increased risk that we may fail to meet timing or other deliveryrequirements and milestones pursuant to the terms of such contracts. If wefailed to meet such requirements or milestones, customers may assert against uscompensatory or liquidated damages, breach of contract, or other claims. Fromtime to time, customers have given notice of their intention to assert claimsfor liquidated damages. For example, in the fourth quarter of 2004 and in thefirst quarter of 2005, customers provided notice that they may elect to assertliquidated damages under the terms of their respective contracts. Managementbelieves that these assertions are part of the resolution process involvingcommercial disagreements over the delivery terms of these contracts. Suchdisputes are not uncommon and tend to be resolved over time. To date, we havenot paid liquidated damages in connection with a dispute with a domestic customer.We recently elected to pay a minor amount in settlement of a liquidated damagesclaim in connection with our Mexican contract. While there is always risk thatliquidated damages could be assessed in the future, management does not believethat it is probable that material amounts will be paid, nor can we predict whatthe amount of any such damages would be if they were to be imposed. However,our failure to meet contractual milestones or other performance requirements aspromised could result in our having to incur increased costs, lower margins, orcompensatory obligations in addition to other losses, such as harm to ourreputation. Such unexpected increases in costs to meet our contractualobligations or any other requirements necessary to address claims and damageswith regard to our customer contracts could have a material adverse effect onour business and financial results. We anticipate that future contracts willcontinue to have such provisions unless and until industry practices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on such contracts inthe recent past. Such contracts involve greater financial risks because we bearthe risk if actual project costs exceed the amounts we are paid under thecontracts. A material percentage of our revenues are derived from fixed pricecontracts and our reliance on fixed price contracts may grow.

A significant portion of our business depends on a limited number oflarge, public-sector contracts, which are generally subject to termination forconvenience, as determined by the subject agency, or for lack of budgetaryappropriation provided for the subject agency. Some government contracts alsomay be one-time events, such as in the case of some personal identificationsystems in non-U.S. markets involving voter registration programs. In suchcases, we may generate substantial revenue that may not be subject to futurerenewal. Further, we may face competitive bids for a number of our majoraccounts in 2005 including California, Texas, Indiana, and Georgia. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations 

F-13

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

in appropriations cycles, and protests ofcontract awards. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain largerestricted cash reserves as a guarantee, reducing our ability to use thesefunds for our other business purposes. Even with the availability of such cashreserve guarantees, we may not be able to obtain such performance bondunderwriting at a favorable rate or at all. Our failure to be able to providesuch performance bonds may preclude our ability to bid on new governmentcontracts or maintain our existing contracts for the entirety of their fullterms. The size, nature and purpose of, and the risks and uncertaintiesassociated with, public sector contracts can potentially cause our quarterlyresults to fluctuate and anticipated revenue to decrease significantly.

*Revenue Recognition*

Revenue from the Company’s long-term identificationand driver’s license issuance systems is generated from the production ofcards. The Company recognizes revenue on these contracts based on the actualmonthly production, if available and in limited situations of estimated volumeinformation. When actual production information becomes available, typicallywithin one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Differences to date have not been significant. Revenue earned which has notbeen invoiced is classified as unbilled trade receivables in the consolidatedbalance sheets. Revenue related to an enhancement of or upgrade to an existingsystem is deferred and recognized over the remaining life of the contract.

Revenue for sales of consumables and equipment notrelated to a driver’s license production contract is recognized when theproducts have been shipped, ownership has been transferred, evidence of anarrangement exists, the sales price is fixed and determinable, andcollectibility is reasonably assured.

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. Progress towards completion is measured using costs incurredcompared to the budgeted amounts contained in the contract. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the consolidatedbalance sheets.

Royalty revenue is recognized when the royalty amountsowed to the Company have been earned, are determinable, and collection isprobable. Subscriptions are paid in advance and revenue is recognized ratablyover the term of the subscription.

Maintenance revenue is recognized when the maintenanceamounts owed to the Company have been earned, are determinable, and collectionis probable. Maintenance contracts are, at times, paid in advance and revenueis recognized ratably over the term of the service period.

Deferred revenue consists of payments received inadvance for professional services, subscriptions and hardware for which revenuehas not been earned.

F-14

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorizedduplication or alteration of high-value documents, for use in communicatingcopyright, asset management and business-to-business image commerce solutions,and for use in connecting analog media to a digital environment. Software revenueis recognized in accordance with AICPA SOP No. 97-2, as amended by AICPASOP No. 98-9, *Modification of SOP 97-2*,*With Respect to Certain Transactions*.Revenue for licenses of the Company’s software products is recognized upon theCompany meeting the following criteria: persuasive evidence of an arrangementexists; delivery has occurred; the vendor’s fee is fixed or determinable; andcollectibility is probable.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence exists only for undelivered elements. Under the residualmethod, revenue is recognized as follows: (1) the total fair value ofundelivered elements, as indicated by vendor specific objective evidence, isdeferred and subsequently recognized in accordance with the relevant sectionsof AICPA SOP No. 97-2, and (2) the difference between the totalarrangement fee and the amount deferred for the undelivered elements isrecognized as revenue related to the delivered elements.

Certaincustomer arrangements encompass multipledeliverables, such as hardwaresales, consumables sales, maintenance fees, and software development fees. TheCompany accounts for these arrangements in accordance with Emerging Issues TaskForce Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If the deliverables meet the criteria inEITF Issue No. 00-21, the deliverables are divided into separate units ofaccounting and revenue is allocated to the deliverables based on their relativefair values. The criteria specified in EITF Issue No. 00-21 are as follows(i) the delivered item has value to the customer on a stand-alone basis, (ii) thereis objective and reliable evidence of the fair value of the undelivered item,and (iii) if the arrangement includes a general right of return relativeto the delivered item, delivery or performance of the undelivered item isconsidered probable and substantially in the control of the vendor. For ourpurposes, fair value is generally defined as the price at which a customercould purchase each of the elements independently from other vendors or as theprice that the Company has sold the element separately to another customer.Applicable revenue recognition criteria is considered separately for eachseparate unit of accounting. Management applies judgment to ensure appropriateapplication of EITF Issue No. 00-21, including value allocation among multiple deliverables, determination of whether undelivered elements areessential to the functionality of delivered elements and timing of revenuerecognition, among others.

*Research andDevelopment*

Research and developmentcosts are expensed as incurred as defined in SFAS No. 2, *Accounting for Research and Development Costs*. The Companyaccounts for amounts received under its funded research and developmentarrangements in accordance with the provisions of SFAS No. 68, *Research and Development Arrangements*.Under the terms of the arrangements, the Company is not obligated to repay anyof the amounts provided by the funding parties. As a result, the Companyrecognizes revenue as the services are performed.

F-15

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

*Advertising Costs*

Advertising costs areexpensed as incurred. Total advertising expenses were $16, $40, and $20 for theyears ended December 31, 2004, 2003 and 2002, respectively.

*Stock-BasedCompensation*

At December 31, 2004, the Company had variousstock-based compensation plans, including stock option plans and an employeestock purchase plan. The Company continues to apply the recognition andmeasurement principles of Accounting Principles Board (“APB”) Opinion No. 25,*Accounting for Stock Issued to Employees,*andrelated interpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, *Accounting forCertain Transactions involving Stock Compensation, an Interpretation of APBOpinion No. 25*, as allowed by FASB statement No. 123, *Accounting for Stock-Based Compensation*. FASBstatement No. 123 and FASB statement No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, an amendment of FASB Statement No. 123,*establishedaccounting and disclosure requirements using a fair-value-based method ofaccounting for stock-based employee compensation plans. Under APB Opinion No. 25,stock-based compensation expense is recognized for stock awards granted with anexercise price below fair market value on the date of grant.

Stock-based compensation expense recorded by theCompany in 2003 and 2002 relates to stock options granted prior to the Company’sinitial public offering in December 1999 and was recognized over thevesting periods of the related options, usually four years. No stock-basedcompensation was recognized during 2004 as the Company recognized the entireremaining amount as expense in 2003.

The following tableillustrates the effect on net income (loss) and earnings per share if thecompany had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation.
| ** **                                                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                       | ** ** | ** **                                 | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Net income (loss),  as reported                                                                                  |       | $                                          | (9,022     | ) | $ | 175 |   | $ | (8,689 | ) |
| Add: Stock-based compensation expense determined  under the intrinsic value method                               |       | —                                     |       | 1,291 |   | 1,828 |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards |       | (12,834                                    | )          | (14,121 | ) | (26,142 | ) |
| Pro forma net  loss                                                                                              |       | $                                          | (21,856    | ) | $ | (12,655 | ) | $ | (33,003 | ) |
| *Earnings per share:*                                                                                            |       |                                       |       |   |   |   |   |
| Basic—as reported                                                                                           |       | $                                          | (0.44      | ) | $ | 0.01 |   | $ | (0.50 | ) |
| Diluted—as  reported                                                                                        |       | $                                          | (0.44      | ) | $ | 0.01 |   | $ | (0.50 | ) |
| Basic—pro forma                                                                                             |       | $                                          | (1.08      | ) | $ | (0.68 | ) | $ | (1.90 | ) |
| Diluted—pro forma                                                                                           |       | $                                          | (1.08      | ) | $ | (0.68 | ) | $ | (1.90 | ) |

 

F-16

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

On December 16, 2004, the FASB issued Statement No. 123(R) *Share-Based Payment*, which is a revisionof Statement No. 123 and supersedes APB Opinion No. 25. Statement No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be valued at fair value on the date of grant, and to be expensedover the applicable vesting period. Pro forma disclosure of the incomestatement effects of share-based payments is no longer an alternative. StatementNo. 123(R) is effective for all stock-based awards granted on orafter July 2005. In addition, companies must recognize compensation expenserelated to any awards that are not fully vested as of the effective date. Compensationexpense for the unvested awards will be measured based on the fair value of theawards previously calculated in developing the pro forma disclosures inaccordance with the provisions of Statement No. 123. Digimarc is currentlyassessing the impact of adopting SFAS 123(R) to its consolidated resultsof operations.

On December 21, 2004, the Audit, Compensation andCorporate Governance Committees of the Board of Directors of the Companyapproved the acceleration of vesting of the Company’s outstanding stock optionswith option exercise prices greater than $15.00. The acceleration applies toall options outstanding under the Company’s Restated 1999 Stock Incentive Planand 2000 Non-Officer Employee Stock Incentive Plan that would not haveotherwise vested in full by June 30, 2005 in accordance with their terms. Theeffective date of the vesting acceleration is December 31, 2004. The$15.00 exercise price was selected because it was higher than (i) theprice at which the Company’s stock had traded during the period prior to theannouncement of the restatement of prior financial results, (ii) theaverage trading price of the Company’s common stock for the last two years, and(iii) the purchase price per share of the Company’s common stock in theCompany’s private placement in August 2003. Options to purchase 310,057shares of the Company’s common stock, or 5% of the total number of options ofthe Company outstanding as of December 31, 2004 with remaining vestingschedules, were accelerated. Accelerating the vesting of the Company’s optionsprior to the time at which these new accounting changes become effectiveaccelerates the recognition of any remaining expense calculated under Statement123 associated with these options. No additional compensation expense wasrecorded in the statement of operations as the options that were acceleratedhad an exercise price greater than the fair market value of the sharesunderlying the options on the date of the modification. The incremental proforma expense as a result of the acceleration was $1,138 and has been includedin the table above as a result of this acceleration. Of these 310,057 options,approximately 50,000 options are held by the Company’s executive officers. Otherthan the Company’s chairman and chief executive officer, no director of theCompany holds any options subject to the acceleration.

Information regardingdeferred stock compensation expense and information related to the assumptionsused in the above calculations is further described in Note 7.

*Non-Employee StockCompensation*

The Company accounts forstock issued to non-employees in accordance with the provisions of SFAS No. 123and EITF Issue No 96-18, *Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services*.

F-17

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description ofBusiness and Summary of Significant Accounting Policies (Continued)

*Income Taxes*

The Company accounts forincome taxes under the asset and liability method. Under the asset andliability method, deferred income taxes reflect the future tax consequences ofdifferences between the tax bases of assets and liabilities and their financialreporting amounts at each year-end. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered or settled.The effect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date. Valuationallowances are established when necessary to reduce tax assets to the amountexpected to be realized.Net Income (Loss) Per Share

Net income (loss) per share is calculated inaccordance with SFAS No. 128, *Earningsper Share,*which provides that basic and diluted net income (loss)per share for all periods presented are to be computed using the weightedaverage number of common shares outstanding during each period, with dilutednet income per share including the effect of potentially dilutive commonshares.
|                | ** ** | **Twelve Months Ended December 31, 2004** | ** ** | **Twelve Months Ended December 31, 2003** | ** ** | **Twelve Months Ended December 31, 2002** | ** ** |
|----------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **     | ** ** | **Income  (000’s)  (Numerator)**                              | ** ** | **Shares  (000’s)  (Denominator)**                            | ** ** | **Per  Share    Amount  **                     | ** ** | **Income  (000’s)  (Numerator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** | **Income  (000’s)  (Numerator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| ** **     | ** ** | ** **                                                         | ** ** | ** **                                                         | ** ** | ** **                                                         | ** ** | **(Restated)** | ** ** | ** ** | ** ** | **(Restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic  EPS** |       |                                                               |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                |            |                                                                    |            |                                                                    |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
| Income available to common stockholders  |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $      | (0.44  | )      |   |   | $      | 175    |   |   |   | 18,572 |   |   |   | $      | 0.01   |   |   |   | $      | (8,689 | )      |   |   | 17,361 |   |   |   | $ | 0.50 |   |   |
|------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|------|--------|--------|
| **Effect of Dilutive Securities**        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options                                  |   |   |   |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   | 778    |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Warrants                                 |   |   |   |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   | 1      |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| **Diluted EPS**                          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income available to common  stockholders |   |   | $      | (9,022 | )      |   |   | 20,326 |   |   |   | $      | (0.44  | )      |   |   | $      | 175    |   |   |   | 19,351 |   |   |   | $      | 0.01   |   |   |   | $      | (8,689 | )      |   |   | 17,361 |   |   |   | $ | 0.50 |   |   |

 

Common stock equivalents related to stock options andwarrants of 5,893,251, 3,942,393 and 3,222,929 were excluded from diluted netincome per share calculations for 2004, 2003, and 2002, respectively, as theirexercise price was higher than the average market price of the underlyingcommon stock for the period. Common stock equivalents related to stock optionsand warrants of 308,944 and 803,007 are antidilutive in a net loss year and,therefore, are not included in 2004 and 2002 diluted net loss per share,respectively.

*Comprehensive Income(Loss)*

Comprehensive income (loss) is defined as changes instockholders’ equity exclusive of transactions with owners. To date, onlyforeign currency translation adjustments are required to be reported incomprehensive income (loss). Comprehensive income (loss) for the years ended December 31is as follows:
| ** **                               | ** ** | **2004**   | ** ** | **2003**       | ** ** | **2002**   | ** ** |
|------------------------------------------|------------|------------|------------|----------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Net income (loss)                        |       | $          | (9,022     | )              |       | $          | 175        |   |   | $ | (8,689 | ) |
| Foreign currency  translation adjustment |       | 51         |       |           | 139        |       |       | (43 | ) |
| Comprehensive income  (loss)             |       | $          | (8,971     | )              |       | $          | 314        |   |   | $ | (8,732 | ) |

 

F-18

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(1)**   Description of Business and Summary ofSignificant Accounting Policies (Continued)

*Recent AccountingPronouncements*

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an amendment of ARB No. 43,Chapter 4* (FAS 151). FAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges. The Company is currently evaluating the provisions of FAS 151 and doesnot expect that the adoption will have a material impact on its consolidatedfinancial position or results of operations.

**(2)**   Restatement of Financial Statements

*Summary.*   The Company hasrestated its audited consolidated financial statements as of and for the fiscalyear ended December 31, 2003, including as of and for each of the quarters inthe fiscal year ended December 31, 2003, and the quarterly periods ended March31, 2004 and June 30, 2004 primarily as a result of the improper orunsubstantiated capitalization of costs related to internal use software andproject accounting cost tracking and cost deferrals at Digimarc ID Systems(“DIDS”).

*Background*.   On September 13, 2004 theCompany announced that it was reviewing certain accounting practices andpreviously reported financial statements as a result of possible errorsdiscovered by its management in the accounting for software development costsand project capitalization and other project cost capitalization accountingpractices at the Company’s DIDS business unit. On November 8, 2004, theCompany announced that it was delaying the filing of its Form 10-Q for thethird quarter ended September 30, 2004 due to the ongoing evaluation ofcertain accounting issues relating to transactions entered into in priorperiods. During the course of its review, the Company determined that errors inthe accounting for software development costs, project accounting, revenuerecognition, and tax accruals among other areas with respect to certain priorperiods had been made and required adjustment. The Company has restated itsconsolidated financial statements to correct these accounting errors.

The Company identifiedthese errors as a result of a review of its accounting and the review of itsinternal control over financial reporting in preparation for compliance with Section 404of the Sarbanes-Oxley Act of 2002 and its implementing regulations. This reviewinvolves a detailed analysis and documentation of the processes that impact thepreparation of the Company’s financial statements, an assessment of the risksthat could adversely affect the accurate and timely preparation of thosefinancial statements and the identification of the controls that are in placeto mitigate the risks of untimely or inaccurate preparation of those financialstatements.

*Description ofAdjustments.*

*Capitalized software developmentcosts*.   The Company produces software that is usedinternally, and as such has costs that qualify under the AICPA’s SOP 98-1, *Accounting for the Costs of Computer Software Developed or Obtained forInternal Use.* The Company’s policy requires expensing ofactivities related to the preliminary stage of a software project (such as theconceptual formulation of alternatives), allows capitalization of activitiesrelated to the application development stage of a software project (such ascoding, installation, and testing), and requires expensing of activitiesrelated to the post-implementation stage (such as training, maintenance, andsupport) consistent with the guidance in SOP 98-1. Under this policy, theCompany capitalizes costs in the application development stage of a softwareproject. In 

F-19

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(2)**   Restatement ofFinancial Statements (Continued)

connection with therestatement, the Company determined that certain costs had been erroneouslycapitalized because either a portion of such costs did not qualify forcapitalization (e.g., costs related to the preliminary or post-implementationstages) or the project itself did not qualify as internal-use software (e.g.,costs related to a non-software project).

*Project accounting cost tracking andcost deferrals*.   The Company erroneously tracked costsfor various projects as a result of certain difficulties the Company hadimplementing a new accounting system in late 2003 and early 2004. As a result,certain costs that should have been recognized as expenses in the periodincurred were erroneously recorded as inventory or as fixed assets.

*Tax accrual timing*.   TheCompany identified certain international tax expenses that had not beenproperly accrued in the period incurred.

*Other Adjustments.  *Anumber of other adjustments were made in the restatement, including adjustmentsto (i) correctly record inventory receipts in the proper period, (ii) correctthe timing of revenue recognized for a maintenance contract, (iii) correctcommission liability relating to a long-term card product contract and (iv) correctVAT payables and expenses. While the amounts associated with these otheradjustments are relatively small, the Company believes that it is appropriateto record them as part of this restatement.

The following tables setforth certain of the restatement adjustments to the financial statements forthe year ended December 31, 2003. The restatement adjustments for therestated quarterly periods are contained in Note 13 of these consolidatedfinancial statements. The amounts in the tables are expressed in thousands.

***As of and for theyear ended December 31, 2003:***
| **Consolidated Statement of Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|-----------|------------|------------------|------------|
| Revenue                                                           |       |       | 85,618     |                         |       |                         | —     |                    |       |              | —     |      |       |             | —     |   |   | (27 | ) | 85,591 |   |
| Cost of revenue                                                   |       |       | 46,283     |                         |       |                         | 341        |                    |       |              | 360        |      |       |             | —     |   |   | (48 | ) | 46,936 |   |
| Gross profit                                                      |       |       | 39,335     |                         |       |                         | (341       | )                       |       |              | (360       | )         |       |             | —     |   |   | 21 |   | 38,655 |   |
| Operating expense                                                 |       |       | 38,169     |                         |       |                         | 596        |                    |       |              | 93         |      |       |             | (82        | ) |   | (52 | ) | 38,724 |   |
| Operating income  (loss)                                          |       |       | 1,166      |                         |       |                         | (937       | )                       |       |              | (453       | )         |       |             | 82         |   |   | 73 |   | (69 | ) |
| Other income                                                      |       |       | 567        |                         |       |                         | —     |                    |       |              | —     |      |       |             | —     |   |   | — |   | 567 |   |
| Provision for  income taxes                                       |       |       | (203       | )                            |       |                         | —     |                    |       |              | —     |      |       |             | (120       | ) |   | — |   | (323 | ) |
| Net income (loss)                                                 |       |       | 1,530      |                         |       |                         | (937       | )                       |       |              | (453       | )         |       |             | (38        | ) |   | 73 |   | 175 |   |

 

F-20

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(2)**   Restatement of Financial Statements (Continued)

Costof service revenue increased $422 related primarily to project accountingadjustments and cost of product and subscriptions increased $231 relatedprimarily to software capitalization adjustments. Research and developmentexpense increased $627 related primarily to software capitalization, sales andmarketing expense increased $61 primarily related to other adjustments andgeneral and administrative expense decreased $133 related primarily to incometax adjustments. The effect of the restatement entries was to decrease netincome from $0.08 per share to net income of $0.01 per share and decrease revenuesby $27 for the year ended December 31, 2003.
| **Balance Sheet Data**                | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | ** Income   taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |   |
|-------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------------------|------------|-----------|------------|------------------|------------|--------|
| **Assets:**                                     |       |       |       |                         |       |                         |       |                    |       |                          |       |      |       |             |       |   |   |   |   |
| Trade accounts  receivable, net                 |       | $          | 9,195      |                         |       | —                       |       |                    |       | —                        |       |      |       | —           |       |   | $ | (27 | ) | $ | 9,168 |   |
| Inventory, net                                  |       | 5,739      |       |                         | —     |                         |       |                    | $          | 514                           |       |      |       | —           |       |   | — |   | 6,253 |   |
| Other current assets                            |       | 2,227      |       |                         | —     |                         |       |                    | (357       | )                             |       |      | 82         |             |       | 100    |   | 2,052 |   |
| Total current assets                            |       | 100,115    |       |                         | —     |                         |       |                    | 157        |                          |       |      | 82         |             |       | 73     |   | 100,427 |   |
| Property and equipment,  net                    |       | 37,755     |       |                         | $          | (937                         | )          |                    |       | (967                          | )          |      |       | —           |       |   | (38 | ) | 35,813 |   |
| Other assets, net                               |       | 858        |       |                         | —     |                         |       |                    | 357        |                          |       |      | —     |             |       | — |   | 1,215 |   |
| Total assets                                    |       | $          | 162,426    |                         |       | $                            | (937       | )                       |       |                          | $          | (453      | )          |             |       | 82     |   |   | $ | 35 |   | $ | 161,153 |   |
| **Liabilities and Stockholders’  Equity:** |       |       |       |                         |       |                         |       |                    |       |                          |       |      |       |             |       |   |   |   |   |
| Accounts payable                                |       | $          | 6,671      |                         |       | —                       |       |                    |       | —                        |       |      |       | —           |       |   | $ | (87 | ) | $ | 6,584 |   |
| Accrued payroll and  related costs              |       | 969        |       |                         | —     |                         |       |                    | —     |                          |       |      | —     |             |       | 100    |   | 1,069 |   |
| Other current  liabilities                      |       | 235        |       |                         | —     |                         |       |                    | —     |                          |       |      | $          | 120              |       |   | (51 | ) | 304 |   |
| Total current  liabilities                      |       | 11,035     |       |                         | —     |                         |       |                    | —     |                          |       |      | 120        |             |       | (38    | ) | 11,117 |   |
| Total liabilities                               |       | 12,321     |       |                         | —     |                         |       |                    | —     |                          |       |      | 120        |             |       | (38    | ) | 12,403 |   |
| Total stockholders’  equity                |       | 150,105    |       |                         | $          | (937                         | )          |                    |       | $                             | (453       | )         |       |             | $          | (38    | ) |   | 73 |   | 148,750 |   |
| Total liabilities and stockholders’ equity |       | $          | 162,426    |                         |       | $                            | (937       | )                       |       |                          | $          | (453      | )          |             |       | 82     |   |   | $ | 35 |   | $ | 161,153 |   |

 
| **Cash Flow Changes**              | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | ** Income   taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------------------|------------|-----------|------------|------------------|------------|
| Cash flows from  operating activities:       |       |                         |       |                         |       |                    |       |                          |       |      |       |             |       |   |   |   |   |   |   |
| Net income                                   |       | $                            | 1,530      |                         |       | $                       | (937       | )                             |       |      | $          | (453             | )          |   |   | $ | (38 | ) |   | $ | 73 |   | $ | 175 |   |
| Depreciation and  amortization               |       | 10,756                       |       |                         | 24         |                    |       |                          | —     |      |       |             | —     |   |   | — |   | 10,780 |   |
| Trade and unbilled  accounts receivable, net |       | 1,788                        |       |                         | —     |                    |       |                          | —     |      |       |             | —     |   |   | 27 |   | 1,815 |   |
| Inventory                                    |       | (648                         | )          |                         | —     |                    |       |                          | (514       | )         |       |             | —     |   |   | — |   | (1,162 | ) |
| Other current assets                         |       | 880                          |       |                         | —     |                    |       |                          | 357        |      |       |             | (82        | ) |   | (100 | ) | 1,055 |   |
| Other assets, net                            |       | 32                           |       |                         | 16         |                    |       |                          | (357       | )         |       |             | —     |   |   | — |   | (309 | ) |
| Accounts payable                             |       | (1,337                       | )          |                         | —     |                    |       |                          | —     |      |       |             | —     |   |   | (87 | ) | (1,424 | ) |
| Accrued payroll and  related costs           |       | (418                         | )          |                         | —     |                    |       |                          | —     |      |       |             | —     |   |   | 100 |   | (318 | ) |
| Other liabilities                            |       | (12                          | )          |                         | —     |                    |       |                          | —     |      |       |             | 120        |   |   | (51 | ) | 57 |   |
| Net cash provided by  operating activities   |       | 27,224                       |       |                         | (897       | )                       |       |                          | (967       | )         |       |             | —     |   |   | (38 | ) | 25,322 |   |
| Cash flows from  investing activities:       |       |                         |       |                         |       |                    |       |                          |       |      |       |             |       |   |   |   |   |   |   |
| Purchase of property and  equipment          |       | (8,367                       | )          |                         | (40        | )                       |       |                          | 967        |      |       |             | —     |   |   | 38 |   | (7,402 | ) |
| Capitalization of labor  costs               |       | (7,546                       | )          |                         | 937        |                    |       |                          | —     |      |       |             | —     |   |   | — |   | (6,609 | ) |
| Net cash used in  investing activities       |       | (39,154                      | )          |                         | 897        |                    |       |                          | 967        |      |       |             | —     |   |   | 38 |   | (37,252 | ) |
|                                              |            |                              |            |                              |            |                         |            |                               |            |           |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-21

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(3)**   Propertyand Equipment
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | ** **            | ** ** | **(Restated)** | ** ** |
| Office furniture and  equipment                 |       | 4,957                 |       | $ | 13,102 |   |
| Production equipment                            |       | 81,890                |       | 39,222 |   |
| Leasehold improvements                          |       | 897                   |       | 1,406 |   |
|                                            |       | 87,744                |       | 53,730 |   |
| Less accumulated  depreciation and amortization |       | (23,769               | )          | (17,917 | ) |
|                                            |       | $                     | 63,975     |   | $ | 35,813 |   |
|                                                 |            |                       |            |  |  |  |  |

 

**(4)**   Leases

The Company leases certain computers and officeequipment under long-term capital leases, which expire over the next48 months. The cost of these assets was $1,541 and $2,067 at December 31,2004 and 2003, respectively, and accumulated amortization was $463 and $616 at December 31,2004 and 2003, respectively.

Future minimum leasepayments under non-cancelable operating leases and the present value of futureminimum capital lease payments are as follows:
| **Year ending December 31:** | ** ** | ** ** | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** |
|---------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| 2005                                        |       | $          | 551        |                |       | $                     | 2,189      |   |   |
| 2006                                        |       | 540        |       |                | 2,139      |                  |       |
| 2007                                        |       | 366        |       |                | 1,728      |                  |       |
| 2008                                        |       | —     |       |                | 1,502      |                  |       |
| 2009                                        |       | —     |       |                | 1,413      |                  |       |
| Thereafter                                  |       | —     |       |                | 1,450      |                  |       |
| Total minimum lease  payments               |       | 1,457      |       |                | $          | 10,421                |       |   |
| Less amount representing  interest          |       | (125       | )          |                |       |                  |       |
|                                        |       | 1,332      |       |                |       |                  |       |
| Less current portion of  capital lease      |       | (479       | )          |                |       |                  |       |
|                                        |       | $          | 853        |                |       |                  |       |   |

 

Rent expense on theoperating leases for the years ended December 31, 2004, 2003 and 2002totaled $2,998, $2,863 and $2,875, respectively.

**(5)**   DefinedContribution Pension Plan

TheCompany sponsors an employee savings plan (the “Plan”) which qualifies as adeferred salary arrangement under Section 401(k) of the InternalRevenue Code. Employees become eligible to participate in the Plan at the beginningof the following quarter after the employees’ hire date. Employees maycontribute up to 20% of their pay to the Plan, subject to the limitations ofthe Internal Revenue Code. Company matching contributions are discretionary.For the year ending December 31, 2004, the Company made discretionarymatching contributions in the aggregate amount of $70. For the years endingDecember 31, 2003 and 2002 the Company made no discretionary matchingcontributions.

F-22

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’Equity

*Preferred Stock*

In December 1999, alloutstanding preferred stock of the Company was converted to common stock uponthe closing of the Company’s initial public offering. The authorized preferredstock of the Company following its re-incorporation and the initial publicoffering consists of 5,000,000 shares of undesignated preferred stock.

*Common Stock*

In August 2003, the Company completed a privateplacement of 1,785,996 units, with each unit consisting of one share of commonstock and warrants exercisable for 0.15 shares of common stock, resultingin net proceeds of $23,450, after deducting commissions and offering expenses.

In November 2004, the Board of Directors authorized and declared adividend of one right for each outstanding share of common stock tostockholders of record at the close of business on November 29, 2004, andauthorized the issuance of one right for each share of common stock issued byDigimarc under certain circumstances in the future. Each right entitles theregistered holder, subject to the terms of the Rights Agreement between us andthe rights agent, to purchase from us one one-hundredth of a share (a unit) of Series APreferred Stock, par value $0.001 per share, at a purchase price of $100.00 perunit, under circumstances described in the Rights Agreement. The purchaseprice, the number of units of preferred stock and the type of securitiesissuable upon exercise of the rights are subject to adjustment. The rights willexpire at the close of business November 16, 2014 unless earlier redeemedor exchanged. Until a right is exercised, the holder thereof, as such, willhave no rights as one of our stockholders, including the right to vote or toreceive dividends. The rights are not immediately exercisable. Subject to theterms and conditions of the Rights Agreement, they will become exercisable tenbusiness days after a person or group acquires, or commences a tender orexchange offer which would lead to the acquisition of beneficial ownership of15% or more of Digimarc’s outstanding common stock, subject to prior redemptionor exchange and subject to exceptions specified in the Rights Agreement,including an exception for certain existing large shareholders that havehistorically held ownership positions in excess of 15 percent. Subject to theseexceptions, once a person or group acquires beneficial ownership of 15% or moreof Digimarc’s outstanding common stock, each right not owned by that person orgroup or certain related parties will entitle its holder to purchase, at theright’s then-current purchase price, units of Series A preferred stock or,at Digimarc’s option, shares of common stock or cash, property or othersecurities of our company having a market value equal to twice the then-currentpurchase price, subject to terms and conditions of the Rights Agreement.

*Deferred StockCompensation*

Deferredstock compensation expense is based on the difference between the fair marketvalue of the Company’s common stock and the exercise price of options to purchasethat stock on the date of grant, and was recognized over the vesting period ofthe related options, generally four years. No stock-based compensation wasrecorded as expense in 2004 while $1,291 and $1,828 was recorded for the yearsended December 31, 2003 and 2002, respectively. At December 31, 2004,no stock-based compensation remains deferred as the Company has recognized theentire remaining amount as expense in 2003.

F-23

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’Equity (Continued)

*Stock IncentivePlan*

In October 1995, the 1995 Stock Incentive Plan,subsequently amended (the “1995 Plan”), was approved by the Company’s Board ofDirectors. Under the terms of the 1995 Plan, the Board of Directors isauthorized to grant incentive stock options, non-qualified stock options and restrictedstock to officers, directors, employees or consultants. Prices for all optionsor stock granted under the 1995 Plan are determined by the Board of Directors.Option prices for incentive stock options are set at not less than the fairmarket value of the common stock at the date of grant. Options vest overperiods determined by the Board of Directors, generally four years. Options arecontingent upon continued employment with the Company and, unless otherwisespecified, expire ten years from the date of grant. The Company has reserved2,800,000 shares of its common stock for issuance under the 1995 Plan.

In October 1999, the 1999 Stock Incentive Plan,subsequently amended and restated (the “1999 Plan”) was approved by the Company’sBoard of Directors. The Company initially reserved 1,500,000 shares of itscommon stock for issuance under the 1999 Plan. Upon completion of the Company’sinitial public offering, shares available for grant from the 1995 Plan weretransferred to the 1999 Plan. Since adoption, the Company has reserved anadditional 6,271,543 shares of its common stock for issuance under the 1999Plan bringing the total reserved under the 1999 plan to 7,771,543 shares, andthe total reserved under the 1995 Plan and the 1999 Plan combined to 10,571,543shares. The exercise price and term of options granted under the 1999 Plan aredetermined by the Company’s Board of Directors or by a committee theydesignate.

As part of the 1999 Plan, the Company adopted the 1999Non-Employee Director Option Program (the “Director Plan”). Under the DirectorPlan, an automatic option grant to acquire 10,000 shares will be given to eachnon-employee director then-existing or first elected to the Company’s Board ofDirectors which vest in three annual increments on the anniversary date of thegrant date. Additionally, an annual option grant of 10,000 shares is given toeach non-employee director on the date of the Company’s annual stockholders’meeting if certain conditions are met. These options vest on the first anniversaryof the grant date. The exercise price of the options under the Director Plan isthe fair market value on the date of grant. In 2002, the Director Plan wasfurther amended to allow for 20,000 shares to be granted to non-employeedirectors elected or appointed to the Board of Directors for the first time onor after March 29, 2002. These options vest and become exercisable in 36equal installments on each monthly anniversary of the grant date, such that thestock options will be fully exercisable three years after the grant date. Uponthe date of each annual stockholders meeting, each non-employee director whohas been a member of the Company’s Board of Directors for at least six monthsprior to the date of the stockholders meeting will receive an automatic grantof options to acquire 12,000 shares of the Company’s common stock at anexercise price per share equal to fair market value of the common stock at thedate of grant. These options vest and become exercisable in twelve equalinstallments on each monthly anniversary of the grant date, such that the stockoptions will be fully exercisable one year after the grant date. The DirectorPlan was also amended to allow for the grant of options exercisable for 3,000shares of common stock at an exercise price equal to the fair market value ofthe common stock at the date of grant to each non-employee director who servesas a member of a committee of the Board of Directors immediately following eachannual meeting of the Company’s stockholders, provided such non-employeedirector has been a member of the Company’s Board of Directors for at least sixmonths prior to the date of the stockholders meeting. 

F-24

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’Equity (Continued)

These stock options vestand become exercisable in twelve equal installments on each monthly anniversaryof the grant date, such that the stock options will be fully exercisable oneyear after the date of grant. The Director Plan was amended on April 17,2003 to clarify that committee-related option grants were to be made tonon-employee directors serving only on “standing committees” of the Board ofDirectors. The Director Plan was also amended on May 2, 2003 to eliminate therequirement that a non-employee director must have been a member of the Company’sBoard of Directors for at least six months prior to the date of thestockholders meeting in order to receive a committee-related option grant. TheDirector Plan was further amended on March 10, 2004 to provide that theBoard of Directors may waive the issuance of option grants under the DirectorPlan, in whole or in part, for any particular year. The Board of Directorsdetermined not to grant an option to purchase 3,000 shares of common stock todirectors in 2004 and 2005 under the Director Plan for service on each standingcommittee of the Board of Directors.

In June 2000, the 2000 Non-Officer Employee StockIncentive Plan (the “2000 Plan”) was approved by the Company’s Board ofDirectors. The Company initially reserved 275,000 shares of its common stockfor issuance under the 2000 Plan. Options from the 2000 Plan cannot be grantedto officers or directors of the Company. The exercise price and term of optionsgranted under the 2000 Plan are determined by the Company’s Board of Directorsor by a committee they designate. The exercise price is generally set at thefair market value of the stock on the date of grant. Options under the 2000Plan generally vest over four years.

SFAS No. 123 definesa fair value based method of accounting for an employee stock option andsimilar equity instrument. As is permitted under SFAS No. 123, the Companyhas elected to continue to account for its stock-based compensation plans underAPB Opinion No. 25. The Company has computed, for pro forma disclosurepurposes as shown in Note 1, the value of all options granted during 2004,2003 and 2002 using the Black-Scholes option pricing model as prescribed bySFAS No. 123 with the following weighted average assumption for grants:
| ** **                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate  |       | 4.00     | %          | 4.00     | %          | 4.00     | %          |
| Expected dividend  yield  |       | —   |       | —   |       | —   |       |
| Expected life (in  years) |       | 4        |       | 4        |       | 4        |       |
| Expected volatility       |       | 50       | %          | 50       | %          | 100      | %          |

 

Using the Black-Scholes methodology, the total valueof options granted during 2004, 2003, and 2002 was $9,387, $8,516 and $24,279,respectively, which would be amortized on a pro forma basis over the vestingperiod of the options. The weighted average fair value of options grantedduring 2004, 2003, and 2002 was $6.56, $7.81 and $11.57 per share,respectively.

The effects of applying SFAS No. 123 in this proforma disclosure are not indicative of future amounts. SFAS No. 123 doesnot apply to awards prior to January 1, 1995, and additional awards areanticipated in future years.

F-25

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’Equity (Continued)

Transactions involving thestock incentive plans are summarized as follows:
| ** **                                   | ** ** | **Number of  shares** | ** ** | **Weighted average  Exercise price** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| Options  outstanding, December 31, 2001 |       | 5,797,074                  |       |                                           | $          | 16.02 |   |   |
| Granted                                      |       | 2,098,747                  |       |                                           | 14.38      |   |   |
| Exercised                                    |       | (535,526                   | )          |                                           | 3.34       |   |   |
| Canceled                                     |       | (727,406                   | )          |                                           | 18.04      |   |   |
| Options  outstanding, December 31, 2002 |       | 6,632,889                  |       |                                           | 16.31      |   |   |
| Granted                                      |       | 1,090,887                  |       |                                           | 15.19      |   |   |
| Exercised                                    |       | (622,108                   | )          |                                           | 5.73       |   |   |
| Canceled                                     |       | (793,130                   | )          |                                           | 17.74      |   |   |
| Options  outstanding, December 31, 2003 |       | 6,308,538                  |       |                                           | 16.98      |   |   |
| Granted                                      |       | 1,429,952                  |       |                                           | 11.95      |   |   |
| Exercised                                    |       | (160,622                   | )          |                                           | 4.23       |   |   |
| Canceled                                     |       | (741,688                   | )          |                                           | 16.00      |   |   |
| Options outstanding,  December 31, 2004 |       | 6,836,180                  |       |                                           | $          | 16.33 |   |   |

 
| ** **                              | ** ** | **Outstanding** | ** ** | **Exercisable**                | ** ** |
|-----------------------------------------|------------|-----------------|------------|--------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** **      | ** ** | **Number of Shares** | ** ** | **Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Price** | ** ** | **Number of Shares** | ** ** | **Weighted  Average  Price** | ** ** |
| $  0.50  - $11.34             |       |            | 728,190    |                           |       |   | 7.45 |   |   |   | $ | 7.51 |   |   |   | 465,399 |   |   |   | $ | 6.20 |   |   |
| $11.42 - $12.25                         |       |            | 736,535    |                           |       |   | 9.05 |   |   |   | $ | 11.72 |   |   |   | 221,789 |   |   |   | $ | 11.73 |   |   |
| $12.40 - $13.00                         |       |            | 685,782    |                           |       |   | 7.85 |   |   |   | $ | 12.76 |   |   |   | 475,055 |   |   |   | $ | 12.71 |   |   |
| $13.02 - $14.02                         |       |            | 700,215    |                           |       |   | 7.1 |   |   |   | $ | 13.75 |   |   |   | 562,441 |   |   |   | $ | 13.86 |   |   |
| $14.06 - $14.44                         |       |            | 687,400    |                           |       |   | 6.04 |   |   |   | $ | 14.13 |   |   |   | 674,432 |   |   |   | $ | 14.13 |   |   |
| $14.49 - $15.24                         |       |            | 819,626    |                           |       |   | 8.03 |   |   |   | $ | 15.14 |   |   |   | 772,631 |   |   |   | $ | 15.14 |   |   |
| $15.25 - $16.79                         |       |            | 708,720    |                           |       |   | 8.3 |   |   |   | $ | 15.84 |   |   |   | 567,401 |   |   |   | $ | 15.85 |   |   |
| $16.91 - $18.16                         |       |            | 844,648    |                           |       |   | 6.97 |   |   |   | $ | 17.58 |   |   |   | 744,600 |   |   |   | $ | 17.58 |   |   |
| $18.29 - $35.13                         |       |            | 640,064    |                           |       |   | 5.93 |   |   |   | $ | 24.39 |   |   |   | 617,076 |   |   |   | $ | 24.56 |   |   |
| $53.94 - $53.94                         |       |            | 285,000    |                           |       |   | 5.08 |   |   |   | $ | 53.94 |   |   |   | 285,000 |   |   |   | $ | 53.94 |   |   |
| $  0.50 -  $53.94             |       |            | 6,836,180  |                           |       |   | 7.34 |   |   |   | $ | 16.33 |   |   |   | 5,385,824 |   |   |   | $ | 17.50 |   |   |
|                                         |            |                 |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31,2004, 2,876,910 shares were available for grant.

*Employee StockPurchase Plan*

Under the 1999 Employee Stock Purchase Plan,subsequently amended and restated (the “Purchase Plan”), the Company hasauthorized the issuance of 1,556,665 shares of common stock, 1,216,803 of whichare available for purchase at December 31, 2004. The Purchase Plan allowseligible employees to purchase the Company’s common stock through payrolldeductions, which may not exceed 15% of an employee’s base compensation, not toexceed $21 per year, including commissions, bonuses and overtime, at a priceequal to 85% of the lower of the fair value at the beginning or end of eachenrollment period. The 

F-26

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’Equity (Continued)

Company delayed thepurchase of shares under the Purchase Plan that would have occurred on November 30,2004 until May 31, 2005. The purchase was delayed because the Company’sfailure to timely file its third quarter Form 10-Q caused the registrationstatements on Form S-8 on file with the SEC for the Purchase Plan to notreflect current information. As a result of the delay, participants wereprovided with the opportunity to withdraw all of the accumulated payrolldeductions credited to their account under the Purchase Plan, or terminatefuture payroll deductions.

TheCompany has computed, for pro forma purposes as disclosed in Note 1, theestimated fair value of purchase rights granted under the Purchase Plan on thedate of grant using the Black-Scholes option pricing model with the followingweighted average assumptions for the years ended December 31, 2004, 2003and 2002:
| ** **                | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|------------|------------|
| Risk-free  interest rate  |       | 4.00       | %          | 4.00       | %          | 4.00       | %          |
| Expected dividend  yield  |       | —     |       | —     |       | —     |       |
| Expected life (in  years) |       | 0.5 to 2.0 |       | 0.5 to 2.0 |       | 0.5 to 2.0 |       |
| Expected volatility       |       | 50         | %          | 50         | %          | 100        | %          |

 

The weighted-average fairvalue of the purchase rights granted under the Purchase Plan during fiscal2004, 2003 and 2002 was $4.01, $6.24 and $6.24, respectively.

*Warrants*

In October 1999, the Company entered into atwo-year agreement with Hearst Communications, Inc. (Hearst) in which theCompany and Hearst would jointly promote Internet-enabled advertising. Inconnection with the Hearst agreement, the Company issued a warrant to purchase150,000 shares of common stock to Hearst at $20 per share. Of the 150,000shares, 62,500 vested upon the Company’s initial public offering, another62,500 shares were to vest based on the achievement of certain milestoneswithin the first year of the agreement, and the final 25,000 were to vest uponreaching the one-year anniversary of the commercial availability date forDigimarc MediaBridge. The warrant was exercisable for three years after eachvesting date.

The Company recorded $633 of sales and marketingexpense during 1999 that related to the vested portion of the warrant. During2000 and 2001, the specified milestones for vesting were not met and the agreementwith Hearst was terminated prior to the one-year anniversary of the commercialavailability date for Digimarc MediaBridge. Therefore, no additional warrantexpense was recorded as no additional vesting occurred. As of December 31,2002, no portion of the warrant had been exercised. As of December 31,2002, these warrants had expired.

In 2001, the Company issued 5,000 options tonon-employees who provided consulting services and recorded expense related tothose options of $42 using the Black-Scholes option pricing model with thefollowing weighted average assumptions: no expected dividends; expectedvolatility of 100%; risk-free interest rate of 4.40%; and contractual liferanging from 0.5 to 3.0 years.

F-27

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(6)**   Stockholders’ Equity (Continued)

In August 2003,the Company issued an aggregate of 267,899 warrants with an exercise price of$14.00 per share as a part of a private placement of 1,785,996 units, with eachunit consisting of one share of common stock and warrants exercisable for0.15 shares of common stock. The warrants are exercisable for 15 daysbeyond the effective date of the common stock registration for the privateplacement. The effective date of the common stock registration was December 23,2003. In January 2004, 74,506 warrants were exercised.  The remainder of these warrants have expiredunexercised.

**(7)**   IncomeTaxes

Domesticand foreign pre-tax income (loss) is as follows:
| ** ** | ** ** | **Year ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** ** | ** ** | ** **                                 | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Domestic   |       | $                                          | (7,226     | ) |   | $ | 374 |   |   | $ | (8,087 | ) |
| Foreign    |       | (1,431                                     | )          |   | 124 |   |   | (602 | ) |
| Total      |       | $                                          | (8,657     | ) |   | $ | 498 |   |   | $ | (8,689 | ) |

 

Due to the Company’sdomestic losses before the provision for income taxes for the year ended December 31,2002, there was no provision for federal, foreign, or state taxes. However, forthe years ended December 31, 2004 and 2003, the Company was profitable insome foreign jurisdictions. Therefore, a provision for current foreign tax of $365and $323, respectively, was recorded. No provision was recorded for federal orstate taxes. The reconciliation of the statutory federal income tax rate to theCompany’s effective income tax rate is as follows:
| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                     | ** ** | ** **                                 | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Income taxes  computed at statutory rates:     |       | (2,943                                     | )          |   | 169 |   |   | (2,954 | ) |
| Increases  (decreases) resulting from:         |       |                                       |       |   |   |   |   |   |   |
| State income taxes, net of federal tax benefit |       | (270                                       | )          |   | 41 |   |   | (544 | ) |
| Change in valuation allowance                  |       | 3,524                                      |       |   | 328 |   |   | 4,028 |   |
| Recharge expenses                              |       | 381                                        |       |   | 290 |   |   | — |   |
| Generated research credits                     |       | (273                                       | )          |   | (558 | ) |   | (652 | ) |
| Foreign rate differential, net of credits      |       | 89                                         |       |   | (13 | ) |   | (15 | ) |
| Meals and entertainment                        |       | 78                                         |       |   | 65 |   |   | 92 |   |
| Provision to return true up                    |       | (182                                       | )          |   | — |   |   | — |   |
| Other                                          |       | (39                                        | )          |   | 1 |   |   | 45 |   |
| Total                                          |       | 365                                        |       |   | 323 |   |   | — |   |

 

F-28

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(7)**   Income Taxes(Continued)

Deferred income taxesreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. The tax effects of significant itemscomprising the Company’s deferred tax assets and deferred tax liabilities as ofDecember 31 are as follows:
| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                            | ** ** | ** **            | ** ** | **(Restated)** | ** ** |
| Deferred tax assets:                  |       |                  |       |   |   |
| Net operating loss  carryforwards     |       | $                     | 31,490     |   | $ | 28,765 |   |
| Tax depreciation and  amortization    |       | —                |       |   |   |
| Research and experimentation  credits |       | 2,617                 |       | 2,344 |   |
| Accrued expenses and  allowances      |       | 1,030                 |       | 278 |   |
| Deferred revenue                      |       | 1,177                 |       | 495 |   |
| Deferred compensation                 |       | 643                   |       | 1,019 |   |
| Foreign tax credit                    |       | 331                   |       | 120 |   |
| Other                                 |       | 2                     |       | 3 |   |
| Total gross deferred tax  assets      |       | 37,290                |       | 33,024 |   |
| Less valuation allowance              |       | (34,571               | )          | (30,954 | ) |
| Net Deferred Tax Assets               |       | 2,719                 |       | 2,070 |   |
| Deferred tax liabilities:             |       |                  |       |   |   |
| Tax depreciation and  amortization    |       | 2,719                 |       | 2,070 |   |
| Total deferred tax  liabilities       |       | 2,719                 |       | 2,070 |   |
| Net deferred tax asset (liability)    |       | $                     | —     |   | — |   |
|                                       |            |                       |            |  |  |  |  |

 

The Company has recorded a full valuation allowanceagainst deferred tax assets as it is not more likely than not that deferred taxassets will be recoverable. The net change in the total valuation allowance forthe year ended December 31, 2004, 2003 and 2002 was an increase of $3,617,$656 and $5,332, respectively. Included in the valuation allowance at December 31,2004 is $10,465 for deferred tax assets for which subsequently recognized taxbenefits, if any, will be allocated to contributed capital.

At December 31, 2004, the Company had netoperating loss carryforwards of approximately $82,213 to offset against futureincome for foreign, federal and state tax purposes, and research andexperimentation credits of $2,966. These carryforwards expire through 2024.

A provision of the Internal Revenue Code requires theutilization of net operating losses and research and experimentation credits belimited when there is a change of more than 50% in ownership of the Company. TheCompany has had several such changes since 1996, with the last change occurringwith the Company’s initial public offering in December 1999. As such, theutilization of net operating loss carryforwards generated from periods prior toJune and December of 1999 is limited. The amount of net operatingloss carryforwards subject to the utilization limitation is approximately$9,037.

F-29

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(7)**   Income Taxes (Continued)

We consider the earnings of our foreign subsidiariesto be indefinitely reinvested and, accordingly, no provision for United Statesfederal and state income tax has been provided. In the event the subsidiarieswere to remit these earnings to the U.S., we would be subject to U.S. federaland state income taxes. We have been unable to estimate the deferred income taxliability on these unremitted earnings at December 31, 2004 and 2003because of the uncertainty surrounding the utilization of the associatedforeign tax credits that may be available to off-set some or all of the tax.

**(8)   SegmentInformation**

*GeographicInformation*

The Company derives its revenue from a singlereporting segment: secure media solutions. Revenue is generated in this segmentthrough licensing and subscription of its various products and the delivery ofcontracted and consulting services related to these products. The Companymarkets its products in the United States and in non-U.S. countries through itssales personnel and its subsidiaries. The Company’s management evaluatesresource allocation decisions and the performance of the Company based uponrevenue by the geographic regions of the segment and does not receive discretefinancial information about asset allocation and expense allocation on adisaggregated basis.

Informationregarding geographic areas for the years ended December 31 is as follows:
| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| **Revenue:**  | ** ** | ** **                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| United States |       | $                                           | 72,173     |   | $ | 71,542 |   | $ | 68,839 |   |
| International |       | 20,774                                      |       | 14,049 |   | 17,778 |   |
|          |       | $                                           | 92,947     |   | $ | 85,591 |   | $ | 86,617 |   |
|               |            |                                             |            |  |  |  |  |  |  |  |  |  |

 

Revenueis attributed to countries based on the location of the identifiable customers.
| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| **Long-lived tangible assets:** | ** ** | ** **            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                | ** ** | ** **            | ** ** | **(Restated)** | ** ** |
| United States                             |       | $                     | 59,683     |   | $ | 35,716 |   |
| International                             |       | 4,292                 |       | 97 |   |
|                                      |       | $                     | 63,975     |   | $ | 35,813 |   |
|                                           |            |                       |            |  |  |  |  |  |  |

 
| **Intangible assets, net:** | ** ** | ** ** | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2004**   | ** ** | **2003**              | ** ** |
| United States                         |       | 19,903     |       | 22,262                |       |
| International                         |       | 1,259      |       | 1,436                 |       |
|                                  |       | 21,162     |       | 23,698                |       |

*Major Customers*

No single customeraccounted for 10% or more of the Company’s revenues for the year ended December 31,2004, 2003 or 2002. No customer accounted for more than 10% of trade andunbilled accounts receivable at December 31, 2004 or 2003.

F-30

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(8)**   Segment Information (Continued)

*Operating SegmentInformation*

TheCompany has one reporting segment which is made up of two operating segments:Digimarc ID Systems (DIDS) and Digimarc Digital Watermarking (DWM). Informationregarding each of the operating segments is as follows:
| ** **                             | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                             | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| **DIDS**                               |       |                                        |       |   |   |   |   |
| Revenue                                |       | $                                           | 81,752     |   | $ | 76,286 |   | $ | 75,996 |   |
| Revenue as a  percent of total revenue |       | 88                                          | %          | 89 | % | 88 | % |
| Gross profit  percentage               |       | 34                                          | %          | 44 | % | 38 | % |
| **DWM**                                |       |                                        |       |   |   |   |   |
| Revenue                                |       | $                                           | 11,195     |   | $ | 9,305 |   | $ | 10,621 |   |
| Revenue as a  percent of total revenue |       | 12                                          | %          | 11 | % | 12 | % |
| Gross profit  percentage               |       | 69                                          | %          | 59 | % | 56 | % |
| **Total  Company**                     |       |                                        |       |   |   |   |   |
| Revenue                                |       | $                                           | 92,947     |   | $ | 85,591 |   | $ | 86,617 |   |
| Revenue as a  percent of total revenue |       | 100                                         | %          | 100 | % | 100 | % |
| Gross profit percentage                |       | 38                                          | %          | 45 | % | 40 | % |

 

**(9)   Commitments andContingencies**

Beginning in September 2004, three purported classaction lawsuits were commenced against the Company and certain of the Company’scurrent and former directors and officers by or on behalf of persons claimingto have purchased or otherwise acquired the Company’s securities during theperiod from April 17, 2002 to July 28, 2004. These lawsuits were filed in theUnited States District Court for the District of Oregon and were consolidatedinto one action for all purposes on December 16, 2004. The complaints assertclaims under the federal securities laws, specifically Sections 10(b) and20(a) of the Securities Exchange Act of 1934, relating to the Company’sannouncement that it had discovered errors in its accounting for softwaredevelopment costs and project capitalization and other project costcapitalization accounting practices at the Company’s DIDS business unit, andthat the Company likely would be required to restate its previously reportedfinancial statements for full fiscal year 2003 and the first two quarters of2004. Specifically, these actions allege that the Company issued false andmisleading financial statements in order to inflate the value of Digimarc stock,which resulted in insider sales of personal holdings at inflated values, andthat the Company maintained insufficient accounting controls, which created anenvironment where improper accounting could be used to manipulate financialresults. The complaints seek unspecified damages. The Company believes that ithas substantial legal and factual defenses to the claims, which it intends topursue vigorously. Due to the inherent uncertainties of litigation and becausethe lawsuits are still at a preliminary stage, the ultimate outcome of thematter cannot be predicted. No accrual has been recorded because the amountsare not probable or reasonably estimatable in accordance with SFAS No. 5, *Accounting for Contingencies*.

F-31

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(9)**   Commitments andContingencies (Continued)

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo. Thesuits claim that certain of these officers and directors breached theirfiduciary duties to the Company’s shareholders and to the Company. Thecomplaints are derivative in nature and do not seek relief from the Company. OnNovember 8, 2004, a letter was mailed to the chairman of the Company’sBoard of Directors by a law firm purporting to represent a shareholder of theCompany, demanding that the board commence a civil action against each of thedirectors and officers on behalf of the Company to recover for damages allegedto have been incurred as a result of alleged breaches of fiduciary duties. TheCompany has appointed a committee to investigate the claims asserted in thedemand letter and in the derivative lawsuits.

The Company has received a notice from the staff ofthe Securities and Exchange Commission stating that it is conducting aninformal inquiry relating to the Company’s previous announcement that it wasrestating its prior financial results. The inquiry focuses on the errors madein the capitalization of certain software and other project costs. The staffhas requested that the Company voluntarily produce documents and informationrelated to the SEC’s inquiry. The Company is cooperating with the staff’srequest. It is not possible to predict whether this inquiry will have anyimpact on the Company or its financial results.

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including the Company, certainof its officers and directors, and certain underwriters of the Company’sinitial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensationarrangements (such as undisclosed commissions or stock stabilization practices)in the Company’s initial public offering registration statement and by engagingin manipulative practices to artificially inflate the price of the Company’sstock in the after-market subsequent to the Company’s initial public offering.The Company and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. Theindividual officer and director defendants entered into tolling agreements and,pursuant to a court order dated October 9, 2002, were dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, acommittee of the Company’s Board of Directors conditionally approved a proposedpartial settlement with the plaintiffs in this matter. In June 2004, an agreementof settlement was submitted to the court for preliminary approval. Thesettlement would provide, among other things, a release of the Company and ofthe individual defendants for the conduct alleged in the amended complaint tobe wrongful. The Company would agree to undertake other responsibilities underthe partial settlement, including agreeing to assign away, not assert, orrelease certain potential claims the Company may have against its underwriters.Any direct financial impact of the proposed settlement (other 

F-32

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(9)**   Commitments andContingencies (Continued)

than defense costsincurred and expensed prior to May 31, 2003) is expected to be borne bythe Company’s insurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. The parties are directed to report backto the court regarding the modifications. If the parties are able to agree uponthe required modifications, and such modifications are acceptable to the court,notice will be given to all class members of the settlement, a “fairness”hearing will be held and if the court determines that the settlement is fair tothe class members, the settlement will be approved. There can be no assurancethat this proposed settlement would be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation, the ultimateoutcome of the matter cannot be predicted.

DIDS in its normal course of business from time totime experiences delays in identification system implementation, timelyacceptance for identification systems programs, concerns regardingidentification system program performance, and other contractual disputes.Management does not believe that there will be any material effect to theresults of operations for costs related to these contingencies. In addition,from time to time, customers have given notice of their intention to assertclaims for liquidated damages. Management believes that these assertions are partof the resolution process involving commercial disagreements over the deliveryterms of these contracts. Such disputes are not uncommon and tend to beresolved over time. To date, we have not paid liquidated damages in connectionwith a dispute with a domestic customer. While there is always risk thatliquidated damages could be assessed in the future, management does not believethat it is probable that material amounts will be paid, nor can we predict whatthe amount of any such damages would be if they were to be imposed.

The Company’s product license and services agreementsinclude a limited indemnification provision for claims from third partiesrelating to the Company’s intellectual property. Such indemnificationprovisions are accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*. Theindemnification is generally limited to the amount paid by the customer. Todate, claims under such indemnification provisions have not been significant.

Digimarc is subject fromtime to time to other legal proceedings and claims arising in the ordinarycourse of business. Although the ultimate outcome of these matters cannot bedetermined, management believes that the final disposition of these proceedingswill not have a material adverse effect on the consolidated financial position,results of operations, or liquidity of the Company. No accrual has beenrecorded because the amounts are not probable or reasonably estimatable inaccordance with SFAS No. 5, *Accounting forContingencies*.

**(10)   Restructuring**

During 2002 the Company recorded restructuring chargesthat include employee severance costs associated with the June 2002reduction of 30 personnel and abandoned space. Gross restructuring charges were$575 for the year ended December 31, 2002. Excess leased facility costrelated to abandoned space under non-cancelable leases of $120 was included inrestructuring charges and payments extend over the next 13 months. As of December 31,2003, all amounts have been paid related to restructuring charges and noaccrual remains on the Company’s books from these charges.

F-33

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(10)**   Restructuring(Continued)

During 2001 the Companyrecorded restructuring charges that include employee severance costs associatedwith the October 2001 reduction of 34 personnel and abandoned space.Restructuring charges were $574 for the year ended December 31, 2001. TheCompany subsequently adjusted its estimate relating to restructuring chargestaken in the fourth quarter of 2001. The Company reduced its remainingrestructuring accrual by $82 related to a change in estimate for excess leasedfacility costs resulting in net restructuring charges as of December 31,2002 of $493. As of December 31, 2003, all amounts have been paid relatedto restructuring charges and no accrual remains on the Company’s books fromthese charges.

**(11)**   Related Party Transactions

In 2004, 2003 and 2002, the Company entered intoservices and licensing arrangements with a holder of common stock. The Companyrecognized $638, $118 and $207 in revenue for the years ended December 31,2004, 2003 and 2002, respectively, in connection with these arrangements. At December 31,2004 and 2003, net accounts receivable from this customer were $202 and $218,respectively. At December 31, 2004 and 2003, deferred revenue from thiscustomer was $480 and $200, respectively.

The Company entered intotwo loans in 2002 with a former executive officer of the Company prior to suchofficer’s departure from the Company. Both loans were entered into inconnection with the former officer’s relocation to the Company’s facilities inMassachusetts. The first loan was entered into on July 1, 2002, and has aprincipal amount of $100 and an interest rate of 6.75% per year. Such loan isnot due and payable to the Company until June 30, 2006; provided, however,that the entire amount of the loan accelerates if the former officer’semployment was terminated “for cause.” The second loan was also entered into onJuly 1, 2002, and has a principal amount of $260 and an interest rate of4.99% per year. The second loan provides that it will be forgiven in full on apro-rata basis over a term of four years; provided, however, that if the formerofficer voluntarily left the Company’s employment for any reason, or if theformer officer was terminated “for cause,” then the outstanding balance of theloan accelerates and the former officer shall be responsible for paying theoutstanding principal balance, plus any interest that is accrued and unpaid, infull within 90 days of the date of his departure. The former executive officer’semployment with the Company was terminated in July 2004. The Company hasreserved an amount equal to the remaining amount of the loans.

**(12)   SubsequentEvents**

On February 23, 2005,the Compensation Committee of the Board of Directors approved the form of therestricted stock agreement to be used in connection with restricted stockawards to be granted to officers of the Company under the terms of the Company’s1999 Stock Incentive Plan. The Compensation Committee adopted a form ofrestricted stock agreement to be used in connection with such restricted stockawards. The agreement provides, among other things, that the shares will vestin full upon the termination of the officer’s employment without cause or theofficer’s resignation for good reason following a change in control of theCompany. Notwithstanding the foregoing, the plan administrator hasdiscretionary authority, among other things, to determine the terms andconditions of any award granted under the Plan. A copy of the agreement waspreviously filed by the Company with SEC as an exhibit to the Company’s Form 8-Kfiled on March 1, 2005. The Compensation Committee approved grants ofrestricted stock awards to certain of its named executive officers, effectiveas of March 1, 2005, totaling 

F-34

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(12)**   SubsequentEvents (Continued)

270,000shares. One-quarter of the restricted shares granted to these executiveofficers will vest each December 31 beginning on December 31, 2005.

**(13)   QuarterlyFinancial Information—Unaudited**

Asummary of quarterly financial information follows:
| **Quarter ended:**                      | ** ** | ** **     | ** ** | **March 31** | ** ** | **June 30** | ** **     | **September 30** | ** ** | **December 31** | ** **     |
|----------------------------------------------|------------|----------------|------------|-------------------|------------|------------------|----------------|-----------------------|------------|----------------------|----------------|
| **2004**                                     | ** ** | **(Restated)** | ** ** | **(Restated)**    | ** ** | ** **       | ** **     | ** **            | ** ** |
| Total revenue                                |       | $              | 23,658     |              | $          | 23,474           |           |                  | $          | 23,520               |           |   |   | $ | 22,295 |   |   |
| Cost of revenue                              |       | 14,844         |       | 14,764            |       |             | 13,730         |                  |       |                 | 14,389         |   |   |
| Operating income  (loss)                     |       | (936           | )          | (1,259            | )          |             | (2,667         | )                     |       |                 | (4,649         | ) |   |
| Net income (loss)                            |       | (786           | )          | (1,271            | )          |             | (2,467         | )                     |       |                 | (4,498         | ) |   |
| Net income (loss)  per share—basic      |       | (0.04          | )          | (0.06             | )          |             | (0.12          | )                     |       |                 | (0.22          | ) |   |
| Net income (loss)  per share—diluted    |       | (0.04          | )          | (0.06             | )          |             | (0.12          | )                     |       |                 | (0.22          | ) |   |
| **2003**                                     |       | **(Restated)** |       | **(Restated)**    |       |             | **(Restated)** |                  |       |                 | **(Restated)** |   |   |
| Total revenue                                |       | $              | 21,704     |              | $          | 22,546           |           |                  | $          | 22,300               |           |   |   | $ | 19,041 |   |   |
| Cost of revenue                              |       | 11,956         |       | 12,411            |       |             | 11,944         |                  |       |                 | 10,625         |   |   |
| Operating income  (loss)                     |       | (186           | )          | 24                |       |             | 777            |                  |       |                 | (684           | ) |   |
| Net income (loss)                            |       | (150           | )          | 96                |       |             | 842            |                  |       |                 | (613           | ) |   |
| Net income (loss)  per share—basic(1)   |       | (0.01          | )          | 0.01              |       |             | 0.04           |                  |       |                 | (0.03          | ) |   |
| Net income (loss)  per share—diluted(1) |       | (0.01          | )          | 0.01              |       |             | 0.04           |                  |       |                 | (0.03          | ) |   |

 

The following tables anddiscussion set forth certain of the restatement adjustments to our financialstatements for the quarterly periods indicated. The amounts in the tables areexpressed in thousands.

*Description ofAdjustments.*

*Capitalized software developmentcosts*.   The Company produces software that is usedinternally, and as such has costs that qualify under the AICPA’s SOP 98-1, *Accounting for the Costs of Computer Software Developed or Obtained forInternal Use.*The policy requires expensing of activitiesrelated to the preliminary stage of a software project (such as the conceptualformulation of alternatives), allows capitalization of activities related tothe application development stage of a software project (such as coding,installation, and testing), and requires expensing of activities related to thepost-implementation stage (such as training, maintenance, and support)consistent with the guidance in SOP 98-1. Under this policy, the Companycapitalizes costs in the application development stage of a software project.In connection with the restatement, the Company determined that certain costshad been erroneously capitalized because either a portion of such costs did notqualify for capitalization (e.g., costs related to the preliminary orpost-implementation stages) or the project itself did not qualify asinternal-use software (e.g., costs related to a non-software project).

*Project accounting cost tracking andcost deferrals*.   The Company erroneously tracked costsfor various projects as a result of certain difficulties the Company hadimplementing a new accounting system 

F-35

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(13)**   QuarterlyFinancial Information—Unaudited (Continued)

in late 2003 and early2004. As a result, certain costs that should have been recognized as expensesin the period incurred were erroneously recorded as inventory or as fixedassets.

*Tax accrual timing*.   TheCompany identified certain international tax expenses that had not beenproperly accrued in the period incurred.

*Revenue accrual based on estimated production.*   TheCompany recognizes revenue on long-term identification and driver licenseproduction contracts using a price-per-card method. The Company uses actualmonthly volume amounts, if available. Otherwise, the Company estimates thecard production volume on a monthly basis for certain of these contracts inorder to recognize revenue earned during the 

period. In the case ofestimates, prior to publicly reporting results, the Company’s practice isto compare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. However, for the first and second quartersof 2004, this practice was not followed and, as a result, the Companyunderstated revenues during the first quarter of 2004 and overstated revenuesfor the second quarter of 2004.

*Other Adjustments.  *Anumber of other adjustments were made in the restatement, including adjustmentsto (i) correctly record inventory receipts in the proper period,(ii) correct the timing of revenue recognized for a maintenance contract,(iii) correct commission liability relating to a long-term card productcontract, (iv) correct VAT payables and expenses, (v) correct revenuerecognized on a milestone based contract to match revenue recognized when themilestones were completed, and (vi) correct intercompany allocations whichwere not properly recorded. While the amounts associated with these otheradjustments are relatively small, the Company believes that it is appropriateto record them as part of this restatement.

***As of and for thethree months ended March 31, 2003:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Income  Taxes** | ** ** | ** As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------|------------|-------------------|------------|------------------------|------------|
| Total revenue                                                 |       |       | 21,704     |                             |       |                         | —     |              |       |                   | —     |   |   | 21,704 |   |
| Cost of revenue                                               |       |       | 11,946     |                             |       |                         | 10         |              |       |                   | —     |   |   | 11,956 |   |
| Operating expense                                             |       |       | 9,795      |                             |       |                         | 139        |              |       |                   | —     |   |   | 9,934 |   |
| Operating loss                                                |       |       | (37        | )                                |       |                         | (149       | )                 |       |                   | —     |   |   | (186 | ) |
| Other income                                                  |       |       | 116        |                             |       |                         | —     |              |       |                   | —     |   |   | 116 |   |
| Provision for  income taxes                                   |       |       | (50        | )                                |       |                         | —     |              |       |                   | (30        | ) |   | (80 | ) |
| Net income (loss)                                             |       |       | 29         |                             |       |                         | (149       | )                 |       |                   | (30        | ) |   | (150 | ) |

 

The effect of therestatement entries was to decrease net income from $0.00 per share to a netloss of $0.01 per share for the quarter ended March 31, 2003.

F-36

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(13)**   QuarterlyFinancial Information—Unaudited(Continued)

***As of and for thethree months ended June 30, 2003:***
| **Consolidated Statements of  Operation Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  Taxes** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|------------------|------------|
| Total revenue                                                 |       |       | 22,546     |                         |       |                         | —     |                    |       |              | —     |             |       |   | — |   |   | 22,546 |   |
| Cost of revenue                                               |       |       | 12,293     |                         |       |                         | 103        |                    |       |              | 15         |             |       |   | — |   |   | 12,411 |   |
| Operating expense                                             |       |       | 10,068     |                         |       |                         | 125        |                    |       |              | —     |             |       |   | (82 | ) |   | 10,111 |   |
| Operating income                                              |       |       | 185        |                         |       |                         | (228       | )                       |       |              | (15        | )                |       |   | 82 |   |   | 24 |   |
| Other income                                                  |       |       | 154        |                         |       |                         | —     |                    |       |              | —     |             |       |   | — |   |   | 154 |   |
| Provision for income  taxes                                   |       |       | (52        | )                            |       |                         | —     |                    |       |              | —     |             |       |   | (30 | ) |   | (82 | ) |
| Net income (loss)                                             |       |       | 287        |                         |       |                         | (228       | )                       |       |              | (15        | )                |       |   | 52 |   |   | 96 |   |

 

The effect of therestatement entries was to decrease net income from $0.02 per share to netincome of $0.01 per share for the quarter ended June 30, 2003.

***As of and for thethree months ended September 30, 2003:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  Taxes** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|------------------|------------|
| Total revenue                                                 |       |       | 22,300     |                         |       |                         | —     |                    |       |              | —     |             |       |   | — |   |   | 22,300 |   |
| Cost of revenue                                               |       |       | 11,706     |                         |       |                         | 185        |                    |       |              | 53         |             |       |   | — |   |   | 11,944 |   |
| Operating expense                                             |       |       | 9,405      |                         |       |                         | 146        |                    |       |              | 28         |             |       |   | — |   |   | 9,579 |   |
| Operating income                                              |       |       | 1,189      |                         |       |                         | (331       | )                       |       |              | (81        | )                |       |   | — |   |   | 777 |   |
| Other income                                                  |       |       | 146        |                         |       |                         | —     |                    |       |              | —     |             |       |   | — |   |   | 146 |   |
| Provision for income  taxes                                   |       |       | (51        | )                            |       |                         | —     |                    |       |              | —     |             |       |   | (30 | ) |   | (81 | ) |
| Net income (loss)                                             |       |       | 1,284      |                         |       |                         | (331       | )                       |       |              | (81        | )                |       |   | (30 | ) |   | 842 |   |

 

The effect of therestatement entries was to decrease net income from $0.07 per share to netincome of $0.04 per share for the quarter ended September 30, 2003.

***As of and for thethree months ended December 31, 2003:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Income  taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------------|------------|-----------|------------|------------------|------------|
| Total revenue                                                 |       |       | 19,068     |                         |       |                         | —     |                    |       |              | —     |      |       |             | —     |   |   |   | (27 | ) |   | 19,041 |   |
| Cost of revenue                                               |       |       | 10,338     |                         |       |                         | 43         |                    |       |              | 292        |      |       |             | —     |   |   |   | (48 | ) |   | 10,625 |   |
| Operating expense                                             |       |       | 8,901      |                         |       |                         | 186        |                    |       |              | 65         |      |       |             | —     |   |   |   | (52 | ) |   | 9,100 |   |
| Operating loss                                                |       |       | (171       | )                            |       |                         | (229       | )                       |       |              | (357       | )         |       |             | —     |   |   |   | 73 |   |   | (684 | ) |
| Other income                                                  |       |       | 151        |                         |       |                         | —     |                    |       |              | —     |      |       |             | —     |   |   |   | — |   |   | 151 |   |
| Provision for income  taxes                                   |       |       | (50        | )                            |       |                         | —     |                    |       |              | —     |      |       |             | (30        | ) |   |   | — |   |   | (80 | ) |
| Net income (loss)                                             |       |       | (70        | )                            |       |                         | (229       | )                       |       |              | (357       | )         |       |             | (30        | ) |   |   | 73 |   |   | (613 | ) |

 

The effect of therestatement entries was to increase net loss from $0.00 per share to net lossof $0.03 per share.

F-37

----

**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data)**

**(13)**   QuarterlyFinancial Information—Unaudited (Continued)

***As of and for thethree months ended March 31, 2004:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|-----------|------------|------------------|------------|
| Total revenue                                                 |       |       | 23,490     |                         |       |                         | —     |                    |       |        | —     |      |       |             | 280        |   |   | (112 | ) | 23,658 |   |
| Cost of revenue                                               |       |       | 13,714     |                         |       |                         | 21         |                    |       |        | 1,139      |      |       |             | —     |   |   | (30 | ) | 14,844 |   |
| Operating expense                                             |       |       | 9,401      |                         |       |                         | 382        |                    |       |        | 7          |      |       |             | —     |   |   | (40 | ) | 9,750 |   |
| Operating income (loss)                                       |       |       | 375        |                         |       |                         | (403       | )                       |       |        | (1,146     | )         |       |             | 280        |   |   | (42 | ) | (936 | ) |
| Other income                                                  |       |       | 200        |                         |       |                         | —     |                    |       |        | —     |      |       |             | —     |   |   | — |   | 200 |   |
| Provision for  income taxes                                   |       |       | (50        | )                            |       |                         | —     |                    |       |        | —     |      |       |             | —     |   |   | — |   | (50 | ) |
| Net income (loss)                                             |       |       | 525        |                         |       |                         | (403       | )                       |       |        | (1,146     | )         |       |             | 280        |   |   | (42 | ) | (786 | ) |

 

The effect of therestatement entries was to decrease net income from $0.03 per share to a netloss of $0.04 per share.

***As of and for thethree months ended June 30, 2004:***
| **Consolidated Statement of  Operations Data** | ** ** | ** ** | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Income  taxes** | ** ** | **Other** | ** ** | **As  Restated** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|-------------------|------------|-----------|------------|------------------|------------|
| Total revenue                                                 |       |       | 23,673     |                         |       |                         | —     |                    |       |        | —     |              |       |      | (251       | )                |       |   | — |   |   | 52 |   | 23,474 |   |
| Cost of revenue                                               |       |       | 15,826     |                         |       |                         | 21         |                    |       |        | (855       | )                 |       |      | (47        | )                |       |   | — |   |   | (181 | ) | 14,764 |   |
| Operating expense                                             |       |       | 9,741      |                         |       |                         | 320        |                    |       |        | 19         |              |       |      | (11        | )                |       |   | — |   |   | (100 | ) | 9,969 |   |
| Operating loss                                                |       |       | (1,894     | )                            |       |                         | (341       | )                       |       |        | 836        |              |       |      | (193       | )                |       |   | — |   |   | 333 |   | (1,259 | ) |
| Other income                                                  |       |       | 172        |                         |       |                         | —     |                    |       |        | —     |              |       |      | —     |             |       |   | — |   |   | — |   | 172 |   |
| Provision for  income taxes                                   |       |       | (222       | )                            |       |                         | —     |                    |       |        | —     |              |       |      | —     |             |       |   | 38 |   |   | — |   | (184 | ) |
| Net income (loss)                                             |       |       | (1,944     | )                            |       |                         | (341       | )                       |       |        | 836        |              |       |      | (193       | )                |       |   | 38 |   |   | 333 |   | (1,271 | ) |

 

The effect of the restatement entries was to decreasenet loss from $0.10 per share to a net loss of $0.06 per share.

 

F-38

----

**EXHIBIT INDEX**
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | **Document** |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|
| 2.1              |       | Asset Purchase Agreement  among Polaroid Corporation, Polaroid ID Systems, Inc. and Digimarc  Corporation (incorporated by reference to Exhibit 2.1 to the  Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on January 3, 2002)                                                                                                                                                                                                                                                                                |
| 3.1              |       | Second Amended and  Restated Certificate of Incorporation of the Registrant (incorporated by  reference to Exhibit 3.1 to the Registrant’s Quarterly Report on  Form 10-Q, as filed with the Securities and Exchange Commission on  November 14, 2000)                                                                                                                                                                                                                                                                                                             |
| 3.2              |       | Certificate of Amendment  of Second Amended and Restated Certificate of Incorporation of the Registrant  (incorporated by reference to Exhibit 3.2 to the Registrant’s Quarterly Report  on Form 10-Q, as filed with the Securities and Exchange Commission  on November 14, 2000)                                                                                                                                                                                                                                                                                 |
| 3.3              |       | Amended and Restated  Bylaws of the Registrant, as amended (incorporated by reference to  Exhibit 3.3 to the Registrant’s Annual Report on Form 10-K,  as filed with the Securities and Exchange Commission on March 15, 2004)                                                                                                                                                                                                                                                                                                                                     |
| 3.4              |       | Certificate of  Designation of the Series A Preferred Stock of Digimarc Corporation  (incorporated by reference to Exhibit 3.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on November 17, 2004)                                                                                                                                                                                                                                                                                                   |
| 4.1              |       | Reference is made to  Exhibits 3.1, 3.2 and 3.3                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2              |       | Second Amended and  Restated Investor Rights Agreement, dated as of November 2, 1999,  between the Registrant and the holders of the Registrant’s preferred stock  (incorporated by reference to Exhibit 4.2 to the Registrant’s  Registration Statement on Form S-1 (Commission File No. 333-87501)  which became effective on December 2, 1999)                                                                                                                                                                                                   |
| 4.3              |       | Rights Agreement, dated  as of November 16, 2004, between Digimarc Corporation and EquiServe  Trust Company, N.A. together with: Exhibit A Form of Rights  Certificate; Exhibit B Form of Summary of Rights to Purchase  Preferred Stock; and Exhibit C Form of Certificate of Designation  of the Series A Preferred Stock of Digimarc Corporation (incorporated by reference to Exhibit 4.1  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on November 17, 2004) |
| 10.1             |       | Form of  Indemnification Agreement between the Registrant and each of its executive  officers and directors (incorporated by reference to Exhibit 10.1 to the  Registrant’s Registration Statement on Form S-1 (Commission File  No. 333-87501) which became effective on December 2, 1999)                                                                                                                                                                                                                                                              |
| 10.2             |       | Registrant’s 1995 Stock Incentive  Plan, as amended (incorporated by reference to Exhibit 99.1 to the  Registrant’s Registration Statement on Form S-8 (Commission File  No. 333-31114) which became effective on February 25, 2000)                                                                                                                                                                                                                                                                                                                     |
| 10.3             |       | Registrant’s Restated  1999 Stock Incentive Plan, as amended and restated on April 17, 2003  (incorporated by reference to Exhibit 10.3 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 15, 2004)                                                                                                                                                                                                                                                                                        |
| 10.4             |       | Form of Notice of  Stock Option Award and Stock Option Award Agreement for the Digimarc  Corporation 1999 Stock Incentive Plan (incorporated by reference to  Exhibit 99(d)(2) of the Company’s Schedule TO, as filed with the  Securities and Exchange Commission on February 16, 2001)                                                                                                                                                                                                                                                                      |

----

 
| 10.5  |   | Registrant’s 1999  Employee Stock Purchase Plan, as amended and restated on February 19,  2004, including forms of agreements thereunder (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-115074) which became effective on  April 30, 2004)                                                       |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6  |   | Lease Agreement,  dated as of June 25, 1999, between the Registrant and Southplace  Associates LLC (incorporated by reference to Exhibit 10.8 to the  Registrant’s Registration Statement on Form S-1 (Commission File  No. 333-87501) which became effective on December 2, 1999)                                                                                                  |
| 10.7  |   | First Amendment  to Lease Agreement, dated as of February 17, 2000, between the  Registrant and Southplace Associates LLC (incorporated by reference to  Exhibit 10.10 to the Registrant’s Registration Statement on Form S-1  (Commission File No. 333-32778) which was filed with the  Securities and Exchange Commission on March 17, 2000 and withdrawn on  July 31, 2000) |
| 10.8  |   | CityPlex Towers Lease  Agreement, dated as of January 4, 2000, between the Registrant and Oral  Roberts University (incorporated by reference to Exhibit 10.11 to the  Registrant’s Registration Statement on Form S-1 (Commission File  No. 333-32778) which was filed with the Securities and Exchange  Commission on March 17, 2000 and withdrawn on July 31, 2000)         |
| 10.9  |   | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Macrovision Corporation (incorporated by reference to Exhibit 10.12 to  the Registrant’s Quarterly Report on Form 10-Q, as filed with the Securities  and Exchange Commission on November 14, 2000)                                                                                         |
| 10.10 |   | Strategic Investment  Agreement, dated as of September 17, 2000, between the Registrant and  Koninklijke Philips Electronics N.V. (incorporated by reference to  Exhibit 10.13 to the Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on November 14,  2000)                                                                           |
| 10.11 |   | Registrant’s 2000 Non-Officer  Employee Stock Incentive Plan, as amended and restated on February 19,  2004 (incorporated by reference to Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q, as filed with the Securities and  Exchange Commission on May 10, 2004)                                                                                                   |
| 10.12 |   | Registrant’s 1999 Non-Employee  Director Option Program, as amended and restated on March 10, 2004  (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on May 10, 2004)                                                                                                           |
| 10.13 |   | First Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.16 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                       |
| 10.14 |   | Second Promissory Note,  dated July 1, 2002, between Digimarc Corporation and Indraneel Paul  (incorporated by reference to Exhibit 10.17 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                      |
| 10.15 |   | Employment Agreement,  dated as of July 16, 2001, between the Registrant and Bruce Davis (incorporated  by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on  Form 10-Q, as filed with the Securities and Exchange Commission on  May 15, 2003)                                                                                                                          |
| 10.16 |   | Form of Warrant  (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report  on Form 8-K, as filed with the Securities and Exchange Commission  on August 27, 2003)                                                                                                                                                                                                    |
| 10.17 |   | Purchase Agreement by  and between the Registrant and each of the purchasers whose names are set  forth on the signature pages thereof (incorporated by reference to  Exhibit 10.1 to the Registrant’s Current Report on Form 8-K,  as filed with the Securities and Exchange Commission on August 27, 2003)                                                                             |

----

 
| 10.18 |   | Form of Notice of  Stock Option Award and Stock Option Award Agreement for employees under the  Digimarc Corporation 1999 Stock Incentive Plan (incorporated by reference to  Exhibit 99(d)(2) of the Company’s Schedule TO, as filed with the  Securities and Exchange Commission on February 16, 2001)                      |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | Form of Restricted  Stock Agreement for the Digimarc Corporation 1999 Stock Incentive Plan  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, as filed with the Securities and Exchange  Commission on March 1, 2005)                                                               |
| 10.20 |   | Form of Stock  Option Award Agreement for the 1999 Non-Employee Director Option Program  adopted under the Digimarc Corporation 1999 Stock Incentive Plan (incorporated by reference to Exhibit 10.2  to the Registrant’s Current Report on Form 8-K, as filed with the  Securities and Exchange Commission on March 1, 2005) |
| 10.21 |   | Forms of Notice of Stock  Option Award and Stock Option Award Agreement for officers under the Digimarc  Corporation 1999 Stock Incentive Plan                                                                                                                                                                                                         |
| 10.22 |   | Full Service Lease,  dated March 22, 2004, by and between PS Business Parks, L.P., and the  Registrant                                                                                                                                                                                                                                            |
| 21.1  |   | List of Subsidiaries  (incorporated by reference to Exhibit 21.1 to the Registrant’s Annual  Report on Form 10-K, as filed with the Securities and Exchange  Commission on March 31, 2003)                                                                                                                                         |
| 23.1  |   | Consent of KPMG LLP,  Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                                    |
| 24.1  |   | Power of Attorney  (included on the signature page of this report)                                                                                                                                                                                                                                                                                |
| 31.1  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                                                           |
| 31.2  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                                                           |
| 32.1  |   | Section 1350 Certification  of Chief Executive Officer                                                                                                                                                                                                                                                                                            |
| 32.2  |   | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                            |

 

----