**UNITED
      STATES**


**SECURITIES** **AND
      EXCHANGE** **COMMISSION**




**Washington,
      D.C. 20549**




**FORM
      10-Q**




**QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF**




**THE
      SECURITIES EXCHANGE ACT OF 1934**


**For
      the quarterly period ended**  **March
      31, 2007**




**1-32146**Commission
                file number





**DOCUMENT
                SECURITY SYSTEMS, INC.**(Exact
                name of registrant as specified in its
                charter)





**New
                York**
            
            **16-1229730**(State
                of incorporation)
            
            (IRS
                Employer Identification Number)





**28
                Main Street East, Suite 1525****Rochester,****NY****14614**[Missing
                Graphic Reference](Address
                of principal executive office)





**(585)
                325-3610**(Registrant's
                telephone number)





**Indicate
                by check mark whether the registrant:**(1)
                filed all reports required to be filed by Section 13 or 15(d) of
                the
                Exchange Act during the preceding 12 months (or for such shorter
                period
                that the registrant was required to file such reports)And(2)
                has been subject to such filing requirements for the past 90
                days.
              **Yes x 
No
o**





Indicate
                by check mark whether the registrant is a large accelerated filer,
                an
                accelerated filer, or a non-accelerated filer. See definition of
                “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the
                Exchange Act. (Check one):
              
              Large
                accelerated filer oAccelerated
                filer oNon-accelerated
                filer x
              
              Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act)
              **Yes o
                No x**
              
              **Applicable
                only to corporate issuers**As
                of May 10, 2007 (the most recent practicable date), there were 13,678,966
                shares of the issuer's Common Stock, $0.02 par value per share,
                outstanding.














**DOCUMENT
                SECURITY SYSTEMS, INC.**
              **FORM
                10-Q**
              **TABLE
                OF CONTENTS****PART
                I**
            
            **FINANCIAL
                INFORMATION**Item
                1
            
            Financial
                StatementsConsolidated
                Balance Sheets
            
            F-1Consolidated
                Statements of Operations
            
            F-2Consolidated
                Statements of Cash Flows
            
            F-3Notes
                to Financial Statements
            
            F-4Item
                2
            
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            14Item
                3
            
            Quantitative
                and Qualitative Disclosures about Market Risk
            
            24Item
                4
            
            Controls
                and Procedures
            
            24**PART
                II**
            
            **OTHER
                INFORMATION**Item 1
            
            Legal
              Proceedings
            
            25Item
                1a
            
            Risk
                Factors
            
            26Item
                2
            
            UnregisteredSales
                of Equity Securities and Use of Proceeds
            
            32Item
                3
            
            Defaults
                upon Senior Securities
            
            32Item
                4
            
            Submission
                of Matters to a Vote of Security Holders
            
            33Item
                5
            
            Other
                Information
            
            33Item
                6
            
            Exhibits
            
            34**SIGNATURES**




2


**PART
      I**






**FINANCIAL
      INFORMATION**






ITEM
      1 -
      FINANCIAL STATEMENTS




**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Balance Sheets****March
                  31,**
              
              **December
                  31,****2007**
              
              **2006****(unaudited)**
              
              **(audited)****ASSETS****Current
                  assets:**Cash
                  and cash equivalents
              
              $
              4,439,785
              
              $
              5,802,615Accounts
                  receivable, net of allowanceof
                  $74,000 ($74,000 -2006)
              
              
              1,018,562
              
              
              618,622Inventory
              
              
              316,579
              
              
              239,416Prepaid
                  expenses and other current assets
              
              
              229,211
              
              
              224,782Total
                  current assets
              
              
              6,004,137
              
              
              6,885,435**Fixed
                  assets, net**
              
              
              619,135
              
              
              637,732**Other
                  assets**
              
              
              158,370
              
              
              156,734**Goodwill**
              
              
              1,396,734
              
              
              1,396,734**Other
                  intangible assets, net**
              
              
              6,142,182
              
              
              5,389,564**Total
                  Assets**
              
              $
              14,320,558
              
              $
              14,466,199**LIABILITIES
                  AND STOCKHOLDERS' EQUITY****Current
                  liabilities:**Accounts
                  payable
              
              $
              1,444,994
              
              $
              1,283,503Accrued
                  expenses & other current liabilities
              
              
              914,722
              
              
              877,261Deferred
                  revenue
              
              
              603,499
              
              
              564,439Current
                  portion of capital lease obligations
              
              
              33,093
              
              
              34,814Total
                  current liabilities
              
              
              2,996,308
              
              
              2,760,017**Long-term
                  capital lease obligations**
              
              
              42,417
              
              
              50,417**Long-term
                  deferred revenue**
              
              
              385,954
              
              
              466,875**Commitments
                  and Contingencies (see Note 7)****Stockholders'
                  equity**Common
                  stock, $.02 par value;200,000,000
                  shares authorized,13,612,597
                  shares issued and outstanding(13,544,724
                  in 2006)
              
              
              272,252
              
              
              270,894Additional
                  paid-in capital
              
              
              29,061,367
              
              
              28,145,793Accumulated
                  deficit
              
              
              (18,437,740
              )
              
              (17,227,797
              )Total
                  stockholders' equity
              
              
              10,895,879
              
              
              11,188,890**Total
                  Liabilities and Stockholders' Equity**
              
              $
              14,320,558
              
              $
              14,466,199




See
      accompanying notes




3




**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Operations****For
                  the Three Months Ended March 31,**(Unaudited)
  **2007**
              
              **2006**RevenueSecurity
                  printing
              
              $
              1,112,352
              
              $
              656,038Royalties
              
              
              298,796
              
              
              36,614Digital
                  solutions
              
              
              162,802
              
              
              -Legal
                  products
              
              
              175,682
              
              
              170,058Total
                  Revenue
              
              
              1,749,632
              
              
              862,710Costs
                  of revenueSecurity
                  printing
              
              
              555,540
              
              
              443,480Digital
                  solutions
              
              
              33,507
              
              
              -Legal
                  products
              
              
              103,174
              
              
              102,717Total
                  costs of revenue
              
              
              692,221
              
              
              546,197**Gross
                  profit**
              
              
              1,057,411
              
              
              316,513**Operating
                  expenses:**Selling,
                  general and administrative expenses
              
              
              1,858,878
              
              
              1,039,906Research
                  and development
              
              
              94,408
              
              
              72,602Amortization
                  of intangibles
              
              
              345,639
              
              
              220,000Operating
                  expenses
              
              
              2,298,925
              
              
              1,332,508**Operating
                  loss**
              
              
              (1,241,514
              )
              
              (1,015,995
              )**Other
                  income (expense):**Interest
                  income
              
              
              40,808
              
              
              26,896Gain/(loss)
                  on foreign currency adjustments
              
              
              (3,346
              )
              
              -Interest
                  expense
              
              
              (1,153
              )
              
              (5,463
              )**Loss
                  before income taxes**
              
              
              (1,205,205
              )
              
              (994,562
              )Income
                  taxes
              
              
              4,738
              
              
              -**Net
                  loss**
              
              $
              (1,209,943
              )
              $
              (994,562
              )**Net
                  loss per share, basic and diluted**
              
              $
              (0.09
              )
              $
              (0.08
              )**Weighted
                  average common shares outstanding,****basic
                  and diluted**
              
              
              13,584,795
              
              
              12,803,861




See
      accompanying notes.


4


**DOCUMENT
                  SECURITY SYSTEMS, INC. AND SUBSIDIARIES****Consolidated
                  Statements of Cash Flows****For
                  the three Months Ended March 31,**(Unaudited)
  **2007**
              
              **2006****Cash
                  flows from operating activities:**Net
                  loss
              
              $
              (1,209,943
              )
              $
              (994,562
              )Adjustments
                  to reconcile net loss to net cash used by operatingactivities:Depreciation
                  and amortization expense
              
              
              391,398
              
              
              276,647Stock
                  based compensation
              
              
              335,948
              
              
              27,329(Increase)
                  decrease in assets:Accounts
                  receivable
              
              
              (399,940
              )
              
              (131,749
              )Inventory
              
              
              (77,163
              )
              
              7,027Prepaid
                  expenses and other assets
              
              
              (6,065
              )
              
              7,802Increase
                  (decrease) in liabilities:Accounts
                  payable
              
              
              99,043
              
              
              260,458Accrued
                  expenses and other current liabilities
              
              
              142,961
              
              
              (50,105
              )Deferred
                  revenue
              
              
              (41,861
              )
              
              -Net
                  cash used by operating activities
              
              
              (765,622
              )
              
              (597,153
              )**Cash
                  flows from investing activities:**Purchase
                  of fixed assets
              
              
              (27,162
              )
              
              (37,229
              )Business
                  combination
              
              
              -
              
              
              (1,250,000
              )Purchase
                  of other intangible assets
              
              
              (380,306
              )
              
              (94,869
              )Net
                  cash used by investing activities
              
              
              (407,468
              )
              
              (1,382,098
              )**Cash
                  flows from financing activities:**Repayment
                  of long-term debt
              
              
              -
              
              
              (12,476
              )Repayment
                  of capital lease obligations
              
              
              (9,721
              )
              
              (8,080
              )Payment
                  of stock issuance costs
              
              
              (519,619
              )
              
              -Issuance
                  of common stock
              
              
              339,600
              
              
              589,901Net
                  cash provided (used) by financing activities
              
              
              (189,740
              )
              
              569,345**Net
                  decrease in cash and cash equivalents**
              
              
              (1,362,830
              )
              
              (1,409,906
              )**Cash
                  and cash equivalents beginning of period**
              
              
              5,802,615
              
              
              3,953,482**Cash
                  and cash equivalents end of period**
              
              $
              4,439,785
              
              $
              2,543,576
 See
        accompanying notes.




5


**DOCUMENT
      SECURITY SYSTEMS, INC.**


**NOTES
      TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS**


**March
      31, 2007**


**(Unaudited)**






**1. Basis
      of
      Presentation and Significant Accounting Policies**




The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in accordance with U.S. generally accepted accounting principles for
      interim financial information and with the instructions to Form 10-Q and Article
      10 of Regulation S-X. Accordingly, these statements do not include all of the
      information and footnotes required by U.S. generally accepted accounting
      principles for complete financial statements. In the opinion of management,
      the
      accompanying balance sheets and related interim statements of operations and
      cash flows include all adjustments, consisting only of normal recurring items,
      necessary for their fair presentation in accordance with U.S. generally accepted
      accounting principles. All significant intercompany transactions have been
      eliminated.





Interim
      results are not necessarily indicative of results expected for a full year.
      For
      further information regarding Document Security Systems, Inc (the “Company”)
      accounting policies, refer to the audited consolidated financial statements
      and
      footnotes thereto included in the Company's Form 10-K for the fiscal year ended
      December 31, 2006.





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States requires management to make estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ materially from those estimates
      and assumptions.





***Revenue
      Recognition*** - Sales
      of
      security and other printing products, and legal products are recognized when
      a
      product or service is delivered, shipped or provided to the customer and all
      material conditions relating to the sale have been substantially performed.




We
      recognize revenue from technology licenses over the term of license agreements
      once all the following criteria for revenue recognition have been met: (1)
      persuasive evidence of an agreement exists; (2) the right and ability to use
      the
      product or technology has been rendered; (3) the fee is fixed and determinable
      and not subject to refund or adjustment; and (4) collection of the amounts
      due
      is reasonably assured.




For
      digital solutions sales, revenue is recognized in accordance with the American
      Institute of Certified Public Accountant's Statement of Position (SOP) No.
      97-2,
      "Software Revenue Recognition," as modified by SOP No. 98-9, "Modification
      of
      SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions"
      and Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition." Accordingly,
      revenue is recognized when all of the following conditions are satisfied: (1)
      there is persuasive evidence of an arrangement; (2) the service or product
      has
      been provided to the customer; (3) the amount of fees to be paid by the customer
      is fixed or determinable (4) the collection of our fees is reasonably
      assured.




6


We
      also
      enter into arrangements under which we provide hosted software applications.
      We
      recognize revenue for these arrangements based on the provisions of EITF No.
      00-3, Application of AICPA SOP 97-2 to Arrangements That Include the Right
      to
      Use Software Stored on Another Entity’s Hardware (“EITF 00-3”), and the
      provisions of Staff Accounting Bulletin No. 104, “Revenue Recognition in
      Financial Statements”, when there is persuasive evidence of an arrangement,
      collection of the resulting receivable is probable, the fee is fixed or
      determinable and acceptance has occurred. Our revenues related to these
      arrangements consist of system implementation service fees and software
      subscription fees. We have determined that the system implementation services
      represent set-up services that do not qualify as separate units of accounting
      from the software subscriptions as the customer would not purchase these
      services without the purchase of the software subscription. As a result, we
      recognize system implementation fees ratably over a period of time from when
      the
      core system implementation services are completed and accepted by the customer
      over the remaining customer relationship life, which we have determined is
      the
      contractual life of the customer’s subscription agreement. We recognize software
      subscription fees, which typically commence upon completion of the related
      system implementation, ratably over the applicable subscription period. Amounts
      billed and/or collected prior to satisfying our revenue recognition policy
      are
      reflected as deferred revenue.





***Recent
      Accounting Pronouncements*** -In July
      2006, the Financial Accounting Standards Board (“FASB”) issued Financial
      Interpretation 48, Accounting for Uncertainty in Income Taxes - an
      interpretation of FASB Statement 109 (“FIN 48”). FIN 48 clarifies the
      accounting for uncertainty in income taxes recognized in the financial
      statements in accordance with SFAS 109, Accounting for Income Taxes and requires
      a two-step approach to evaluate tax positions and determine if they should
      be
      recognized in the financial statements. The two-step approach involves
      recognizing any tax positions that are “more likely than not” to occur and then
      measuring those positions to determine if they are recognizable in the financial
      statements. The interpretation is effective for fiscal years beginning after
      December 15, 2006. We adopted FIN 48 on January 1, 2007.




**2. Inventory**




Inventory
      consisted of the following:


**March
                  31,**
              
              **December
                  31,****2007**
              
              **2006****(unaudited)**
              
              **(audited)**Finished
                  Goods
              
              $
              204,394
              
              $
              145,206Materials
              
              
              112,185
              
              
              94,210$
              316,579
              
              $
              239,416




7


**3. Goodwill
      and
      Other Intangible Assets**




***Other
      Intangible Assets*** -





Other
      intangible assets are comprised of the following:


**March
                  31, 2007**
              
              
              **December
                  31, 2006****Gross**
              
              
              
              
              
              **Net**
              
              
              **Gross**
              
              
              
              
              
              **Net****Useful**
              
              
              **Carrying**
              
              
              **Accumulated**
              
              
              **Carrying**
              
              
              **Carrying**
              
              
              **Accumulated**
              
              
              **Carrying****Life**
              
              
              **Amount**
              
              
              **Amortizaton**
              
              
              **Amount**
              
              
              **Amount**
              
              
              **Amortizaton**
              
              
              **Amount**Royalty
                  rights
              
              
              5
                  years
              
              $
              90,000
              
              $
              58,500
              
              $
              31,500
              
              $
              90,000
              
              $
              54,000
              
              $
              36,000Other
                  intangibles
              
              
              5
                  years
              
              
              666,300
              
              
              183,416
              
              
              482,884
              
              
              666,300
              
              
              149,036
              
              
              517,264Patent
                  and contractual rights
              
              
              Varied
                  (1
              )
              
              7,310,657
              
              
              1,682,859
              
              
              5,627,798
              
              
              6,212,400
              
              
              1,376,100
              
              
              4,836,300$
              8,066,957
              
              $
              1,924,775
              
              $
              6,142,182
              
              $
              6,968,700
              
              $
              1,579,136
              
              $
              5,389,564(1)-
                  patent rights are amortized over their expected useful life which
                  is
                  generally the legal life of the patent. Asof
                  March 31, 2007 the weighted average remaining useful life of these
                  assets
                  in service was 4.4 years.
 **4. Shareholders’
        Equity**




***Stock
      Issued for Patent Defense Costs -*** On
      November 14, 2006, the Company entered into an stock payment agreement with
      McDermott Will & Emery LLP (“MWE”), its lead counsel on its European Central
      Bank (“ECB Litigation”) patent infringement and related cases. The agreement
      with MWE allows the Company to use its common stock to eliminate the Company’s
      cash requirements for MWE’s legal fees related to the ECB litigation, not to
      exceed $1.2 million in stock. During the three months ended March 31, 2007,
      23,593 restricted shares were issued to MWE to pay for approximately $268,000
      of
      legal incurred through December 31, 2006.





***Stock
      Issued in Private Placement -*** On
      January 22,  2007, the Company sold 6 units at a price of $50,000 per unit
      for gross cash proceeds of $300,000, consisting of 35,280 unregistered shares
      of
      our common stock and five-year warrants to purchase up to an aggregate of 17,640
      shares of our common stock, at an exercise price of $11.75 per share. The
      Company incurred placement agent fees associated with the offering equal to
      9%
      commissions of $27,000. The fair market value of these warrants was determined
      using the Black Scholes Option Pricing Model at $107,000.





***Stock
      Warrants*** - During
      the three months ended March 31, 2007, the Company received approximately
      $39,600 in proceeds from the exercise of 9,000 warrants.





8


The
      following is a summary with respect to warrants outstanding at March 31,
      2007:




**2007****Weighted****Average****Exercise****Warrants**
              
              **Price**Warrants
                  outstanding at December 31, 2007
              
              
              923,818
              
              $
              9.96Granted
              
              
              17,640
              
              $
              11.75Exercised
              
              
              9,000
              
              $
              4.4Lapsed
              
              
              -
              
              $
              -Warrants
                  outstanding at March 31, 2007
              
              
              932,458
              
              $
              10.05Weighted
                  average years remaining
              
              
              
              
              
              2.0




The
      following table summarizes the warrants outstanding and exercisable as of March
      31, 2007:





**Warrants
                  Outstanding**
              
              **Warrants
                  Exercisable****Weighted**
              
              
              
              
              
              **Weighted****Average**
              
              **Weighted**
              
              
              
              **Average****Remaining**
              
              **Average**
              
              
              
              **Remaining**
              
              **Weighted****Range
                  of**
              
              **Number
                  of**
              
              **Contractual**
              
              **Exercise**
              
              **Number
                  of**
              
              **Contractual**
              
              **Average****Exercise
                  Prices**
              
              **Shares**
              
              **Life
                  (in years)**
              
              **Price**
              
              **Shares**
              
              **Life
                  (in years)**
              
              **Exercise
                  Price**$2.00-$4.99
              
              
              50,375
              
              
              1.3
              
              $
              2.02
              
              
              50,375
              
              
              1.3
              
              $
              2.02$5.00-$7.75
              
              
              32,811
              
              
              1.7
              
              $
              5.00
              
              
              32,811
              
              
              1.7
              
              $
              5.00$7.76-$11.75
              
              
              849,272
              
              
              2.0
              
              $
              10.72
              
              
              849,272
              
              
              2.0
              
              $
              10.72932,458
              
              
              
              
              
              
              
              
              932,458





***Stock
      Based Compensation*** **-** Stock-based
      compensation includes expense charges for all stock-based awards to employees,
      directors and consultants. Such awards include option grants and restricted
      stock awards. As of March 31, 2007, the Company has two shareholder approved
      plans: the
      2004
      Employees’ Stock Option Plan (the “2004 Plan”) and  the
      Non-Executive Director Stock Option Plan (the “Director Plan”). During the three
      months ended March 31, 2007, the company recognized approximately $336,000
      ($27,000- 2006) in stock based compensation.





The
      fair
      value of each option award is estimated on the date of grant utilizing the
      Black
      Scholes Option Pricing Model that uses the assumptions noted in the following
      table.




**Three
                Months Ended March 31,****2007**
            
            
            **2006**Volatility
            
            
            54.4
            %
            
            42.6
            %Expected
                option term
            
            
            3
                years
            
            
            3
                yearsRisk-free
                interest rate
            
            
            4.7
            %
            
            4.4
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





9


A
      summary
      of the status of the options granted is presented below:


**Weighted****Average**
              
              **Weighted****Number
                  of**
              
              **Exercise**
              
              **Average
                  Life****Options**
              
              **Price**
              
              **Remaining**(years)Outstanding
                  at December 31, 2006
              
              
              354,750
              
              
              8.14Granted
              
              
              170,000
              
              
              10.91Exercised
              
              
              -
              
              
              -Canceled
              
              
              -
              
              
              -Outstanding
                  at March 31, 2007:
              
              
              524,750
              
              
              9.04Exercisable
                  at March 31, 2007:
              
              
              304,750
              
              
              7.83Aggregate
                  Intrinsic Value of outstandingoptions
                  at March 31, 2007
              
              $
              990,540
              
              
              
              
              
              3.70Aggregate
                  Intrinsic Value of exercisableoptions
                  at March 31, 2007
              
              $
              951,790
              
              
              
              
              
              3.33





The
      weighted-average grant date fair value of options granted during the three-month
      period ended March 31, 2007 was $5.06 ($4.24 -2006). There were no options
      exercised during the three-month periods ended March 31, 2007 or 2006,
      respectively.





**Options
                  Outstanding**
              
              **Options
                  Exercisable****Weighted**
              
              
              
              
              
              **Weighted****Average**
              
              **Weighted**
              
              
              
              **Average**
              
              **Weighted****Range
                  of**
              
              
              
              **Remaining**
              
              **Average**
              
              
              
              **Remaining**
              
              **Average****Exercise**
              
              **Number
                  of**
              
              **Contractual**
              
              **Exercise**
              
              **Number
                  of**
              
              **Contractual**
              
              **Exercise****Prices**
              
              **Shares**
              
              **Life
                  (in years)**
              
              **Price**
              
              **Shares**
              
              **Life
                  (in years)**
              
              **Price**$2.20-$5.00
              
              
              13,750
              
              
              1.8
              
              $
              3.57
              
              
              13,750
              
              
              1.8
              
              $
              3.57$5.01-$9.00
              
              
              251,000
              
              
              3.3
              
              $
              7.49
              
              
              251,000
              
              
              3.3
              
              $
              7.49$9.01-$12.91
              
              
              260,000
              
              
              4.2
              
              $
              10.83
              
              
              40,000
              
              
              4.2
              
              $
              11.42524,750
              
              
              
              
              
              
              
              
              304,750





The
      following table summarizes the status of the Company’s non-vested options under
      its stock option plans:





Number
                  of Non-
              
              Weighted-vested
                  Shares
              
              AverageSubject
                  to
              
              Grant
                  DateOptions
              
              Fair
                  ValueNon-vested
                  as of December 31, 2006
              
              
              70,000
              
              $
              4.33Non-vested
                  granted- 2007
              
              
              170,000
              
              $
              5.06Vested
                  - 2007
              
              
              20,000
              
              $
              4.24Forfeited
                  - 2007
              
              
              -
              
              $
              -Non-vested
                  as of March 31, 2007
              
              
              220,000
              
              $
              4.90





10





As
      of
      March 31, 2007, there was approximately $961,000 of total unrecognized
      compensation cost related to non-vested options granted under the Company’s
      option plans. That cost will be recognized over a weighted average period of
      approximately 3 years. The total fair value of shares that vested during the
      three-month period ended March 31, 2007 was $84,800 ($0- 2006).





**5. Earnings
      Per
      Share**





Basic earnings per share is computed by dividing net income by the
      weighted-average number of common shares outstanding for the period. Diluted
      earnings per share is computed by including the number of additional shares
      that
      would have been outstanding if dilutive potential shares had been issued. In
      periods of losses, diluted loss per share is computed on the same basis as
      basic
      loss per share as the inclusion of any other potential shares outstanding would
      be anti-dilutive. If
      the
      Company had generated earnings during the three-month period ended March 31,
      2007, 566,711 (202,362-2006) common equivalent shares would have been added
      to
      the weighted average shares outstanding to compute the diluted weighted average
      shares outstanding.




**6. Income
      Taxes**




We
      adopted the Financial Accounting Standard Board’s Interpretation No. 48,
      Accounting for Income Tax Uncertainties (“FIN 48”), on January 1, 2007. 
FIN 48 clarifies the accounting for uncertain income tax positions recognized
      in
      financial statements and requires the impact of a tax position to be recognized
      in the financial statements if that position is more likely than not of being
      sustained by the taxing authority.  As of January 1, 2007, there were no
      unrecognized tax benefits. Our policy is to recognize interest and penalties
      on
      unrecognized tax benefits in provision for income taxes in the consolidated
      statements of operations.  As of March 31, 2007, the Company has no accrued
      interest or penalties related to uncertain tax positions. Federal tax years
      beginning in 2003 are subject to examination by taxing authorities, although
      net
      operating loss and credit carryforwards from all years are subject to
      examinations and adjustments for at least three years following the year in
      which the attributes are used. U.S State and jurisdiction have status of
      limitation, generally ranging from 4 to 6 years.




**7. Commitments
      and Contingencies**




Pursuant
      to an agreement made in December 2004, the Company is required to share the
      economic benefit derived from settlements, licenses or subsequent business
      arrangements that the Company obtains from any infringer of patents formerly
      owned by the Wicker Family. For infringement matters involving certain U.S.
      patents, the Company will be required to disburse 30% of the settlement
      proceeds. For infringement matters involving certain foreign patents, the
      Company will be required to disburse 14% of the settlement proceeds. These
      payments do not apply to licenses or royalties to patents that the Company
      has
      developed or obtained from persons other than the Wicker Family. As of March
      31,
      2007, there have been no settlement amounts related to these
      agreements.




The
      Company is engaged in a patent dispute with the European Central Bank (see
      Part
      II Item 1- Legal Proceedings). The patent dispute includes patent validity
      suits
      that the Company is engaged in nine European national courts. To date, the
      Company has been able to significantly mitigate the cash outlays required for
      legal costs associated with the dispute by negotiating legal fee caps and using
      shares of its common stock for payments. However, the Company will be required
      to pay additional legal costs and related fees in each of the nine validity
      suits. In addition, each party to the lawsuit will typically be responsible
      for
      reimbursements to the other party for a portion of the winning party’s legal
      fees related to individual rulings each of the various cases. To date, the
      Company has received a favorable ruling regarding validity in the German Court
      and an unfavorable ruling regarding validity in the English Court. In the
      English Court, the Company was ordered to pay 180,000 pounds (USD $365,000)
      for
      reimbursement to the ECB for legal cost reimbursement, of which 90,000 pounds
      (USD $182,000) was paid on April 4, 2007. The Company has accrued the legal
      cost
      reimbursement of $365,000 as of March 31, 2007. In the German Court, the Company
      is awaiting a determination by the German Court on the amount that it will
      receive from the ECB for reimbursement of the Company’s legal costs. As the
      validity cases and the infringement case ensue, the Company will be required
      to
      utilize outside counsel in each foreign court and could continue to receive
      adverse rulings which will require the Company to reimburse the ECB legal costs
      which would likely be significant, with current estimates of the potential
      remaining litigation costs, not including costs covered by cap fees negotiated
      with its lead counsel, of between $1,000,000 to $2,000,000 The payment of these
      amounts could adversely affect the Company’s financial position and would likely
      require the Company to raise additional funds, which may not be on terms
      favorable to the Company.




11




In
      May
      2005, the Company made an agreement with its legal counsel in charge of the
      Company’s infringement litigation with the European Central Bank which capped
      its fees for all matters associated with that infringement litigation at
      $540,000 plus expenses which may include third-party legal fees, and a $150,000
      contingent payment upon a successful ruling or settlement on the Company’s
      behalf in that litigation. The Company will record the $150,000 in the period
      in
      which the Company has determined that a successful ruling or settlement is
      probable.




In
      addition to the foregoing, we are subject to other legal proceedings that have
      arisen in the ordinary course of business and have not been finally adjudicated.
      Although there can be no assurance in this regard, in the opinion of management,
      none of the legal proceedings to which we are a party, whether discussed herein
      or otherwise, will have a material adverse effect on our results of operations,
      cash flows or our financial condition.




**8. Supplemental
      Cash Flow Information**




During
      the three months ended March 31, 2007, the Company issued 23,593 shares of
      Common Stock valued at approximately $268,000 in conjunction with the payment
      of
      legal expenses which were capitalized as other intangible assets. During the
      three months ended March 31, 2006, the Company issued 18,704 shares of Common
      Stock valued at $250,000 in conjunction with the acquisition of Plastic Printing
      Professionals.




**9. Segment
      Information**




The Company's businesses are organized, managed and internally reported as
      four
      operating segments. Three of these operating segments, Document Security
      Systems, Plastic Printing Professionals and Patrick Printing, respectively,
      are
      engaged in various aspects of developing and applying printing technologies
      and
      procedures to produce, or allow others to produce, documents with a wide range
      of features, including the Company’s patented technologies and trade secrets.
      For the purposes of providing segment information, these three operating
      segments have been aggregated into one reportable segment in accordance with
      Financial Accounting Standards Board (“FASB”) Statement No. 131- *“Disclosures
      about Segments of an Enterprise and Related Information”* .
      A
      summary of the two segments is as follows:




**Document
                Security and Production**
            License,
                manufacture and sale of document security technologies, including
                digital
                security print solutions and secure printed products at Document
                Security
                Systems, Plastic Printing Professionals and Patrick Printing divisions.
                Also, includes revenues from copying services and residual royalties
                from
                motion picture operations.**Legal
                Supplies**
            Sale
                of specialty legal supplies to lawyers and law firms located throughout
                the United States as
                Legalstore.com.







12


Approximate information concerning the operations by reportable segment for
      the
      three months ended March 31, 2007 and 2006 is as follows. The Company relies
      on
      intersegment cooperation and management does not represent that these segments,
      if operated independently, would report the results contained herein:




**Document****Legal**
              
              **Security
                  &****3
                  months ended March 31, 2007:**
              
              **Supplies**
              
              **Production**
              
              **Corporate**
              
              **Total**Revenues
                  from external customers
              
              $
              176,000
              
              $
              1,574,000
              
              $
              -
              
              $
              1,750,000Depreciation
                  and amortization
              
              
              3,000
              
              
              376,000
              
              
              12,000
              
              
              391,000Segment
                  profit or (loss)
              
              
              (1,000
              )
              
              (463,000
              )
              
              (746,000
              )
              
              (1,210,000
              )**3
                  months ended March 31, 2006:**Revenues
                  from external customers
              
              $
              171,000
              
              $
              692,000
              
              $
              -
              
              
              863,000Depreciation
                  and amortization
              
              
              1,000
              
              
              247,000
              
              
              28,000
              
              
              276,000Segment
                  profit or (loss)
              
              
              (13,000
              )
              
              (499,000
              )
              
              (483,000
              )
              
              (995,000
              )




13




**ITEM
      2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**




***FORWARD-LOOKING
      STATEMENTS***




Certain
      statements contained herein constitute “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995 (the “1995
      Reform Act”). Document Security Systems, Inc. desires to avail itself of certain
“safe harbor” provisions of the 1995 Reform Act and is therefore including this
      special note to enable us to do so. Except for the historical information
      contained herein, this report contains forward-looking statements (identified
      by
      the words "estimate," "project," "anticipate," "plan," "expect," "intend,"
      "believe," "hope," "strategy" and similar expressions), which are based on
      our
      current expectations and speak only as of the date made. These forward-looking
      statements are subject to various risks, uncertainties and factors, including,
      without limitation, those contained in our Form 10-K for the year ended December
      31, 2006 and those described herein that could cause actual results to differ
      materially from the results anticipated in the forward-looking
      statements.




**Overview**




Document
      Security Systems, Inc. (referred to in this report as “Document Security,” “we,”
“us,” “our” or “Company”) markets and sells products designed to protect
      valuable information from unauthorized scanning, copying, and digital imaging.
      Developing sophisticated security technologies that are applied during the
      normal printing process and by all printing methods including traditional
      offset, gravure, flexo, digital or via the internet on paper, plastic, or
      packaging. We are a leader of customized document protection solutions for
      companies and governments worldwide. We hold seven patents that protect our
      technology and have over a dozen patents in process or pending. Our technologies
      and products are used by federal, state and local governments, law enforcement
      agencies and are also applied to a broad variety of industries as well,
      including financial institutions, high technology and consumer goods,
      entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts
      industries. **** Our
      customers use our technologies where there is a need for enhanced security
      for
      protecting and verification of critical financial instruments and vital records,
      or where there are concerns of counterfeiting, fraud, identity theft, brand
      protection and liability.





Our
      core
      business is counterfeit prevention, brand protection and validation of authentic
      print media, including government-issued documents, currency, private corporate
      records, securities and more. We are a world leader in the research and
      development of optical deterrent technologies and have commercialized these
      technologies with a broad suite of products that offer our customers a wide
      array of document security solutions that satisfy their specific
      anti-counterfeiting requirements. We provide document security technology to
      security printers, corporations and governments worldwide. Our technology can
      be
      used in securing sensitive and critical documents such as currency, automobile
      titles, spare parts forms for the aerospace industry, gift certificates,
      permits, checks, licenses, receipts, prescription and medical forms, engineering
      schematics, ID cards, labels, original music, coupons, homeland security
      manuals, consumer product and pharmaceutical packaging, tickets, and school
      transcripts. In addition, we have developed an On-Demand TM product
      to implement our technologies in Internet-based environments utilizing standard
      desktop printers. We believe that our On-Demand technology greatly expands
      the
      reach and potential market for our technologies and solutions.





14


*Technologies*





We
      have
      developed or acquired over 30 technologies that provide to our customers a
      wide
      spectrum of solutions. Our primary anti-counterfeiting products and technologies
      are marketed under the following trade names:





·
            **AuthentiGuardTM
                On-Demand**


·
            **AuthentiGuardTMLaser
                Moiré**


·
            **AuthentiGuardTM
                Prism**


·
            **AuthentiGuardTM
                Pantograph 4000**


·
            **AuthentiGuardTM
                Survivor 21**


·
            **AuthentiGuardTM
                Obscurascan**


·
            **AuthentiGuardTM
                Block-Out**


·
            **AuthentiGuardTM
                MicroPerf**


·
            **AuthentiGuardTM
                Phantom**


·
            **AuthentiGuardTMVeriGlow**.





*Products
      and Services*





**Document
      Security Solutions and Production** :
      Our
      technology portfolio allows us to create unique custom secure paper, plastic,
      packaging and Internet-based solutions. We target end-users that require
      anti-counterfeiting and authentication features in a wide range of printed
      materials like documents, vital records, driver’s licenses, birth certificates,
      receipts, manuals, identification materials, entertainment tickets, coupons,
      parts tracking forms, as well as product packaging including pharmaceutical
      and
      a wide range of consumer goods.





Additionally,
      our custom security solutions include our On-Demand technology that provides
      custom hosted or server-based digital solutions for our customers. Depending
      on
      our customer’s specific requirements, we host a secure server that accepts user
      inputs and delivers custom, variable secure documents for output at the user
      location, or offer a bundled server solution that allows for the production
      of
      custom, variable secure documents within the user’s network environment. .





**Security
      Paper** : Our
      primary product for the retail end-user market is AuthentiGuard Security Paper.
      AuthentiGuard Security Paper uses our Pantograph 4000 technology. It is a paper
      that reveals hidden warning words, logos or images using The Authenticator-
      our
      proprietary viewing lens - or when the paper is faxed, copied, scanned or
      re-imaged in any form. The hidden words appear on the duplicate or the computer
      digital file and essentially prevents important documents from being
      counterfeited. We market and sell our Security Paper primarily through two
      major
      paper distributors: Boise Cascade and PaperlinX Limited.





**Technology
      Licensing:** We
      license our anti-counterfeiting technology and trade secrets through licensing
      arrangements with security printers. We seek licensees that have a broad
      customer base that can benefit from our technologies or have unique and
      strategic capabilities that expand the capabilities that we can offer our
      potential customers. Revenue from Licensing can take several forms. Licenses
      can
      be for a single technology or for a package of technologies.  
Licensee's can choose from a variety of payment models, such as:





·
            Pay
                one price per year - Licensee will estimate their annual usage and
                a
                single payment is paid and reviewed each year based on actual
                results.





15


·
            Pay
                a percentage of sales of the technology - Licensees only pay as they
                sell
                product containing the technology. If, for example, they sell $1
                million
                in our security technology printing, they would pay us from 2.5%
                to 10% of
                the sales price of their jobs.


·
            Pay
                on a per piece method - Licensees pay royalties based on a price
                per
                piece.   A pre-determined price schedule is implemented based on
                job volumes and a per-piece price is utilized. Typically, the higher
                the
                volume, the lower the price per
                piece.


·
            Joint
                venture licensing- profit sharing arrangement with clients where
                DSS
                shares the net profit of all products sold containing DSS
                Technologies.





**Legal
      Products** :
      We also
      own and operate Legalstore.com, an Internet company which sells legal supplies
      and documents, including security paper and products for the users of legal
      documents and supplies in the legal, medical and educational fields. While
      not a
      component of our core business strategy, we continuously seek to maximize the
      revenue and profitability of this operation.




***Results
      of Operations for the Three Months Ended***  ***March
      31, 2007***




The following discussion and analysis provides information that our management
      believes is relevant to an assessment and understanding of our results of
      operations and financial condition. The discussion should be read in conjunction
      with the financial statements and footnotes in this quarterly report and in
      our
      annual report on Form 10-K for the year ended December 31, 2006.




The
      following discussion also includes a non-GAAP financial measure which has been
      reconciled to the most comparable GAAP financial measure of net loss. Our
      management believes that this performance measure is a relevant indicator of
      the
      Company’s financial performance.




**Summary**




**Three
                  Months Ended March 31, 2007****%
                  change vs. 3 months******ended
                    March **31,
                    2006**Revenue
              
              
              1,750,000
              
              
              103
              %Costs
                  of revenue
              
              $
              692,000
              
              
              27
              %Gross
                  profit
              
              
              1,058,000
              
              
              234
              %Total
                  Operating Expenses
              
              
              2,299,000
              
              
              72
              %Operating
                  loss
              
              
              (1,241,000
              )
              
              22
              %Other
                  income (expense), net:
              
              
              36,000
              
              
              71
              %Loss
                  before income taxes
              
              
              (1,205,000
              )
              
              21
              %Income
                  taxes
              
              
              5,000
              
              
              -Net
                  loss
              
              
              (1,210,000
              )
              
              22
              %




16




**Revenue**


**Three
                  Months Ended March 31, 2007****%
                  change vs. 3 months****ended
                  March 31, 2006**RevenueSecurity
                  printing
              
              $
              1,112,000
              
              
              70
              %Royalties
              
              
              299,000
              
              
              708
              %Digital
                  solutions
              
              
              163,000
              
              
              naLegal
                  products
              
              
              176,000
              
              
              4
              %Total
                  Revenue
              
              
              1,750,000
              
              
              103
              %


For
      the
      three month periods ended March 31, 2007, total revenue increased 103% from
      the
      same period ended March 31, 2006. The increase in revenue resulted primarily
      from increases in royalty revenue from the licensing of the Company’s patented
      technology, a digital solution sale for a custom On-Demand solution and an
      increase in sales of security products and documents, including initial
      shipments on a foreign driver license project. In addition, the revenue increase
      reflects the effect of the Company’s acquisition in February 2006 of Plastic
      Printing Professionals.




Security
      Printing




For
      the
      three month periods ended March 31, 2007, Security Printing sales increased
      70%,
      or $456,000, of which approximately $215,000 is derived from the absence of
      one
      month of P3 sales in the first quarter of 2006 revenue number as the result
      of
      the acquisition of P3 as of February 2006. The remaining increase of
      approximately $225,000 relates to overall volume increases of security printing,
      primarily at the Company’s P3 division.




Royalties




Royalty
      revenue growth during the first quarter of 2007 reflects the positive impact
      of
      the Company’s license agreement with RR Donnelley, which began in August 2006
      and therefore, did not exist in the first quarter of 2006. In addition, the
      2007
      revenue includes the impact of amortization of the deferred revenue from the
      Company’s license agreement with the Ergonomic Group, which began in September
      2006.




Digital
      Solutions




Digital
      solutions revenue is derived from sales and implementations of the Company’s
      On-Demand security printing products. This product line was introduced in 2006.
      During the first quarter of 2007, the Company installed an On-Demand solution
      for its customer, Indra Systems, for securing temporary passports at the Panama
      Canal. There was no On-Demand revenue recorded during the first quarter of
      2006.




Legal
      Products




Revenue from our legal supplies business, Legalstore.com, grew 4%during the
      first quarter of 2007, respectively, compared with the first quarter of 2006.
      While we view our legal supplies business segment as a non-core part of our
      company, we continue to seek growth opportunities for the business.




17




**Cost
      of Sales and Gross Profit**




**Three
                  Months Ended March 31, 2007**
                **%
                  change vs. 3 months****ended
                  March 31, 2006**Costs
                  of revenueSecurity
                  printing
              
              $
              555,000
              
              
              25
              %Digital
                  solutions
              
              
              34,000
              
              
              naLegal
                  products
              
              
              103,000
              
              
              0
              %Total
                  cost of sales
              
              
              692,000
              
              
              27
              %Gross
                  profitSecurity
                  printing
              
              
              557,000
              
              
              162
              %Royalties
              
              
              299,000
              
              
              708
              %Digital
                  solutions
              
              
              129,000
              
              
              naLegal
                  products
              
              
              73,000
              
              
              9
              %Total
                  gross profit
              
              
              1,058,000
              
              
              234
              %
  **Three
                  Months Ended March 31, 2007**
                **%
                  change vs. 3 months****ended
                  March 31, 2006**Gross
                  profit percentage:Security
                  printing
              
              
              50
              %
              
              54
              %Royalties
              
              
              100
              %
              
              0
              %Digital
                  solutions
              
              
              79
              %
              
              naLegal
                  products
              
              
              41
              %
              
              5
              %Gross
                  profit percentage:
              
              
              60
              %
              
              65
              %Gross
                  Profit




Gross
      Profit




During
      the first quarter of 2007, gross profit increased 234% to $1,058,000. Along
      with
      increases as the result of recent license agreements and a digital solution
      implementation, the Company realized significant growth in security printing
      gross profits primarily due to the impact of a large secure driver’s license
      project which was delivered during the first quarter of 2007. As a result,
      gross
      profit percentage increased during the three months of 2007, as the Company
      benefited from the impact of revenue growth in higher profit product lines.




18




**Operating
      Expenses**




****Three
                  Months Ended March 31, 2007****
                **%
                  change vs. 3 months****ended
                  March 31, 2006**Selling,
                  general and administrativeSG&A
                  compensation
              
              $
              463,000
              
              
              45
              %Stock
                  based payments
              
              
              336,000
              
              
              1144
              %Professional
                  fees
              
              
              320,000
              
              
              -4
              %Sales
                  and marketing
              
              
              500,000
              
              
              144
              %Depreciation
                  and amortization
              
              
              20,000
              
              
              -31
              %Other
              
              
              220,000
              
              
              75
              %Research
                  and development
              
              
              94,000
              
              
              29
              %Amortization
                  of intangibles
              
              
              346,000
              
              
              57
              %Total
                  Operating Expenses
              
              
              2,299,000
              
              
              72
              %




**Selling,
      General and Administrative**




The
      Company’s selling, general and administrative costs increases generally reflect
      increases to the size of our organization as the result of the Company’s
      acquisition of P3 and increases in executive management, sales and operations
      personnel integral to the company’s sales growth strategy.




General
      and administrative compensation cost
      increased during the first quarter of 2007 reflect the impact of personnel
      additions at the Company during the second half of 2006, and the impact of
      the
      acquisition of P3 in February 2006. In addition, the Company incurred annual
      payrate increases on average of approximately 6% for existing employees as
      compared to 2006 rates.




Stock
      based payments during
      the first three months of 2007 include approximately $223,000 of expense
      recognized for the issuance of warrants to International Barcode Corporation
      (d/b/a Barcode Technology) (“BTI”) in June 2006 in consideration for a
      cross-marketing relationship that enables the Company to expedite its entry
      into
      the Chinese market for secure documents, and $113,000 associated stock based
      compensation to employees and directors. Employee stock based compensation
      costs
      during the first quarter of 2006 were minimal primarily as a result of the
      Company’s acceleration of vesting of all unvested stock options in December
      2005.






19


**Three
                  Months Ended March 31, 2007**
                **%
                  change vs. 3 months****ended
                  March 31, 2006***Professional
                  Fees Detail*Accounting
                  and auditing
              
              $
              113,000
              
              
              77
              %Consulting
              
              
              91,000
              
              
              203
              %Legal
                  Fees
              
              
              55,000
              
              
              -50
              %Stock
                  Transfer, SEC and InvestorRelations
              
              
              61,000
              
              
              -53
              %$
              320,000
              
              
              -4
              %




Professional
      fees include
      legal, accounting, shareholder services, investor relations, and consulting
      costs. Accounting and auditing fee increases generally reflect an increase
      in
      costs as a result of the growth in the Company as compared to the first quarter
      of 2006, along with additional costs associated with Sarbanes Oxley compliance
      efforts. Consulting fees increased due to the impact of costs associated with
      the use of an intellectual property consultant and the use of various financial
      consultants during the 2007 quarter. Legal fees decreased to a general decrease
      in activity in the Company’s non-ECB related litigation, as well as a decrease
      in use of legal services associated with business related matters. These legal
      costs do not include approximately $1,102,000, of which approximately $475,000
      is payable in shares of the Company’s stock, of legal and related costs incurred
      during the first quarter of 2007 associated with the application and defense
      of
      our patents which the company capitalizes and amortizes over the expected life
      of the patent. (See *Part
      I -Financial Information -Note 7* )
      Stock
      transfer, SEC and Investor Relations costs decreased during the 2007 quarter
      primarily as a result of the absence of registration fees as compared to the
      first quarter of 2006 and a reduction in investor relations consulting
      costs..




Sales
      and marketing expenses
      increases in the first quarter of 2007 are the result of significant increases
      in the resources that the Company is investing to grow the size of its sales
      and
      marketing team and increase the reach of its products through expansion of
      its
      marketing efforts. During the quarter, the Company also experienced a
      significant increase in travel related costs associated with sales and business
      development efforts, including extensive international travel. In addition,
      the
      Company incurred significant costs associated with re-branding efforts,
      including internet development efforts.




Other
      expenses are
      primarily rent and utilities, office supplies, IT support, and insurance costs.
      Increases in 2007 reflect costs associated with a larger organization.




**Research
      and Development**




We
      invest
      in research and development to improve our existing technologies and develop
      new
      technologies that will enhance our position in the document security market.
      Research and development costs consist primarily of compensation costs for
      our
      four persons who spend all or at least half of their time on developing new
      technologies or developing new uses for our existing technology. In addition,
      we
      incur costs for the use of third party printers’ facilities to test our
      technologies on equipment that we do not have access to internally. We seek
      patent protection for many of our inventions, and we currently have over a
      dozen
      formal patents applications pending, including provisional and PCT patent
      applications and applications that have entered the National Phase in various
      countries, including the United States, Canada, Europe, Japan, Brazil, Mexico,
      Indonesia and South Africa. We expect that our research and development costs
      will continue at current levels for the foreseeable future.




20


**Amortization
      of intangibles**




We
      amortize the costs associated with the patents that we acquired in 2005 and
      the
      legal costs associated with the development and defense of our patents,
      including the costs associated with our suit against the European Central Bank
      for patent infringement. In addition, we amortize our acquired intangibles
      from
      business combinations. A significant portion of these assets were acquired
      by
      the issuance of equity in the company. Our amortizable patent asset base at
      March 31, 2007 was approximately $5.3 million and will generate approximately
      $1.3 million in annual amortization expense during the next 4 years. The Company
      reviews these assets for impairment annually. If an impairment, such as
      unfavorable ruling in the Company’s patent infringement lawsuits or an
      assessment of non-commerciability of certain of its patents, then the Company
      would write-off a portion of these assets, which could be a significant expense
      in the period incurred.






In
      addition, the Company has $1,397,000 in goodwill derived from acquisitions.
      Goodwill is not amortized, but could become a component of expense if an
      impairment is determined.




**Net
      loss and loss per share**


****Three
                  Months Ended March 31, 2007****
                **%
                  change vs. 3 months****ended
                  March 31, 2006**Net
                  loss
              
              $
              (1,210,000
              
              
              22
              %Net
                  loss per share, basic and diluted
              
              
              (0.09
              )
              
              13
              %Weighted
                  average common sharesoutstanding,
                  basic and diluted
              
              
              13,584,795
              
              
              6
              %




During
      the first quarter of 2007, the Company experienced a net loss of $1.2 million.
      While we experienced significant growth in our sales and gross profits, these
      increases did not offset significant increases in our operating expenses,
      especially significant increases in amortization expense, stock based
      compensation, compensation and sales and marketing expenses.




During
      the first quarter of 2007, our basic and diluted loss per share increased due
      to
      the increased dollar value of our loss partially offset by an increase in the
      weighted average common shares outstanding in the first quarter of 2007 as
      compared to the first quarter of 2006. Our shares have increased as we have
      issued our common shares for warrants exercised and for the purchase of patent
      assets.




21




**Non-GAAP
      Financial Performance Measure**




The
      following adjusted Earnings before interest, taxes, depreciation, amortization
      and non-cash stock compensation expense (“Adjusted EBITDA”) is presented because
      the Company’s management believes it to be a relevant measure of the performance
      of the Company. The Adjusted EBITDA is used by the Company’s management to
      measure its core operating performance without certain non-cash expenditures.
      The reconciliation of Adjusted EBITDA to net loss, the most comparable GAAP
      measure is presented below.




Adjusted
      EBITDA




**Three
                  Months Ended March 31, 2007****%
                  change vs. 3 months****ended
                  March 31, 2006**Net
                  Loss
              
              $
              (1,210,000
              )
              
              22
              %Add
                  back:Depreciation
              
              
              45,000
              
              
              -21
              %Amortization
                  of Intangibles
              
              
              346,000
              
              
              57
              %Stock
                  based payments
              
              
              336,000
              
              
              1144
              %Interest
                  Income
              
              
              (41,000
              )
              
              52
              %Interest
                  Expense
              
              
              1,000
              
              
              -80
              %Income
                  Taxes
              
              
              5,000Adjusted
                  EBITDA
              
              
              (518,000
              )
              
              -27
              %




As
      described above, Adjusted EBITDA is a non-GAAP measurement of financial
      performance that the Company believes is relevant to the understanding of the
      Company’s financial results. While net loss increased 22% during the first
      quarter of 2007, the Company’s Adjusted EBITDA loss declined by 27% during the
      same period. These results reflect that the increases in sales and gross profits
      have outpaced increases in the Company’s core operating expenses, (core
      operating expenses are general and administrative compensation, professional
      fees, sales and marketing, other and research and development costs) which
      increased 51% during the three months ended March 31, 2007 compared to the
      2006
      comparable quarter.




**LIQUIDITY
      AND CAPITAL RESOURCES**




The
      Company’s cash flows and other key indicators of liquidity are summarized as
      follows:




22




**Three
                  Months Ended****March
                  31**
              
              
              **March
                  31****2007**
              
              
              **2006**
              
              
              **%****(unaudited)**
              
              
              **(unaudited)**
              
              
              **Change**Cash
                flows
                from:Operating
                  activities
              
              $
              (766,000
              )
              $
              (597,000
              )
              
              -28
              %Investing
                  activities
              
              
              (407,000
              )
              
              (1,382,000
              )
              
              71
              %Financing
                  activities
              
              
              (190,000
              )
              
              569,000
              
              
              -133
              %Working
                  capital (a)
              
              
              3,008,000
              
              
              2,064,000
              
              
              46
              %Current
                  ratio (a)
              
              
              2.00
              x
              
              2.46
              x
              
              -19
              %




As
      of
      March 31, 2007, we had cash and cash equivalents of $4,440,000, a 23% decrease
      from December 31, 2006 amounts. As discussed below, the decrease in the
      Company’s cash position was primarily due to the payment of fees related to a
      private placement of equity which the Company closed on December 26, 2006,
      from
      the payment of legal fees associated with its patent applications and defense
      costs, as well as cash used for operations. As discussed below, the Company
      believes that its cash balance as of March 31, 2007 will satisfy its projected
      working capital and capital expenditure requirements, including the costs
      related to its patent defense litigations, for at least the next 12 months.




Operating
      Cash Flow - Over time, operating cash flows are expected to mirror Adjusted
      EBITDA results. During the first quarter of 2007, the Company used approximately
      $761,000 of cash for operations, which is slightly greater than the EBITDA
      loss
      of $518,000 during the same period. This variance is primarily the result of
      the
      timing of cash receipts due for some larger jobs completed during the quarter.
      In addition, the Company did not receive any lump-sum royalty payments as it
      had
      during the third and fourth quarters of 2006 which are generally recognized
      as
      deferred revenue, but have been used to offset operating cash flows. For the
      foreseeable future, the Company will continue to use cash for operations at
      a
      similar pace, only to be offset by increases in revenue. As of March 31, 2007,
      the Company believes that it will need to reach an annual revenue level of
      approximately $7.5 million in order to maintain positive operating cash flow.




Investing
      Cash Flow -During the first quarter of 2007, the Company used approximately
      $407,000 of cash for fixed asset additions and to invest in its patent
      portfolio, including the payment of legal costs associated with patent
      applications and the defense of our patents, which includes payments to cover
      third party experts fees and other fees associated with the Company’s litigation
      against the ECB. As discussed below, the Company was able to use approximately
      $268,000 of its equity to pay for patent related costs as a result of its
      agreement with its lead counsel in its ECB litigation




Financing
      Cash Flows - On December 26, 2006, the Company sold 94 units at a price of
      $50,000 per unit for gross cash proceeds of $4,700,000, consisting of 552,720
      unregistered shares of our common stock and five-year warrants to purchase
      up to
      an aggregate of 276,360 shares of our common stock, at an initial exercise
      price
      of $11.75 per share. During the first quarter of 2007, the Company received
      approximately $340,000 from the private placement of stock and the exercise
      of
      warrants which was offset by the payment of approximately $520,000 in fees
      associated with the private placement. As of March 31, 2007, the Company has
      approximately 915,000 warrants outstanding and exercisable that, if exercised,
      would produce approximately $9.2 million in cash proceeds to the
      Company.




23




**ITEM
      3:   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**






Our
      market risk exposures are related to our cash, cash equivalents and investments.
      We invest our excess cash in certificates of deposits with maturities of 90
      days
      or less. Changes in interest rates affect the investment income we earn and
      therefore impact our cash flows and results of operations.




We
      mitigate our foreign currency risks principally by contracting primarily in
      U.S.
      dollars. For the nine months ended March 31, 2007, all of our billings,
      were denominated in our functional currency, which is the U.S. dollar. However,
      certain of our legal fees are payable in foreign currencies, for which a gain
      or
      loss is recognized on foreign currency transactions is recognized when payments
      are made. To date and for the foreseeable future, gains and losses on such
      transactions have been minimal.






**ITEM
      4 - CONTROLS AND PROCEDURES**






The
      Company maintains disclosure controls and procedures (as defined in Exchange
      Act
      Rule 13a-15(e)) that are designed to assure that information required to be
      disclosed in its Exchange Act reports is recorded, processed, summarized and
      reported within the time periods specified in the Securities and Exchange
      Commission's rules and forms, and that such information is accumulated and
      communicated to management, including the Chief Executive Officer and Acting
      Chief Financial Officer, as appropriate, to allow timely decisions regarding
      required disclosures.






In
      designing and evaluating the disclosure controls and procedures, management
      recognizes that any controls and procedures, no matter how well designed and
      operated, can provide reasonable assurance only of achieving the desired control
      objectives, and management necessarily is required to apply its judgment in
      weighting the costs and benefits of possible new or different controls and
      procedures. Limitations are inherent in all control systems, so no evaluation
      of
      controls can provide absolute assurance that all control issues and any fraud
      within the company have been detected.






As
      required by Exchange Act Rule 13a-15(b), as of the end of the period covered
      by
      this report, management, under the supervision and with the participation of
      its
      Chief Executive Officer and Chief Financial Officer (the same person has both
      titles), evaluated the effectiveness of the Company's disclosure controls and
      procedures. Based on this evaluation, management concluded that the Company's
      disclosure controls and procedures were effective as of that date.




24




During
      the Company’s most recent fiscal quarter, the Company initiated reviews and
      analysis of internal control procedures and designs in the context of Section
      404 of the Sarbanes Oxley Act of 2002. The Company has begun and expects to
      continue to modify and change its internal control procedures to meet the
      compliance standards of the Sarbanes Oxley Act for its fiscal year ended
      December 31, 2007. The Company expects to make internal control changes to
      address control issues typically associated with a small company including
      a
      lack of segregation of duties. These changes may involve the addition of
      accounting staff, the use of consultants and external resources, or a
      combination thereof.






**PART
      II**


**OTHER
      INFORMATION**






**ITEM
      1 - LEGAL PROCEEDINGS**




On
      August
      1, 2005, we commenced a suit against the European Central Bank (the “ECB”)
      alleging patent infringement by the ECB and have claimed unspecified damages.
      We
      brought the suit in European Court of First Instance in Luxembourg. We alleged
      that all Euro banknotes in circulation infringe our European Patent 455750B1
      (the “Patent”), which covers a method of incorporating an anti-counterfeiting
      feature into banknotes or similar security documents to protect against
      forgeries by digital scanning and copying devices. We will seek all remedies
      available to us under the law. In November 2005, the European Central Bank
      filed
      its answer to our complaint asserting mostly procedural and jurisdictional
      arguments. The ECB contended that the proper venue was not in the Court of
      First
      Instance, but rather in each individual country that is a member of the ECB.
      We
      responded to the European Central Bank’s answer in late December 2005, arguing
      that the Court of First instance was the proper venue. The parties are awaiting
      the ruling from the Court of First Instance.





On
      March
      24, 2006, we received notice that the ECB has filed a separate claim in the
      United Kingdom and Luxembourg patent courts (Luxembourg being the seat of the
      European Court of First Instance) seeking the invalidation of the Patent.
      Claims to invalidity in each of the Netherlands, Belgium, Italy, France, Spain,
      Germany and Austria were subsequently served on the Company. The main basis
      of
      the ECB’s claim as to invalidity is the existence of prior art. A second basis
      is that the scope of the Patent was extended in prosecution, which in Europe
      is
      a ground of invalidity. On January 22, 2007, the trial regarding the Patent’s
      validity in the United Kingdom commenced in the High Court of Justice, Chancery
      Division, Patents Court in London, England (the “English Court”) and concluded
      on January 30, 2007. On March 26, 2007, the English Court issued its decision
      in
      the patent invalidity lawsuit brought by the ECB against us. The English Court
      ruled that the Patent hat was awarded to us by the European Patent Office
      Technical Board of Appeal, has been deemed invalid in the United Kingdom. The
      Courts decision does not affect the validity of the Patent in other European
      countries. On March 30, 2007, the Company was given permission by the English
      Court to appeal to the Court of Appeal the ruling. As a result of the ruling
      and
      according to English Court rules, the Company was also required to pay a portion
      of the ECB’s legal costs associated with the case. On April 2, 2007, the English
      Court rewarded the ECB 180,000 pounds (USD $365,000) for such reimbursement,
      of
      which the Company paid 90,000 pounds (USD $182,000) on April 4, 2007. On March
      27, 2007, the Company received a decision in the patent invalidity lawsuit
      that
      the ECB brought against us in Germany. The German Federal Patent Court
      (Bundespatentgericht) in Munich (the “German Court”) ruled that the Patent was
      valid in Germany. This ruling validates the legal basis of the Company’s
      infringement suit against the ECB. In addition, as a result of this ruling,
      the
      Company expects to be awarded reimbursements for its costs associated with
      the
      German validity case, which has not been determined as of the date of this
      report. Additional trials regarding validity are expected to commence in the
      eight other countries during 2007 and 2008.





25


On
      January 31, 2003, we commenced an action, unrelated to the above ECB litigation,
      entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M.
      Wicker, Thomas M.Wicker Enterprises, Inc. And Document Security Consultants
      V.
      Adler Technologies, Inc. N/K/A Adlertech International, Inc. And Andrew
      Mctaggert (United States District Court, Western District Of New York Case
      No.03-Cv-6044t(F)) regarding certain intellectual property in which we have
      an
      interest. We commenced this action alleging various causes of action against
      Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach
      of
      the duty of good faith and fair dealing and various business torts, including
      unfair competiton. Adler distributes and supplies anti-counterfeit currency
      devices and Mr. McTaggert is a principal of Adler. Adler had entered into
      several agreements with Thomas M. Wicker Enterprises and Document Security
      Consultants, both of which we acquired in 2002. These agreements, generally,
      authorized Adler to manufacture in Canada our “Checkmate®” patented system for
      verifying the authenticity of currency and documents. Other agreements were
      entered into between the parties and Thomas Wicker regarding other technology
      owned by Wicker and assigned to us including “Archangel,” an anti-copy
      technology, and “Blockade,” which creates a wave pattern on documents when they
      are reproduced or scanned. It is our contention, among other things, that Adler
      has breached these agreements, failed to make an appropriate accounting and
      payments under these agreements, and may have exceeded the scope of its license.
      Adler has denied the material allegations of the complaint and has
      counterclaimed against our company, claiming Adler owns or co-owns or has a
      license to use certain technologies of ours, including several U.S. patents.
      In
      May 2005, we filed our first amended and supplemental complaint adding
      Blanks/USA and Raymond Maxon as additional defendants. In February 2007, we
      filed our second amended and supplemental complaint adding Judith Wu
      (McTaggart’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu
      is involved) as additional defendants. Maxon has asserted a counterclaim against
      us contenting that our acquisition of certain patents and technology from Thomas
      Wicker in 2002 gave rise to an alleged right on the part of Maxon to receive
      a
      portion of Thomas Wicker’s proceeds from such acquisition. We have denied the
      material allegations of all of the counterclaims. If Adler is successful, it
      may
      materially affect us, our financial condition, and our ability to market and
      sell certain of our technology and related products. This case is in discovery
      phase, and it is too soon to determine how the various issues raised by the
      lawsuit will be determined.





In
      addition to the foregoing, we are subject to other legal proceedings that have
      arisen in the ordinary course of business and have not been finally adjudicated.
      Although there can be no assurance in this regard, in the opinion of management,
      none of the legal proceedings to which we are a party, whether discussed herein
      or otherwise, will have a material adverse effect on our results of operations,
      cash flows or our financial condition.




**ITEM
      1a - RISK FACTORS**




An investment in our securities is subject to numerous risks, including the
      Risk
      Factors described below. Our business, operating results or financial condition
      could be materially adversely affected by any of the following risks. The risks
      described below are not the only ones we face. Additional risks we are not
      presently aware of or that we currently believe are immaterial may also
      materially affect our business. The trading price of our Common Stock could
      decline due to any of these risks. In assessing these risks, you should also
      refer to the other information contained or incorporated by reference in this
      Form 10-Q, including our financial statements and related notes.





26


***We
      have a limited operating history with our business model, which limits the
      information available to you to evaluate our
      business.***




Since
      our
      inception in 1984, we have accumulated deficits from historical operations
      of
      approximately $18,438,000 at March 31, 2007. In 2002, we changed our business
      model and chose to strategically focus on becoming a developer and marketer
      of
      secure technologies for all forms of print media. We have continued to incur
      losses since we began our new business model. Also, we have limited operating
      and financial information relating to this new business to evaluate our
      performance and future prospects. Due to the change in our business model,
      we do
      not view our historical financials as being a good indication of our future.
      We
      face the risks and difficulties of a company going into a new business including
      the uncertainties of market acceptance, competition, cost increases and delays
      in achieving business objectives. There can be no assurance that we will succeed
      in addressing any or all of these risks, and the failure to do so could have
      a
      material adverse effect on our business, financial condition and operating
      results.





***If
      we lose our current litigation, we may lose certain of our technology rights
      which may affect our business plan.***





We
      are
      subject to litigation and alleged litigation, including our litigation with
      the
      European Central Bank, in which parties allege, among other things, that certain
      of our patents are invalid. For more information regarding this litigation,
      see
      Part II -Item I- Legal Proceedings. If the ECB or other parties are successful
      in invalidating any or all of our patents, it may materially affect us, our
      financial condition, and our ability to market and sell certain technology.





***If
      we lose our current infringement litigation we may be liable for significant
      legal costs of our counterparts.***




We
        have
        been able to mitigate the cash outlays that we have been required to make
        for
        legal costs of our current infringement litigation and related invalidity
        cases
        against the European Central Bank by, among other things, negotiating legal
        fee
        caps and using shares of our common stock for payments. As noted above, on
        March
        26, 2007, the High Court of Justice, Chancery Division, Patents Court in
        London England issued its decision in the patent invalidity lawsuit brought
        by
        the European Central Bank (the “ECB”) against us. The English Court ruled that
        European Patent No 0455750B 1, that was awarded to us by the European Patent
        Office Technical Board of Appeal, has been deemed invalid in the United Kingdom.
        We were required to pay a portion of the ECB’s costs associated with the United
        Kingdom invalidity lawsuit, and will likely be required to pay in the future
        an
        additional portion of such costs. If we receive further adverse rulings in
        any
        of our infringement or related invalidity cases against the ECB, we will
        likely
        be responsible for a large portion of the legal costs that were expended
        by the
        ECB in such case, which would likely be significant. The payment of these
        amounts could adversely affect the Company’s financial position.


***If
      we are unable to adequately protect our intellectual property, our competitive
      advantage may disappear.***




Our
      success will be determined in part by our ability to obtain United States and
      foreign patent protection for our technology and to preserve our trade secrets.
      Because of the substantial length of time and expense associated with developing
      new document security technology, we place considerable importance on patent
      and
      trade secret protection. We intend to continue to rely primarily on a
      combination of patent protection, trade secrets, technical measures, copyright
      protection and nondisclosure agreements with our employees and customers to
      establish and protect the ideas, concepts and documentation of software and
      trade secrets developed by us. Our ability to compete and the ability of our
      business to grow could suffer if these intellectual property rights are not
      adequately protected. There can be no assurance that our patent applications
      will result in patents being issued or that current or additional patents will
      afford protection against competitors. We rely on a combination of patents,
      copyrights, trademarks and trade secret protection and contractual rights to
      establish and protect our intellectual property. Failure of our patents,
      copyrights, trademarks and trade secret protection, non-disclosure agreements
      and other measures to provide protection of our technology and our intellectual
      property rights could enable our competitors to more effectively compete with
      us
      and have an adverse effect on our business, financial condition and results
      of
      operations. In addition, our trade secrets and proprietary know-how may
      otherwise become known or be independently discovered by others. No guarantee
      can be given that others will not independently develop substantially equivalent
      proprietary information or techniques, or otherwise gain access to our
      proprietary technology.




27





In
      addition, we may be required to litigate in the future to enforce our
      intellectual property rights, to protect our trade secrets, to determine the
      validity and scope of the proprietary rights of others, or to defend against
      claims of infringement or invalidity. Any such litigation could result in
      substantial costs and diversion of resources and could have a material adverse
      effect on our business, financial condition or results of operations, and there
      can be no assurances of the success of any such litigation.





***We
      may face intellectual property infringement or other claims against us, our
      customers or our intellectual property that could be costly to defend and result
      in our loss of significant rights.***





Although
      we have received U.S. Patents and a European Patent with respect to certain
      technologies of ours, there can be no assurance that these patents will afford
      us any meaningful protection. Although we believe that our use of the technology
      and products we developed and other trade secrets used in our operations do
      not
      infringe upon the rights of others, our use of the technology and trade secrets
      we developed may infringe upon the patents or intellectual property rights
      of
      others. In the event of infringement, we could, under certain circumstances,
      be
      required to obtain a license or modify aspects of the technology and trade
      secrets we developed or refrain from using same. We may not have the necessary
      financial resources to defend an infringement claim made against us or be able
      to successfully terminate any infringement in a timely manner, upon acceptable
      terms and conditions or at all. Failure to do any of the foregoing could have
      a
      material adverse effect on us and our financial condition. Moreover, if the
      patents, technology or trade secrets we developed or use in our business are
      deemed to infringe upon the rights of others, we could, under certain
      circumstances, become liable for damages, which could have a material adverse
      effect on us and our financial condition. As we continue to market our products,
      we could encounter patent barriers that are not known today. A patent search
      will not disclose applications that are currently pending in the United States
      Patent Office, and there may be one or more such pending applications that
      would
      take precedence over any or all of our applications.





Furthermore,
      third parties may assert that our intellectual property rights are invalid,
      which could result in significant expenditures by us to refute such assertions.
      If we become involved in litigation, we could lose our proprietary rights,
      be
      subject to damages and incur substantial unexpected operating expenses.
      Intellectual property litigation is expensive and time-consuming, even if the
      claims are subsequently proven unfounded, and could divert management’s
      attention from our business. If there is a successful claim of infringement,
      we
      may not be able to develop non-infringing technology or enter into royalty
      or
      license agreements on acceptable terms, if at all. If we are unsuccessful in
      defending claims that our intellectual property rights are invalid, we may
      not
      be able to enter into royalty or license agreements on acceptable terms, if
      at
      all. This could prohibit us from providing our products and services to
      customers, which could have a material adverse effect on us and our financial
      condition.





28


***If
      our products and services do not achieve market acceptance, we may not achieve
      our revenue and net income goals in the time prescribed or at
      all.***





We
      are at
      the early stage of introducing our document security technology and products
      to
      the market. If we are unable to operate our business as contemplated by our
      business model or if the assumptions underlying our business model prove to
      be
      unfounded, we could fail to achieve our revenue and net income goals within
      the
      time we have projected, or at all, which could have a material adverse effect
      on
      our business. As a result, the value of your investment could be significantly
      reduced or completely lost.





We
      cannot
      assure you that a sufficient number of such companies will demand our products
      or services or other document security products. In addition, we cannot predict
      the rate of market’s acceptance of our document security solutions. Failure to
      maintain a significant customer base may have a material adverse effect on
      our
      business.





***The
      results of our research and development efforts are uncertain and there can
      be
      no assurance of the commercial success of our
      products.***





We
      believe that we will need to continue to incur research and development
      expenditures to remain competitive. The products we currently are developing
      or
      may develop in the future may not be technologically successful. In addition,
      the length of our product development cycle may be greater than we originally
      expect and we may experience delays in future product development. If our
      resulting products are not technologically successful, they may not achieve
      market acceptance or compete effectively with our competitors’
products.





***Changes
      in document security technology and standards could render our applications
      and
      services obsolete.***





The
      market for document security products, applications, and services is fast moving
      and evolving. Identification and authentication technology is constantly
      changing as we and our competitors introduce new products, applications, and
      services, and retire old ones as customer requirements quickly develop and
      change. In addition, the standards for document security are continuing to
      evolve. If any segments of our market adopt technologies or standards that
      are
      inconsistent with our applications and technology, sales to those market
      segments could decline, which could have a material adverse effect on us and
      our
      financial condition.





***The
      market in which we operate is highly competitive, and we may not be able to
      compete effectively, especially against established industry competitors with
      greater market presence and financial resources.***





Our
      market is highly competitive and characterized by rapid technological change
      and
      product innovations. Our competitors may have advantages over us because of
      their longer operating histories, more established products, greater name
      recognition, larger customer bases, and greater financial, technical and
      marketing resources. As a result, they may be able to adapt more quickly to
      new
      or emerging technologies and changes in customer requirements, and devote
      greater resources to the promotion and sale of their products. Competition
      may
      also force us to decrease the price of our products and services. We cannot
      assure you that we will be successful in developing and introducing new
      technology on a timely basis, new products with enhanced features, or that
      these
      products, if introduced, will enable us to establish selling prices and gross
      margins at profitable levels.





29


***Our
      growth strategy depends, in part, on our acquiring complementary businesses
      and
      assets and expanding our existing operations to include manufacturing
      capabilities, which we may be unable to do.***





Our
      growth strategy is based, in part, on our ability to acquire businesses and
      assets that are complimentary to our existing operations and expanding our
      operations to include manufacturing capabilities. We may also seek to acquire
      other businesses. The success of this acquisition strategy will depend, in
      part,
      on our ability to accomplish the following:





·
            identify
                suitable businesses or assets to buy;


·
            complete
                the purchase of those businesses on terms acceptable to us;


·
            complete
                the acquisition in the time frame we expect;
                and


·
            improve
                the results of operations of the businesses that we buy and successfully
                integrate their operations into our
                own.





Although
      we were able to successfully acquire our P3 subsidiary in February 2006, there
      can be no assurance that we will be successful in pursuing any or all of these
      steps on future transactions. Our failure to implement our acquisition strategy
      could have an adverse effect on other aspects of our business strategy and
      our
      business in general. We may not be able to find appropriate acquisition
      candidates, acquire those candidates that we find or integrate acquired
      businesses effectively or profitably.





Our
      acquisition program and strategy may lead us to contemplate acquisitions of
      companies in bankruptcy, which entail additional risks and uncertainties. Such
      risks and uncertainties include, without limitation, that, before assets may
      be
      acquired, customers may leave in search of more stable providers and vendors
      may
      terminate key relationships. Also, assets are generally acquired on an “as is”
basis, with no recourse to the seller if the assets are not as valuable as
      may
      be represented. Finally, while bankrupt companies may be acquired for
      comparatively little money, the cost of continuing the operations may
      significantly exceed expectations.





We
      have
      in the past used, and may continue to use, our Common Stock as payment for
      all
      or a portion of the purchase price for acquisitions. If we issue significant
      amounts of our Common Stock for such acquisitions, this could result in
      substantial dilution of the equity interests of our stockholders.





***If
      we fail to retain our key personnel and attract and retain additional qualified
      personnel, we might not be able to pursue our growth
      strategy.***





Our
      future success depends upon the continued service of our executive officers
      and
      other key sales and research personnel who possess longstanding industry
      relationships and technical knowledge of our products and operations. The loss
      of any of our key employees, in particular, Patrick White, our Chief Executive
      Officer and Chief Financial Officer; Peter Ettinger, our President; Thomas
      Wicker, our Vice-President of Research and Development; and David Wicker, our
      Vice-President of Operations, could negatively impact our ability to pursue
      our
      growth strategy and conduct operations. Although we believe that our
      relationship with these individuals is positive, there can be no assurance
      that
      the services of these individuals will continue to be available to us in the
      future. We have extended our employment agreements with Patrick White to June
      2009. Our employment agreements with Thomas Wicker and David Wicker expire
      in
      June 2007. Our employment agreement with Peter Ettinger expires in June
      2009.There can be no assurance that these persons will continue to agree to
      be
      employed by us after such dates.





30


***If
      we do not successfully expand our sales force, we may be unable to increase
      our
      revenues.***





We
      must
      expand the size of our marketing activities and sales force to increase
      revenues. We continue to evaluate various methods of expanding our marketing
      activities, including the use of outside marketing consultants and
      representatives and expanding our in-house marketing capabilities. Going
      forward, we anticipate an increasing percentage of our revenues to come from
      the
      licensing of our newer technologies, where profit margins are significantly
      higher than those provided by Security Paper. If we are unable to hire or retain
      qualified sales personnel, if newly hired personnel fail to develop the
      necessary skills to be productive, or if they reach productivity more slowly
      than anticipated, our ability to increase our revenues and grow could be
      compromised. The challenge of attracting, training and retaining qualified
      candidates may make it difficult to meet our sales growth targets. Further,
      we
      may not generate sufficient sales to offset the increased expense resulting
      from
      expanding our sales force or we may be unable to manage a larger sales
      force.





***Future
      growth in our business could make it difficult to manage our
      resources.***





Our
      anticipated business expansion could place a significant strain on our
      management, administrative and financial resources. Significant growth in our
      business may require us to implement additional operating, product development
      and financial controls, improve coordination among marketing, product
      development and finance functions, increase capital expenditures and hire
      additional personnel. There can be no assurance that we will be able to
      successfully manage any substantial expansion of our business, including
      attracting and retaining qualified personnel. Any failure to properly manage
      our
      future growth could negatively impact our business and operating
      results.





***We
      cannot predict our future capital needs and we may not be able to secure
      additional financing.***





We
      may
      need to raise additional funds in the future to fund more aggressive expansion
      of our business, complete the development, testing and marketing of our
      products, or make strategic acquisitions or investments. We may require
      additional equity or debt financings, collaborative arrangements with corporate
      partners or funds from other sources for these purposes. No assurance can be
      given that these funds will be available for us to finance our development
      on
      acceptable terms, if at all. Such additional financings may involve substantial
      dilution of our stockholders or may require that we relinquish rights to certain
      of our technologies or products. In addition, we may experience operational
      difficulties and delays due to working capital restrictions. If adequate funds
      are not available from operations or additional sources of financing, we may
      have to delay or scale back our growth plans.





**Risks
      Related to Our Stock**







***Provisions
      of our certificate of incorporation and agreements could delay or prevent a
      change in control of our company.***





Certain
      provisions of our certificate of incorporation may discourage, delay, or prevent
      a merger or acquisition that a stockholder may consider favorable. These
      provisions include:





·
            the
                authority of the Board of Directors to issue preferred stock;
                and


·
            a
                prohibition on cumulative voting in the election of directors.





31


***We
      have a large number of authorized but unissued shares of common stock, which
      our
      management may issue without further stockholder approval, thereby causing
      dilution of your holdings of our common stock.***





As
      of
      March 31, 2007, there were approximately 185,000,000 of authorized but unissued
      shares of our common stock. Our management will continue to have broad
      discretion to issue shares of our common stock in a range of transactions,
      including capital-raising transactions, mergers, acquisitions, for anti-takeover
      purposes, and in other transactions, without obtaining stockholder approval,
      unless stockholder approval is required for a particular transaction under
      the
      rules of the American Stock Exchange, New York law, or other applicable laws.
      We
      currently have no specific plans to issue shares of our common stock for any
      purpose. However, if our management determines to issue shares of our common
      stock from the large pool of such authorized but unissued shares for any purpose
      in the future without obtaining stockholder approval, your ownership position
      would be diluted without your further ability to vote on that transaction.





***The
      exercise of our outstanding options and warrants and vesting of restricted
      stock
      awards may depress our stock price.***





As
      of
      March 31, 2007, there were outstanding stock options and warrants to purchase
      an
      aggregate of 1,457,208 shares of our Common Stock at exercise prices ranging
      from $2.00 to $12.91 per share, of which 1,237,208 are currently
      exercisable. To the extent that these securities are exercised, dilution to
      our
      stockholders will occur. In addition, as of March 31, 2007, there were 375,000
      restricted shares of our common stock that are subject to various vesting terms.
      To the extent that these securities vest, dilution to our stockholders will
      occur. Moreover, the terms upon which we will be able to obtain additional
      equity capital may be adversely affected, since the holders of these securities
      can be expected to exercise or convert them at a time when we would, in all
      likelihood, be able to obtain any needed capital on terms more favorable to
      us
      than the exercise and conversion terms provided by those
      securities.





Sales
      of
      these shares in the public market, or the perception that future sales of these
      shares could occur, could have the effect of lowering the market price of our
      common stock below current levels and make it more difficult for us and our
      stockholders to sell our equity securities in the future.





Sale
      or
      the availability for sale of shares of common stock by stockholders could cause
      the market price of our common stock to decline and could impair our ability
      to
      raise capital through an offering of additional equity securities.





***We
      do not intend to pay cash dividends.***





We
      do not
      intend to declare or pay cash dividends on our common stock in the foreseeable
      future. We anticipate that we will retain any earnings and other cash resources
      for investment in our business. The payment of dividends on our common stock
      is
      subject to the discretion of our Board of Directors and will depend on our
      operations, financial position, financial requirements, general business
      conditions, restrictions imposed by financing arrangements, if any, legal
      restrictions on the payment of dividends and other factors that our Board of
      Directors deems relevant..




**ITEM
      2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS**




None




**ITEM
      3 - DEFAULTS UPON SENIOR SECURITIES**




None




32


**ITEM
      4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**




Our
      annual meeting of shareholders was held on May 3, 2007. The matters before
      our
      shareholders for vote, as described in our Proxy Statement, dated as of April
      3,
      2007, were:




1.
      The
      election of seven persons to our Board of Directors and




2.
      The ratification
      of Freed Maxick & Battaglia, CPAs PC as our independent public accountants
      for the fiscal year ending December 31, 2007.





Shareholders of record as of March 16, 2007 were entitled to attend and vote
      at
      the meeting. As of the record date of March 17, 2006, 13,677,597 shares of
      our
      Common Stock were outstanding. Shareholders representing 10,882,815 shares
      were present for quorum purposes in person or by proxy.





Our shareholders approved all of the matters before the meeting. The results
      of
      the voting were as follows:





1.
      Election of Directors




**Nominees
                for Director**
            
            **For**
            
            **Withheld**Patrick
                White
            
            
            10,436,071
            
            
            446,744Peter
                Ettinger
            
            
            10,471,671
            
            
            411,144Thomas
                M. Wicker
            
            
            9,682,738
            
            
            1,200,077Timothy
                Ashman
            
            
            10,738,444
            
            
            144,371Alan
                E. Harrison
            
            
            10,455,433
            
            
            427,382Robert
                B. Fagenson
            
            
            10,697,551
            
            
            185,264Ira
                A. Greenstein
            
            
            10,700,297
            
            
            182,518





The directors were elected for terms of one year. The Board is comprised of
      a
      total of seven persons.




2.
      R atification
      of Freed Maxick & Battaglia, CPAs PC as the Company’s independent public
      accountants for the fiscal year ending December 31, 2007.







**For**
            
            **Against**
            
            **Abstain**10,722,425
            
            70,623
            
            89,767






**ITEM
      5 - OTHER INFORMATION**




None




33




**ITEM
      6 - EXHIBITS**




The
      Exhibits listed below designated by an * are incorporated by reference to the
      filings by Document Security Systems, Inc. under the Securities Act of 1933
      or
      the Securities and Exchange Act of 1934, as indicated. All other exhibits are
      filed herewith.




(a)
            
            Exhibits
              Item
                3.1 Articles of Organization, as amended (incorporated by reference
                to
                exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY
                on
                Form S-18).*
              
              Item
                3.2 By-laws, as amended (incorporation by reference to exhibit 3.2
                to the
                Company's Registration Statement No. 2-98684-NY on Form
                S-18).*
              
              Item
                31.1Certifications
                of Chief Executive Officer Pursuant to Section 302 of the Sarbanes
                Oxley
                Act
              
              Item
                31.2Certifications
                of Acting Chief Financial Officer Pursuant to Section 302 of the
                Sarbanes
                Oxley Act
              
              Item
                32.1Certification
                of Chief Executive Officer Pursuant to Section 906 of the Sarbanes
                Oxley
                Act
              
              Item
                32.2Certification
                of Acting Chief Financial Officer Pursuant to Section 906 of the
                Sarbanes
                Oxley Act




**SIGNATURES**






In accordance with the requirements of the Exchange Act, the registrant caused
      this report on Form 10-Q to be signed on its behalf by the undersigned,
      thereunto duly authorized.




**DOCUMENT
                SECURITY SYSTEMS, INC.**May
                15, 2007
            
            By:
            /s/
                Patrick WhitePatrick
                WhiteChief
                Executive OfficerMay
                15, 2007
            
            By:
            /s/
                Philip JonesPhilip JonesActing
                  Chief Financial Officer(Principal Accounting
                Officer)





34