SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 FORM
10-K
 
  x
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 For the
fiscal year ended December 31, 2007.
 
 OR
 
  TRANSITION
      REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 For the
transition period from __________ to __________
 
 Commission
file number 0-23970
 
 FALCONSTOR
SOFTWARE, INC.
 (Exact
name of registrant as specified in its charter)
 
 DELAWARE
              
              77-0216135(State
      or other jurisdiction of
              
              (I.R.S.
      Employerincorporation
      or organization)
              
              Identification
      No.)2
      Huntington Quadrangle, Suite 2S01
              
              11747Melville,
      New York
              
              (Zip
      code)(Address
      of principal executive offices)
 
 
 Registrant's
telephone number, including area code: 631-777-5188
 
 Securities registered pursuant to
Section 12(b) of the Act:None
 
 Securities registered pursuant to
Section 12(g) of the Act:Common Stock, $.001 par
value
 
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes o  No x
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes o  No x
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. 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.
 
 Large
      Accelerated Filer o
              Accelerated
      Filer  xNon-Accelerated
      Filer  o
              Smaller
      Reporting Company o
 
 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
   Table of Contents
 
 Aggregate
market value of Common Stock held by non-affiliates of the Registrant as of June
30, 2007 was $409,674,192 which value, solely for the purposes of this
calculation excludes shares held by Registrant's officers and directors. Such
exclusion should not be deemed a determination by Registrant that all such
individuals are, in fact, affiliates of the Registrant. The number of shares of
Common Stock issued and outstanding as of February 22, 2008 was 51,346,868 and
50,162,768, respectively.
 
 Documents Incorporated by
Reference:
  The
information required by Part III of Form 10-K will be incorporated by reference
to certain portions of a definitive proxy statement which is expected to be
filed by the Company pursuant to Regulation 14A within 120 days after the close
of its fiscal year.


2
 Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES




2007
ANNUAL REPORT ON FORM 10-K




TABLEOF CONTENTS






Page
 PART
      I.
  Item 1.
              Business
              4
 Item 1A.
              Risk Factors
              12
 Item 1B.
              Unresolved Staff
      Comments
              22
 Item 2.
              Properties
              22
 Item 3.
              Legal Proceedings
              22
 Item 4.
              Submission of Matters to a Vote of Security
      Holders
              22
  PART
      II.
  Item 5.
              Market for
      Registrant’s Common Equity, Related Stockholder Matters andIssuer
      Purchases of Equity Securities
              23
  Item 6.
              Selected Consolidated Financial
      Data
              25
 Item7.
              Management’s
      Discussion and Analysis of Financial Condition and
      Results of Operations
              27
  Item 7A.
              Qualitative and Quantitative
      Disclosures About Market Risk
              44
 Item 8.
              Financial Statements and Supplementary
      Data
              44
 Item 9.
              Changes in and Disagreements with
      Accountants on Accounting and Financial
Disclosure
              70
  Item 9A.
              Controls and
      Procedures
              70
 Item 9B.
              Other Information
              70
 
 PART
      III.
  Item 10.
              Directors and Executive Officers and
      Corporate Governance
              71
 Item 11.
              Executive
    Compensation
              71
 Item 12.
              Security Ownership of Certain Beneficial Owners
      and Management and Related
      Stockholder Matters
              71
  Item 13.
              Certain Relationships and Related
      Transactions, Director Independence
              71
 Item 14.
              Principal Accountant Fees and
      Services
              71
  PART
      IV.
  Item 15.
              Exhibits, Financial Statement
      Schedules
              72
  SIGNATURES
              
              74







3
 Table of Contents




PART
I




Item1.
            Business




OVERVIEW




FalconStor
Software, Inc. (“FalconStor”, the “Company”, “we”, “our” or “us”) is the market
leader in disk-based data protection. We deliver proven, comprehensive data
protection solutions that facilitate the continuous availability of
business-critical data with speed, integrity, and simplicity. Our TOTALLY OpenTM
technology solutions, built upon the award-winning IPStor®
virtualization platform, include the industry leading Virtual Tape Library (VTL)
with Single Instance Repository (SIR) for de-duplication, Continuous Data
ProtectorTM (CDP), Network Storage Server (NSS) for storage virtualization, and
Replication option for disaster recovery and remote office protection. From the
Fortune 1000 to small and medium-size businesses, customers across a vast range
of industries worldwide have implemented FalconStor solutions in their
production IT environments in order to meet their recovery time objectives (RTO)
and recovery point objectives (RPO), as well as to manage their storage
infrastructures with minimal total cost of ownership (TCO) and optimal return on
investment (ROI).




The
FalconStor IPStor storage virtualization and data protection platform is
designed to empower IT administrators and end users to recover data easily to
any point in time in the event of hardware failure, data corruption, deletion,
or catastrophic site-level disaster, allowing rollback or failover to a
known-good, immediately useable state. To ensure that businesses maintain
reliable access to their vital applications, and to facilitate accurate data
restoration while concurrently minimizing downtime, the application-aware
FalconStor solutions are engineered to work seamlessly with database, email, and
file systems so that redundant sets of active data are generated with
transactional and point-in-time integrity. Because this eliminates the need for
the time-consuming consistency checks that traditionally create long periods of
downtime during a recovery process, business productivity is
enhanced.




Designed
to contain escalating costs, FalconStor solutions enable companies to aggregate
heterogeneous, distributed storage capacity and to centralize administration of
both storage resources and business-critical data services such as backup,
snapshot, replication, and migration. Companies benefit from lower
administrative overhead, elimination of storage over-provisioning, boundless
scalability, and the ability to make cost-effective storage allocation and
purchasing decisions. Moreover, FalconStor’s commitment to a TOTALLY Open
software-based approach to storage networking entails any-to-any connectivity
via native support for industry standards (including Fibre Channel, iSCSI, SCSI,
SAS, SATA and emerging standards such as InfiniBand) and delivers unified
support for multiple storage architectures. As a result, FalconStor solutions
provide companies of any size and complexity with the freedom to leverage
IP/iSCSI-, Fibre Channel-, or InfiniBand-based networks and to implement their
choice of state-of-the-art equipment based on any standard protocol from any
storage manufacturer, without rendering their existing or future investments
obsolete.




Recognizing
the value proposition of FalconStor’s proven, cutting-edge technology, multiple
Tier-1 partners utilize FalconStor’s innovative software products – including
CDP, VTL, NSS and DiskSafeTM - to power their storage appliances and bundled
solutions. FalconStor’s products have been certified by such industry leaders as
3Par, Acer, Adaptec, Alacritech, ATTO Technology, Bell Microproducts, Brocade,
Cisco, COPAN Systems, Engenio Information Technologies, EMC, Emulex, Fujitsu,
Gadzoox, Hewlett Packard, Hitachi Data Systems, Hitachi Engineering Co., Ltd.,
Huawei, H3C, IBM, Intel, Lanchao, LSI Logic, Microsoft, NEC, Network Appliance,
Nexsan, Novell, NS Solutions Corporation (subsidiary of The Nippon Steel
Corporation, Japan), Oracle, Pillar Data, QLogic, Quantum, Sony, Sun
Microsystems, Virtual Iron, Voltaire, and VMware.




Further
validation of FalconStor solutions comes from the agreements FalconStor has with
many Tier-1 original equipment manufacturers (OEMs) and others to integrate
FalconStor technology with those companies’ products. In the past year, OEM
partners have renewed contracts and pursued a visible market presence with
FalconStor, leveraging both brands for market presence.




FalconStor
was incorporated in Delaware as Network Peripherals, Inc., in 1994. Pursuant to
a merger with FalconStor, Inc., in 2001, the former business of Network
Peripherals, Inc. was discontinued, and the newly re-named FalconStor Software,
Inc., continued the storage software business started in 2000 by FalconStor,
Inc. FalconStor’s headquarters are located at 2 Huntington Quadrangle, Suite
2S01, Melville, NY  11747. The Company also maintains offices
throughout Europe and Asia.






4
 Table of Contents




PRODUCTS
AND TECHNOLOGY




FalconStor’s
flagship product platform, IPStor, is a network infrastructure software platform
that provides the most reliable and complete disk-based data protection and
storage virtualization solutions. FalconStor data protection solutions
accelerate or eliminate the backup window, which allows users to recover data in
minutes, anytime, anywhere, with 100% data integrity. FalconStor offers the
following core products: VTL with SIR for de-duplication, CDP, NSS and
Replication option for disaster recovery and remote branch office protection.
The IPStor platform and subsequent solutions share several key technologies that
foster seamless integration and offer a competitive edge.





·
            One
      independent, TOTALLY Open platform–Built on the IPStor storage
      virtualization platform, FalconStor solutions are completely independent
      of any storage or connectivity, delivering comprehensive data
      protection.




·
            Rapid
      recovery– Unique to FalconStor solutions is
      the ability to return a file, full system, or entire array to service in
      30 minutes and, in some cases, 5 minutes or less. This is due to the
      application-aware snapshot ability of TimeMark® technology as well
      as bare metal recovery
capabilities.




·
            Affordable, scalable protection
      from the data center to the remote office–FalconStor data
      protection technology scales from the data center to the remote office or
      single user laptop. FalconStor and its partners have deployed solutions as
      small as a 2TB desktop network storage server and as large as
      multiple-petabyte architectures. FalconStor MicroScanTM technology
      eliminates redundant data across the network. This eliminates 70%-90% of
      the bandwidth requirements, making disk-based protection for remote or
      disaster recovery sites highly affordable and
  practical.




FalconStor’s
data protection solutions address the full spectrum of data protection business
problems, from the need to accelerate backup to the need to recover data after a
disaster. Customers today are facing massive data growth, often exceeding 60% a
year. Backup windows have not only shrunk; for many organizations they have
disappeared altogether. Traditional backup has also been plagued with media and
hardware failures. These are issues addressed by FalconStor VTL. In addition,
the time to recover is also shrinking, so companies need more recovery points
and times, rather than the once a day offered by daily backup. For this they
turn to the FalconStor CDP solution. To improve the day-to-day management issues
they face with the explosive storage growth, customers use the FalconStor NSS to
virtualize, provision, and protect their data. And for protecting remote office
data from disasters, FalconStor has built a highly efficient Replication
solution that integrates with VTL, CDP, and NSS. Because all of these solutions
are built from a single technology platform, IPStor, deployment is simplified
and businesses benefit from the peace of mind that FalconStor solutions work
together in an easily managed and highly efficient fashion, with high data
availability and rapid recovery always paramount.





FalconStor
sells its solutions as software only, pre-installed on FalconStor-supplied
hardware appliances, or as virtual appliances. Software only solutions are
available as pre-packaged Software Appliance Kits or from an itemized price list
in the form of Enterprise, Standard, and Express Editions.





Software
Products




IPStor




IPStor
software is the product platform for FalconStor’s data protection and storage
virtualization solutions:




·
            Tape
      Backup Optimization – FalconStor
VTL




·
            Business
      Continuity/Disaster Recovery – FalconStor
CDP




·
            Storage
      Virtualization, Provisioning, and Management – FalconStor
    NSS




IPStor
provides data protection services at all levels—from the operating system and
application software, to files, databases, and messaging data across your entire
organization. IPStor is extremely scalable, allowing FalconStor solutions to
address the needs of small/medium businesses, large organizations, and global
enterprises. IPStor offers high availability (HA) through RAID, synchronous and
asynchronous mirroring, HA failover, and clustering technologies.




5
 Table of Contents




Network
Storage Server (NSS)




The FalconStor NSS, provides advanced
storage networking and best-in-class business continuity/disaster recovery
(BC/DR) functionality to all segments of the enterprise, small and medium-size
business (SMB), and small office/home office (SOHO) markets. NSS is comprised of
an extensive set of state-of-the-art network storage services designed to
deliver rapid data recovery and an open, unified SAN infrastructure across
heterogeneous environments. NSS aggregates storage capacity, provisioning, and
services to application servers via all industry-standard protocols with speed,
security, reliability, interoperability, and scalability.





Virtual
Tape Library (VTL)




FalconStor
VTL is the industry-leading, backup/recovery solution that saves money and time
by using disk to emulate an extensive range of physical tape libraries.
Integrating seamlessly with existing backup software and policies, as well as
with FalconStor CDP solutions, VTL enhances backup reliability, speed,
availability, and recoverability, while consolidating management of backup
resources. VTL backup to disk-based virtual tape ensures backup/restore success
by eliminating the media/mechanical errors and manual intervention traditionally
associated with tape backup. Remote offsite replication of virtual tapes
provides disaster protection, while automated data export to physical tape is
supported for archiving purposes. Software-based encryption technology prevents
unauthorized access to data exported to physical tapes and in transit during
replication, without imposing any overhead on the backup process. VTL is fast
and easy to deploy –comparable to adding a new tape drive or library to an existing backup
environment.





The
FalconStor Single Instance Repository (SIR) is a de-duplication enhancement
option to VTL. Because backup by nature copies data over and over again,
de-duplication minimizes storage and bandwidth needs. By eliminating duplicate
copies, VTL with SIR allows customers to keep more data online, longer. Instead
of a month of data on disk for recovery, they can now keep several months or
more.





In 2007,
FalconStor introduced the VTL Storage Appliance with embedded de-duplication for
the remote office and mid-range market and the VTL Virtual Appliance for VMware
Virtual Infrastructure environments. The FalconStor VTL Virtual Appliance is a
pre-configured, ready-to-run software application packaged with the operating
system inside a virtual machine running under VMware Virtual Infrastructure 3.
Developed for quick, easy deployment in virtual environments, the solution
reduces infrastructure cost and complexity while maximizing customers’ return on
investment. The FalconStor VTL Virtual Appliance provides all the benefits and
features of the FalconStor VTL storage appliances for VMware Virtual
Infrastructure 3 users.





Continuous
Data Protector (CDP)




FalconStor
CDP solutions maintain 24x7x365 availability and usability of data in the event
of an unplanned hardware failure, deletion, or software error, or planned
downtime. Combining application-aware TimeMark snapshots and continuous
journaling functions, CDP enables customers to recover data to any point in
time. CDP eliminates the backup window entirely, by enabling customers to use
the CDP copy as the target for the backup software.





In 2007,
FalconStor introduced the industry’s first VMware certified CDP Virtual
Appliance. The CDP Virtual Appliance is a pre-configured, ready-to-run software
application packaged with the operating system inside a virtual machine running
under VMware Virtual Infrastructure 3. Developed for quick, easy deployment in
virtual environments, the solution reduces infrastructure cost and complexity
while maximizing customers’ return on investment. The FalconStor CDP Virtual
Appliance provides all the benefits and features of the FalconStor CDP storage
appliances for VMware Virtual Infrastructure 3 users.





Replication




The
FalconStor Replication option provides rapid, reliable recovery in the event of
catastrophic site failure, such as a fire, power outage, or flood in the main
data center. Disk-to-disk disaster recovery solutions become more affordable and
available to customers of all sizes. Customer benchmarks have indicated that
FalconStor Replication technology can eliminate 70% to 90% of the redundant data
typically replicated by other solutions. When combined with VTL or CDP,
Replication technology delivers a highly efficient remote office protection
solution.





6
 Table of Contents




DiskSafeTM
and FileSafeTM




FalconStor
DiskSafe and FileSafe are host-resident software tools that protect DAS-based
application servers and end user desktops or laptops, as well as servers using
third-party storage networks, by enabling them to replicate entire local disks
(DiskSafe) or individual files and directories (FileSafe) to CDP-managed storage
for automated backup, off-site data storage, and rapid, user-initiated data
recovery. DiskSafe technology capturesthe information necessary
to boot the designated machine in the event of a virus or spyware attack,
application malfunction, or hard disk crash. DiskSafe and FileSafe are integral
components of the FalconStor CDP solutions, facilitating the transfer of
replicated data over the network to a centralized FalconStor data management
appliance for both redundant nearline storage and remote disaster recovery (DR)
purposes.




Application-Aware
Snapshot Agents




FalconStor Snapshot Agents automate and
minimize quiesce time during data replication, backup, and other snapshot-based
operations to ensure transactional integrity and point-in-time consistency of
databases and messaging stores for fast time-to-recovery. Snapshot Agents are
available for IBM® DB2® UDB,
Informix®,
Microsoft® SQL
Server, Oracle®,
Pervasive.SQL®,
Sybase®, IBM
Lotus Notes®/Domino,
Microsoft®
Exchange, Microsoft® VSS,
Novell®
GroupWise®,
VMWare®, and
many file systems.




Application
Specific Recovery Options




FalconStor
recovery agents offer recovery solutions for database and messaging systems. For
instance, FalconStor Message Recovery for Microsoft Exchange and Message
Recovery for Lotus Notes/ Domino expedite mailbox/message recovery by enabling
IT administrators to quickly recover individual mailboxes from point-in-time
snapshot images of their messaging server.  In addition, FalconStor
Database Recovery for Microsoft SQL Server expedites database recovery by
enabling IT administrators to quickly recover a database from point-in-time
snapshot images of their SQL database.




BUSINESS
STRATEGY




FalconStor intends to maintain its
position as a leading provider of TOTALLY Open disk-based data protection and
storage virtualization solutions serving enterprises and SMBs worldwide.
FalconStor intends to achieve this objective through the following
strategies:




Disk-Based
Data Protection Leadership





FalconStor intends to continue to
leverage the protocol-independant, unified architecture, and robust TOTALLY Open
data protection technology of its solutions to maintain a leadership position in
the enterprise and SMB disk-based data protection software market. The
disk-based data protection market is rapidly growing. IDC forecasts the VTL
market will reach $1.2B by 2011, a 30% CAGR. In a recent survey by Gartner at
their enterprise customer summit, 17% of respondents said that their
organization was already utilizing de-duplication technology and 48% said that
their organization will adopt de-duplication technology within the next 12
months. In addition, Gartner forecasts that data replication software for
Disaster Recovery will reach $3.9B by 2011, an 11.8% CAGR. FalconStor plans to
continue its leadership in this market through its deep commitment to research
and development and continued rapid technology innovation.





Expand Product
Offerings





In the
fall of 2007, FalconStor released the first certified CDP Virtual Appliance for
VMware Virtual Infrastructure, complementing our line of CDP products. This
product allows virtual environments to receive the same level of data protection
as physical environments. The release of this product was followed by the
release of a VTL Virtual Appliance, demonstrating our commitment to providing
data protection to all environments whether enterprise or SMB, physical or
virtual, local or remote.





In
addition, FalconStor introduced the SIR de-duplication technology embedded into
a VTL Storage Appliance designed for the SMB and remote office markets. The VTL
Storage Appliances integrate with VTL Enterprise Edition.  The latest
release of VTL Enterprise Edition was launched in the first quarter 2008 as the
industry’s most open, scalable and powerful VTL solution, delivering unmatched
performance with minimal operating cost via tight integration with 3rd party
backup software, disk arrays, and physical




7
 Table of Contents




tape
libraries, as well as having advanced media management capabilities. FalconStor
VTL Enterprise Edition is tightly integrated with FalconStor ́s clustered
de-duplication technology, Single Instance Repository (SIR), and is designed
with scalable IO performance and storage capacity to accommodate implementations
ranging from remote offices to enterprise data centers. We expect many VTL
solutions to be sold with this critical functionality. In addition, we expect as
our customers grow, so will their requirement for scalability, easily met by the
FalconStor VTL and de-duplication solutions.





Expand
Corporate Visibility





Throughout 2007, FalconStor has made
significant steps in increasing its market presence and awareness. First, we
launched a new advertising campaign featuring customer testimonials for each of
our product lines. We have also taken additional steps to increase our online
presence in the form of banner ads on key media and industry community
sites.




Second, through the release of new
products, strategic relationships and customer wins, we increased our engagement
with the press and analyst community to bring our comprehensive disk based data
protection and storage virtualization message to the market. This broad effort
has led to several awards and accolades:




·
            FalconStor
      Voted 1 of 10 ‘Companies to Watch’ in 2008 by
  ChannelWeb


·
            FalconStor
      VTL Named #1 VTL in TheInfoPro Wave 10
Report


·
            FalconStor
      CDP Virtual Appliance for VMware Awarded ‘Excellent’ Rating from
      ZDNet


·
            FalconStor
      CDP Virtual Appliance for VMware Named ‘Product of the Year’ Finalist by
      Storage Magazine


·
            FalconStor
      NSS WINS CRN Virtualization Test


·
            FalconStor
      Named #5 on ‘America’s 25 Fastest-Growing Technology Companies’ List by
      Forbes Magazine


·
            FalconStor
      CDP Virtual Appliance named ‘New Product of the Year’ Finalist by Network
      Computing




We anticipate this positive recognition
will continue throughout 2008, as we refine our message and market
deliverables.




Third, we increased our investment in
our partners, both OEM and channel, for joint marketing and field engagement. In
addition, we have expanded our channel by partnering with distributors to
further penetrate the mid-range market.




Scalable
Packaging




The scalability of our technology
enables FalconStor to team with channel partners to package our various
solutions in many ways. For example, our solutions can be packaged as virtual
appliances, which can be deployed in 5 minutes, providing an instant value-add
to the virtual server and the physical servers on the LAN. Our server appliances
can be deployed as a stackable iSCSI or stand-alone CDP/VTL node in as few as 10
minutes. Our solutions can also be deployed as a Dual-Controller storage array
with embedded storage with CDP or VTL service.  Finally we offer
multi-node clusters for our enterprise accounts. We are looking forward to
seeing the effects of the scalable packaging of our competitive solutions
through the channel in 2008.




Expand
Technologies and Capabilities Through Strategic Acquisitions and
Alliances





FalconStor believes that opportunities
may exist to expand its technological capabilities, product offerings, and
services whether through acquisitions of businesses or software technology, or
through strategic alliances. FalconStor will focus on opportunities that enable
it to acquire or to license:




·
            Important enabling
      technology;


·
            Complementary
      applications;


·
            Marketing,
      sales, customer and technological synergies;
  and/or


·
            Key
    personnel.






8
 Table of Contents





Seek
OEM Relationships With Industry Leaders





FalconStor intends to continue to enter
into OEM agreements with strategic switch, storage, appliance, and operating system vendors. Besides
accelerating overall market growth, the OEM relationships should continue to
bolster FalconStor’s product recognition, corporate credibility, and revenue
stream.





Expand
Inside and Field Sales Organization





FalconStor
intends to expand its worldwide sales force in 2008. Field sales expansion
should provide increased coverage for end user opportunities and partners.
FalconStor is increasing its investment in partners with additional training,
lead generation and market development. The inside sales team has been bolstered
to further support lead generation and incremental revenue opportunities for
current end users and mid-size businesses.





Identify
and Nurture New Growth Drivers





FalconStor has made key investments in
several areas, from which we expect growth in the coming years. We believe we
are strongly positioned to take advantage of the rapid storage growth in China.
OEM relationships with Acer, H3C, Inspur Group, and others and the joint
development/production agreement with The Chinese Academy of Science for
enterprise-class storage, archiving and compliance solutions, will continue to
expand this market.





Recent
Gartner research has stated that by 2012 de-duplication will be applied to 75%
of backups. As the industry leader in VTL market, FalconStor has already fully
integrated de-duplication technology into our enterprise-class VTL. In the
fourth quarter of 2007 FalconStor released the VTL Storage Appliances with
embedded de-duplication technology for the SMB. This enabled corporations to
deploy solutions covering remote offices, and data centers as well as DR sites.
We believe the VTL Storage Appliance will be extremely appealing to the
mid-market because of the following characteristics:





1)
            High
      performance backup via the low-impact post-processing
  model


2)
            High
      speed direct tape duplication via tape library
  integration


3)
            Ability
      to run 3rd party backup software directly on the VTL appliance allows the
      VAR to deliver a cost-effective, All-In-One
  solution





In
addition to VTL, we plan to incorporate De-Duplication into various storage
services such as archiving, WORM and disk-based backup.





With a server virtualization market
that is gaining rapid adoption, we anticipate a growing need for integrated
storage and server virtualization solutions for maximizing IT productivity and
business continuity. This combination of solutions will improve data center
resource management by increasing utilization of existing physical resources,
while optimizing virtual infrastructure performance through real-time data
migration, to deliver more cost-effective and reliable high-availability and
disaster recovery. In 2007, we laid the foundation in building relationships
with vendors like VMware, Virtual Iron, and Microsoft, and we expect that in
2008 these relationships and joint technology solutions will continue to
grow.




With regard to Green computing, we
teamed with our strategic partner COPAN, a pioneer in MAID technology, to launch
the industry’s first enterprise class ‘GREEN’ VTL with de-duplication in 2007.
We are expecting to continue our collaboration to introduce additional
environmentally friendly, energy-efficient storage services in
2008.




9
 Table of Contents




SALES,
MARKETING AND CUSTOMER SERVICE




FalconStor plans to continue to sell
its products primarily through original equipment manufacturers (OEMs),
value-added resellers (VARs, also sometimes called “solution providers”), and
distributors.





OEM
Relationships. OEMs
collaborate with FalconStor to integrate FalconStor technology into their own
product offerings or to resell FalconStor technology under their own
label.





VAR and Distributor
Relationships.FalconStor has entered into VAR and distributor agreements to help sell
its product in various geographic areas. FalconStor’s VARs and distributors
market various FalconStor products and receive a discount off of the list price
on products sold.





Storage Appliances.FalconStor has agreements
with strategic partners to adapt FalconStor products for use in the strategic
partners’ special-purpose storage appliances.





Direct Sales to End
Users.In a limited number of
circumstances, FalconStor has entered into software license agreements directly
with end users.





FalconStor’s
marketing efforts focus on building brand recognition among customers, partners,
analysts, and the media, and developing qualified leads for the sales
force.





FalconStor Professional Services
personnel are also available to assist customers and partners throughout the
life cycle of FalconStor solution deployments. The Professional Services team
includes experienced Storage Architects (expert field engineers) who can assist
in the assessment, planning/design, deployment, and testing phases of a
deployment project, and a Technical Support group for post-deployment assistance
and ongoing support.




COMPETITION




As the
demand for data protection and network-based storage products and services
increases, more competitors will enter this high-growth market segment. Although
there are several companies attempting to offer unified storage services or data
protection, FalconStor believes it is the only software-based solution provider
capable of comprehensive data protection. We believe the IPStor platform and its
integrated services of virtualization, VTL, CDP, Single Instance Repository
(De-duplication), Replication for remote offices and data centers is unique to
the industry.





Although
some of FalconStor’s products provide capabilities that put them in competition
with products from a number of companies with substantially greater financial
resources, FalconStor is not aware of any other software company providing the
same range of unified data protection storage services running on a standard
Linux-, Windows- or Solaris-based appliance. FalconStor believes that the
principal competitive factors affecting its marketability include product
features such as scalability, data availability, ease of use, price,
reliability, hardware/platform neutrality, customer service, and
support.





Additionally,
as more partners offer appliances that integrate FalconStor products, the
Company has experienced competitive pressures from smaller, niche players in the
industry. However, FalconStor believes these competitors currently do not offer
the depth or breadth of data protection or storage services delivered by
FalconStor, nor do they possess the experience and technological innovation
needed to develop and deliver reliable, fully integrated, and proven storage
services.





As
FalconStor continues its move into the non-enterprise storage market, the
products and services offered by its partners may compete with existing or new
products and services offered by current and new entrants to the
market.





FalconStor’s future and existing
competitors could conceivably introduce products with superior features,
scalability, and functionality at lower prices than FalconStor’s products and
could also bundle existing or new products with other more established products
to compete with FalconStor. Increased competition could result in price
reductions and reduced gross margins, which could harm FalconStor’s business.
FalconStor’s success will depend largely on its ability to generate market
demand and awareness of its products and to develop additional or enhanced
products in a timely manner. FalconStor’s success will also depend on its
ability to convince potential partners of the benefits of licensing its software
rather than that of competing technologies.




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INTELLECTUAL
PROPERTY




FalconStor’s success is dependent in
part upon its proprietary technology.  Currently, the IPStor platform
forms the core of this proprietary technology. FalconStor currently has eight
patents and numerous pending patent applications; and multiple registered
trademarks – including “FalconStor,” “FalconStor Software” and “IPStor” – and
many pending trademark applications related to FalconStor and its
products.




FalconStor seeks to protect its
proprietary rights and other intellectual property through a combination of
copyright, trademark and trade secret protection, as well as through contractual
protections such as proprietary information agreements and nondisclosure
agreements. The technological and creative skills of its personnel, new product
developments, frequent product enhancements and reliable product maintenance are
essential to establishing and maintaining a technology leadership
position.




FalconStor generally enters into
confidentiality or license agreements with its employees, consultants, and
corporate partners, and generally controls access to and distribution of its
software, documentation, and other proprietary information. Despite FalconStor’s
efforts to protect its proprietary rights, unauthorized parties may attempt to
copy or otherwise obtain and use its products or technology. Monitoring
unauthorized use of its products is difficult, and there can be no assurance
that the steps FalconStor has taken will prevent misappropriation of its
technology, particularly in foreign countries where laws may not protect its
proprietary rights as fully as do the laws of the United States.




MAJOR
CUSTOMERS




For the year ended December 31, 2007,
we had two customers, EMC Corporation and Sun Microsystems, which accounted for
26% and 12%, respectively, of our total revenues. For the year ended December
31, 2006, EMC Corporation accounted for 27% of our total revenues. For the year
ended December 31, 2005, EMC Corporation and Sun Microsystems accounted for 19%
and 12%, respectively, of our total revenues. As of December 31, 2007, EMC
Corporation’s accounts receivable balance was 17% of our gross accounts
receivable balance. As of December 31, 2006, EMC Corporation’s accounts
receivable balance represented 21% of our gross accounts receivable
balance.




EMPLOYEES




As of
December 31, 2007, we had 414 full-time and part-time employees, consisting of
187 in research and development, 118 in sales and marketing, 84 in service, and
25 in general administration. We are not subject to any collective bargaining
agreements and believe our employee relations are good.





INTERNET
ADDRESS AND AVAILABILITY OF FILINGS




Our
internet address is www.falconstor.com.
The Company makes available free of charge, on or through its Internet website,
the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,
Current Reports on Form 8-K, and amendments to those reports filed or furnished
pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as
amended, as soon as reasonably practicable after the Company electronically
files such material with, or furnishes it to, the Securities and Exchange
Commission.  The Company complied with this policy for every
Securities Exchange Act of 1934, as amended, report filed during the year ended
December 31, 2007.




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Item1A.  Risk Factors




We are
affected by risks specific to us as well as factors that affect all businesses
operating in a global market. The significant factors known to us that could
materially adversely affect our business, financial condition, or operating
results are set forth below.





Due
to the uncertain and shifting development of the data protection and network
storage software markets and our reliance on our partners, we may have
difficulty accurately predicting revenue for future periods and appropriately
budgeting for expenses.




The rapidly evolving nature of the data
protection and network storage software markets in which we sell our products,
the degrees of effort and success of our partners’ sales and marketing efforts,
and other factors that are beyond our control, reduce our ability to accurately
forecast our quarterly and annual revenue. However, we must use our forecasted
revenue to establish our expense budget. Most of our expenses are fixed in the
short term or incurred in advance of anticipated revenue. As a result, we may
not be able to decrease our expenses in a timely manner to offset any shortfall
in revenue.




The
markets for many of our products are still maturing, and our business will
suffer if they do not continue to develop as we expect.




The
continued adoption of Storage Area Networks (IP/iSCSI-, Fibre Channel-, and
InfiniBand-based)) and Network Attached Storage solutions, disk-based backup
solutions, storage virtualization solutions, deduplication solutions, and
virtual environments is critical to our future success. The markets for these
solutions are still maturing, making it difficult to predict their potential
sizes or future growth rates. If these markets develop more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.




We
may not be able to penetrate the small/medium business and small office/home
office markets.




We offer
products for the small/medium business (SMB) and small office/home office (SOHO)
markets.  Our products may not be attractive to the SMB and the SOHO
markets, or to reach agreements with OEMs and resellers with significant
presences in the SMB and SOHO markets. If we are unable to penetrate the SMB and
SOHO markets, we will not be able to recoup the expenses associated with our
efforts in these markets and our ability to grow revenues could
suffer.




If
we are unable to develop and manufacture new products that achieve acceptance in
the network storage software market, our operating results may
suffer.




The
network storage software market continues to evolve and as a result there is
continuing demand for new products. Accordingly, we may need to develop and
manufacture new products that address additional network storage software market
segments and emerging technologies to remain competitive in the data storage
software industry.  We are uncertain whether we will successfully
qualify new network storage software products with our customers by meeting
customer performance and quality specifications or quickly achieve high volume
production of storage networking software products. Any failure to address
additional market segments could harm our business, financial condition and
operating results.




Our
products must conform to industry standards in order to be accepted by customers
in our markets.




Our
current products are only one part of a storage system. All components of these
systems must comply with the same industry standards in order to operate
together efficiently. We depend on companies that provide other components of
these systems to conform to industry standards. Some industry standards may not
be widely adopted or implemented uniformly, and competing standards may emerge
that may be preferred by OEM customers or end users. If other providers of
components do not support the same industry standards as we do, or if competing
standards emerge, our products may not achieve market acceptance, which would
adversely affect our business.




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Our
products may have errors or defects that could result in reduced demand for our
products or costly litigation.




Our
IPStor platform, including VirtualTape Library, is complex and is designed to be
deployed in large and complex networks. Many of our customers have unique
infrastructures, which may require additional professional services in order for
our software to work within their infrastructures. Because our products are
critical to the networks of our customers, any significant interruption in their
service as a result of defects in our product could result in damage to our
customers. These problems could cause us to incur significant service and
engineering costs, divert engineering personnel from product development efforts
and significantly impair our ability to maintain existing customer relationships
and attract new customers. In addition, a product liability claim, whether
successful or not, would likely be time consuming and expensive to resolve and
would divert management time and attention. Further, if we are unable to fix the
errors or other problems that may be identified in full deployment, we would
likely experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.




Our other
products may also contain errors or defects. If we are unable to fix the errors
or other problems that may be discovered, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.




Failure
of storage appliances to integrate smoothly with end user systems could impact
demand for the appliances.




We have
entered into agreements with resellers and OEM partners to develop storage
appliances that combine certain aspects of IPStor or VTL functionality with
third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. In addition, in certain instances, we install our
software onto third party hardware for resale to end-users. If the storage
appliances are not easy to deploy or do not integrate smoothly with end user
systems, the basic premise behind the appliances will not be met and sales would
suffer.




Our
OEM customers require our products to undergo a lengthy and expensive
qualification process that does not assure product sales.




Prior to
offering our products for sale, our OEM customers typically require that each of
our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM’s system as well as rigorous
reliability testing.  This qualification of a product by an OEM does
not assure any sales of the product to the OEM. Despite this uncertainty, we
devote substantial resources, including engineering, sales, marketing and
management efforts, toward qualifying our products with OEMs in anticipation of
sales to them. If we are unsuccessful or delayed in qualifying any products with
an OEM, such failure or delay would preclude or delay sales of that product to
the OEM, which may impede our ability to grow our business.




We
rely on our OEM customers and resellers for most of our sales.




Almost
all of our sales come from sales to end users of our products by our OEM
customers and by our resellers.  These OEM customers and resellers
have limited resources and sales forces and sell many different products, both
in the network storage software market and in other markets. The OEM customers
and resellers may choose to focus their sales efforts on other products in the
network storage software market or other markets. The OEM customers might also
choose not to continue to develop or to market products which include our
products. This would likely result in lower revenues to us and would impede our
ability to grow our business.




Our
OEM customers are not obligated to continue to sell our
products.





We have
no control over the shipping dates or volumes of systems incorporation of our
product that our OEM customers ship and they have no obligation to ship systems
incorporating our software applications. Our OEM customers also have no
obligation to recommend or offer our software applications exclusively or at
all, and they have no minimum sales requirements. These OEMs also could choose
to develop their own data protection and network storage software internally, or
to license software from our competitors, and incorporate those products into
their systems instead of our software applications. The OEMs that we do business
with also compete with one another. If one of our OEMs views our arrangement
with another OEM as competing with its products, it may decide to stop doing
business with us. Any material decrease in the volume of sales generated by OEMs
with whom we do business, as a result of these factors or otherwise, would have
a material adverse effect on our revenues and results of operations in future
periods.


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  The failure of
our resellers to effectively sell our software applications could have a
material adverse effect on our revenues and results of
operations.





We rely
significantly on our value-added resellers, systems integrators and corporate
resellers, which we collectively refer to as resellers, for the marketing and
distribution of our software applications and services. However, our agreements
with resellers are generally not exclusive, are generally renewable annually and
in many cases may be terminated by either party without cause. Many of our
resellers carry software applications that are competitive with ours. These
resellers may give a higher priority to other software applications, including
those of our competitors, or may not continue to carry our software applications
at all. If a number of resellers were to discontinue or reduce the sales of our
products, or were to promote our competitors’ products in lieu of our
applications, it would have a material adverse effect on our future revenues.
Events or occurrences of this nature could seriously harm our sales and results
of operations. In addition, we expect that a significant portion of our sales
growth will depend upon our ability to identify and attract new reseller
partners. The use of resellers is an integral part of our distribution network.
We believe that our competitors also use reseller arrangements. Our competitors
may be more successful in attracting reseller partners and could enter into
exclusive relationships with resellers that make it difficult to expand our
reseller network. Any failure on our part to expand our network of resellers
could impair our ability to grow revenues in the future.





We are dependent
on certain key customers and a significant portion of our receivables is
concentrated with two customers.




We tend
to have one or more customers account for 10% or more of our revenues during
each fiscal quarter. For the year ended December 31, 2007, we had two customers,
EMC Corporation and Sun Microsystems, which accounted for 26% and 12%,
respectively of our total revenues. For the year ended December 31, 2006, EMC
Corporation accounted for 27% of our total revenues. For the year ended December
31, 2005, EMC Corporation and Sun Microsystems accounted for 19% and 12%,
respectively, of our total revenues. While we believe that we will continue to
receive revenue from this client, our agreements do not have any minimum sales
requirements and we cannot guarantee continued revenue. If our contract with
this customer terminates, or if the volume of sales from this customer
significantly declines, it would have a material adverse effect on our operating
results.




In addition, as of December 31, 2007,
EMC Corporation’s accounts receivable balance was 17% of our gross accounts
receivable balance. As of December 31, 2006, EMC Corporation’s accounts
receivable balance represented 21% of our gross accounts receivable balance.
While we currently have no reason to question the collectibility of these
receivables, a business failure or reorganization by either of these customers
could harm our ability to collect these receivables and could damage our cash
flow.




The
reporting terms of some of our OEM agreements may cause us difficulty in
accurately predicting revenue for future periods, budgeting for expenses or
responding to trends.




Certain of our OEM customers do not
report license revenue to us until sixty days or more after the end of the
quarter in which the software was licensed. There is thus a delay before we
learn whether licensing revenue from these OEMs has met, exceeded, or fallen
short of expectations. The reporting schedule from these OEMs also means that
our ability to respond to trends in the market could be harmed as
well.  For example, if, in a particular quarter, we see a significant
increase or decrease in revenue from our channel sales or from one of our other
OEM partners, there will be a delay in our ability to determine whether this is
an anomaly or a part of a trend.  However, we must use our forecasted
revenue to establish our expense budget. Most of our expenses are fixed in the
short term or incurred in advance of anticipated revenue. As a result, we may
not be able to decrease our expenses in a timely manner to offset any shortfall
in revenue or to increase our sales, marketing or support headcounts to take
advantage of positive developments.




Issues
with the hardware sold by our partners could result in lower sales of our
products.




As part
of our sales channel, we license our software to OEMs and other partners who
install our software on their own hardware or on the hardware of other third
parties. If the hardware does not function properly or causes damage to
customers’ systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners’ hardware could
negatively impact our business.




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We
must maintain our existing relationships and develop new relationships with
strategic industry partners.




Part of
our strategy is to partner with major third-party software and hardware vendors
who integrate our products into their offerings and/or market our products to
others. These strategic partners often have customer or distribution networks to
which we otherwise would not have access or the development of which would take
up large amounts of our time and other resources. There is intense competition
to establish relationships with these strategic partners. Some of our agreements
with our OEM customers grant to the OEMs limited exclusivity rights to portions
of our products for periods of time. This could result in lost sales
opportunities for us with other customers or could cause other potential OEM
partners to consider or select software from our competitors for their storage
solutions. In addition, the desire for product differentiation could cause
potential OEM partners to select software from our competitors. We cannot
guarantee that our current strategic partners, or those companies with whom we
may partner in the future, will continue to be our partners for any period of
time. If our software was to be replaced in an OEM solution by competing
software, or if our software is not selected by OEMs for future solutions, it
would likely result in lower revenues to us and would impede our ability to grow
our business.




We
rely on channel partners to sell our solutions, and disruptions to, or our
failure to develop and manage our channel partners would harm our
business.




Our
future success is partially dependent upon establishing and maintaining
successful relationships with a large number of channel partners. A portion of
our revenue is generated by sales through our channel partners, and we expect
channel sales to continue to make up a significant portion of our total revenue
in the future. Accordingly, our revenue depends in part on the effective sales
and lead generation activities of these channel partners.




Recruiting
and retaining qualified channel partners and training them in our technology and
product offerings requires significant time and resources. In order to develop
and expand our distribution channel, we must continue to scale and improve our
processes and procedures that support our channel, including investment in
systems and training. Those processes and procedures may become increasingly
complex and difficult to manage as we grow our organization. We have no minimum
purchase commitments from any of our channel partners, and our contracts with
these channel partners do not prohibit them from offering products or services
that compete with ours. Our competitors may provide incentives to existing and
potential channel partners to favor their products or to prevent or reduce sales
of our solutions. Our channel partners may choose not to offer our solutions
exclusively or at all. Establishing relationships with channel partners who have
a history of selling our competitors’ products may also prove to be difficult.
In addition, some of our channel partners are also competitors. Our failure to
establish and maintain successful relationships with channel partners would harm
our business and operating results.




Consolidation
in the network storage industry could hurt our strategic
relationships.




In the
past, companies with whom we have OEM relationships have been acquired by other
companies. These acquisitions caused disruptions in the sales and marketing of
our products and have had an impact on our revenues. If additional OEM customers
are acquired, the acquiring entity might choose to stop offering solutions
containing our software. Even if the solutions continued to be offered, there
might be a loss of focus and sales momentum as the companies are
integrated.




The
data protection and network storage software markets are highly competitive and
intense competition could negatively impact our business.




The data
protection and network storage software markets are intensely competitive even
during periods when demand is stable. Some of our current and potential
competitors have longer operating histories, significantly greater resources,
broader name recognition and a larger installed base of customers than we have.
Those competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.




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Our
competitors also may:




·
            consolidate
      or establish strategic relationships among themselves to lower their
      product costs or to otherwise compete more effectively against us;
      or




·
            bundle
      their products with other products to increase demand for their
      products.




In
addition, some OEMs with whom we do business, or hope to do business, may enter
the market directly and rapidly capture market share. If we fail to compete
successfully against current or future competitors, our business, financial
condition and operating results may suffer.




Our ability to
sell our software applications is highly dependent on the quality of our
services offerings, and our failure to offer high quality support and
professional services would have a material adverse affect on our sales of
software applications and results of operations.


Our
services include the assessment and design of solutions to meet our customers’
data protection and storage management requirements and the efficient
installation and deployment of our software applications based on specified
business objectives. Further, once our software applications are deployed, our
customers depend on us to resolve issues relating to our software applications.
A high level of service is critical for the successful marketing and sale of our
software. If our partners or we do not effectively install or deploy our
applications, or succeed in helping our customers quickly resolve
post-deployment issues, it would adversely affect our ability to sell software
products to existing customers and could harm our reputation with potential
customers. As a result, our failure to maintain high quality support and
professional services would have a material adverse effect on our sales of
software applications and results of operations.




Failure
to achieve anticipated growth could harm our business and operating
results.




Achieving
our anticipated growth will depend on a number of factors, some of which
include:




·
            retention
      of key management, marketing and technical
  personnel;




·
            our
      ability to increase our customer base and to increase the sales of our
      products; and




·
            competitive
      conditions in the network storage infrastructure software
      market.




We cannot
assure you that the anticipated growth will be achieved. The failure to achieve
anticipated growth could harm our business, financial condition and operating
results.




Our
revenues depend in part on spending by corporate customers.




The
operating results of our business depend in part on the overall demand for
network storage software. Because the market for our software is primarily major
corporate customers, any softness in demand for network storage software may
result in decreased revenues.




Our
future quarterly results may fluctuate significantly, which could cause our
stock price to decline.




Our
previous results are not necessarily indicative of our future performance and
our future quarterly results may fluctuate significantly.




Historically,
information technology spending has been higher in the fourth and second
quarters of each calendar year, and somewhat slower in the other quarters,
particularly the first quarter. Our quarterly results reflected this seasonality
in 2007, and we anticipate that our quarterly results for 2008 will show the
effects of seasonality as well.




Our
future performance will depend on many factors, including:




·
            the
      timing of securing software license contracts and the delivery of software
      and related revenue recognition;




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·
            the
      seasonality of information technology, including network storage
      products,  spending;




·
            the
      average unit selling price of our
products;




·
            existing
      or new competitors introducing better products at competitive prices
      before we do;




·
            our
      ability to manage successfully the complex and difficult process of
      qualifying our products with our
customers;




·
            new
      products or enhancements from us or our
  competitors;




·
            import
      or export restrictions on our proprietary technology;
  and




·
            personnel
      changes.




Many of
our expenses are relatively fixed and difficult to reduce or modify. As a
result, the fixed nature of our expenses will magnify any adverse effect of a
decrease in revenue on our operating results.




Our
stock price may be volatile




The
market price of our common stock has been volatile in the past and may be
volatile in the future. For example, during the past twelve months ended
December 31, 2007, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $8.13 and $15.30 per share. The market
price of our common stock may be significantly affected by the following
factors:




·
            actual
      or anticipated fluctuations in our operating
  results;




·
            failure
      to meet financial estimates;




·
            changes
      in market valuations of other technology companies, particularly those in
      the network storage software
market;




·
            announcements
      by us or our competitors of significant technical innovations,
      acquisitions, strategic partnerships, joint ventures or capital
      commitments;




·
            loss
      of one or more key OEM customers;
and




·
            departures
      of key personnel.




The stock
market has experienced extreme volatility that often has been unrelated to the
performance of particular companies. These market fluctuations may cause our
stock price to fall regardless of our performance.




Our
ability to forecast earnings is limited by the impact of certain accounting
requirements.




The
Financial Accounting Standards Board requires companies to recognize the fair
value of stock options and other share-based payment compensation to employees
as compensation expense in the statement of operations.  However, this
expense, which we estimate based on the “Black-Scholes” model, is subject to
factors beyond our control. These factors include the market price of our stock
on a particular day and stock price “volatility.” In addition, we do not know
how many options our employees will exercise in any future period. These
unknowns make it difficult for us to forecast accurately what the amount of
share-based compensation expense will be in the future. Because of these
factors, our ability to make accurate forecasts of future earnings is
compromised.




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The
amount of income taxes we have to pay may increase.




During 2007, we received the benefit of
net operating loss carryforwards, which reduced the amount of income taxes that
we would have been required to pay so the amount of tax that we paid was
insignificant to our operating results. The availability of these net-operating
losses is limited. As of December 31, 2007, we had approximately $5.1 million of
U.S. Federal net-operating loss carryforwards available for use to offset future
taxable income. We anticipate, although there can be no assurance, that our
taxable income will be significantly in excess of this amount and that we will
have a material tax liability.




The
ability to correctly predict our future effective tax rates could impact our
ability to accurately forecast future earnings.




We
are subject to income taxes in both the United States and the various foreign
jurisdictions in which we operate. Judgment is required in determining our
provision for income taxes and there are many transactions and calculations
where the tax determination may be uncertain. Our future effective tax rates
could be affected by changes in our (i) earnings or losses; (ii) changes in the
valuation of our deferred tax assets; (iii) changes in tax laws; and (iv) other
factors. Our ability to correctly predict our future effective tax rates based
upon these possible changes could significantly impact our forecasted
earnings.




We
have a significant amount of authorized but unissued preferred stock, which may
affect the likelihood of a change of control in our company.




Our Board
of Directors has the authority, without further action by the stockholders, to
issue up to 2,000,000 shares of preferred stock on such terms and with such
rights, preferences and designations, including, without limitation restricting
dividends on our common stock, dilution of the voting power of our common stock
and impairing the liquidation rights of the holders of our common stock, as the
Board may determine without any vote of the stockholders.  Issuance of
such preferred stock, depending upon the rights, preferences and designations
thereof may have the effect of delaying, deterring or preventing a change in
control. In addition, certain “anti-takeover” provisions of the Delaware General
Corporation Law, among other things, may restrict the ability of our
stockholders to authorize a merger, business combination or change of control.
Further, we have entered into change of control agreements with certain
executives, which may also have the effect of delaying, deterring or preventing
a change in control.




We
have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders’ percentage ownership of our common stock,
and a smaller number of restricted shares of stock, the vesting of which will
also dilute the then-existing stockholders’ percentage ownership of our common
stock.




As of
December 31, 2007, we had an aggregate of 9,667,374 outstanding options to
purchase our common stock and 497,650 outstanding restricted shares. If all of
these outstanding options were exercised, and all of the outstanding restricted
stock vested, the proceeds to the Company would average $6.45 per share. As of
December 31, 2007 we had 1,856,526 shares of our common stock reserved for
issuance under our stock plans with respect to options (or restricted stock)
that have not been granted. In addition, if, on July 1st of any calendar year in
which our 2006 Incentive Stock Plan (the “2006 Plan”) is in effect, the number
of shares of stock to which options may be granted is less than five percent
(5%) of the number of outstanding shares of stock, then the number of shares of
stock available for issuance under the 2006 Plan shall be increased so that the
number equals five percent (5%) of the shares of stock outstanding (as is
currently the situation). In no event shall the number of shares of stock
subject to the 2006 Plan in the aggregate exceed twenty million shares, subject
to adjustment as provided in the 2006 Plan. See Note (8) Share-Based Payment Arrangements,to our consolidated financial statements.




The
exercise of all of the outstanding options and/or the vesting of all outstanding
restricted shares and/or the grant and exercise of additional options and/or the
grant and vesting of restricted stock would dilute the then-existing
stockholders’ percentage ownership of common stock, and any sales in the public
market of the common stock issuable upon such exercise could adversely affect
prevailing market prices for the common stock. Moreover, the terms upon which we
would be able to obtain additional equity capital could be adversely affected
because the holders of such 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 than those provided by such
securities.




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Our
business could be materially affected as a result of a natural disaster,
terrorist acts, or other catastrophic events




While
our headquarters facilities contain redundant power supplies and generators, our
domestic and foreign operations, and the operations of our industry partners,
remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.




Terrorist
actions domestically or abroad could lead to business disruptions or to
cancellations of customer orders or a general decrease in corporate spending on
information technology, or could have direct impact on our marketing,
administrative or financial functions and our financial condition could
suffer.




We
are dependent on a variety of IT and telecommunications systems, and any failure
of these systems could adversely impact our business and operating
results.




We depend
on IT and telecommunications systems for our operations. These systems support a
variety of functions including order processing, shipping, shipment tracking,
billing, support center and internal information exchange.




Failures
or significant downtime of our IT or telecommunications systems could prevent us
from taking customer orders, shipping products, billing customers, handling
support calls, or communication among our offices. The Internet and individual
websites have experienced a number of disruptions and slowdowns, some of which
were caused by organized attacks. In addition, some websites have experienced
security breakdowns. If we were to experience a security breakdown, disruption
or breach that compromised sensitive information, it could harm our relationship
with our customers. Our support centers are dependent upon telephone and
data services provided by third party telecommunications service vendors and our
IT and telecommunications system. Any significant increase in our IT and
telecommunications costs or temporary or permanent loss of our IT or
telecommunications systems could harm our relationships with our
customers. The occurrence of any of these events could have an adverse
effect on our operations and financial results.





United
States Government export restrictions could impede our ability to sell our
software to certain end users.




Certain
of our products include the ability for the end user to encrypt data. The United
States, through the Bureau of Industry Security, places restrictions on the
export of certain encryption technology. These restrictions may
include:  the requirement to have a license to export the technology;
the requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. Certain of our products
are subject to various levels of export restrictions. These export restrictions
could negatively impact our business.




The
international nature of our business could have an adverse affect on our
operating results.




We sell
our products worldwide. Accordingly, our operating results could be materially
adversely affected by various factors including regulatory, political, or
economic conditions in a specific country or region, trade protection measures
and other regulatory requirements, and acts of terrorism and international
conflicts.




Our
international sales are denominated primarily in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and, therefore, potentially less competitive in foreign
markets.




Additional
risks inherent in our international business activities generally include, among
others, longer accounts receivable payment cycles, difficulties in managing
international operations, decreased flexibility in matching workforce to needs
as compared with the U.S., and potentially adverse tax consequences. Such
factors could materially adversely affect our future international sales and,
consequently, our operating results.




19
 Table of Contents




Because
we conduct operations in China, risks associated with economic, political and
social events in China could negatively affect our business and operating
results.




China is
becoming a significant market for our products and we are increasing our
operations in China. In addition to two joint ventures with the Chinese Academy
of Science, we have OEM agreements with several Chinese companies.  We
also have research and development and sales offices in China employing a total
of 52 people as of December 31, 2007. We expect to increase our operations in
China in the future. Our operations in China are subject to a number of risks
relating to China’s economic and
political systems, including:




•
            
            A
      government controlled foreign exchange rate and limitations on the
      convertibility of the Chinese
Renminbi;




•
            
            extensive
      government regulation;




•
            
            changing
      governmental policies relating to tax benefits available to foreign-owned
      businesses;




•
            
            the
      telecommunications infrastructure;




•
            
            A
      relatively uncertain legal system;
and




•
            
            Uncertainties
      related to continued economic and social
reform.




Any
significant interruption in our China operations, whether resulting from any of
the above uncertainties, natural disasters or otherwise, could result in delays
or disruptions in our revenue and our research development operations, either of
which could cause our business and operating results to suffer.




If
we are unable to protect our intellectual property, our business will
suffer.




Our
success is dependent upon our proprietary technology. Currently, the IPStor
software suite is the core of our proprietary technology. We have eight patents
issued, and we have multiple pending patent applications, numerous trademarks
registered and multiple pending trademark applications related to our products.
We cannot predict whether we will receive patents for our pending or future
patent applications, and any patents that we own or that are issued to us may be
invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.




We also
rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.




Our
efforts to protect our intellectual property may cause us to become involved in
costly and lengthy litigation, which could seriously harm our
business.




In recent
years, there has been significant litigation in the United States involving
patents, trademarks and other intellectual property rights.





We were
already subject to one action, which alleged that our technology infringed on
patents held by a third party. While we settled this litigation, the fees and
expenses of the litigation as well as the litigation settlement were expensive
and the litigation diverted management’s time and attention. Any additional
litigation, regardless of its outcome, would likely be time consuming and
expensive to resolve and would divert management's time and attention and might
subject us to significant liability for damages or invalidate our intellectual
property rights. Any potential intellectual property litigation against us could
force us to take specific actions, including:





·
            cease
      selling our products that use the challenged intellectual
      property;




20
 Table of Contents




·
            obtain
      from the owner of the infringed intellectual property right a license to
      sell or use the relevant technology or trademark, which license may not be
      available on reasonable terms, or at all;
or





·
            redesign
      those products that use infringing intellectual property or cease to use
      an infringing product or trademark.





Developments
limiting the availability of Open Source software could impact our ability to
deliver products and could subject us to costly litigation.




Many of our products are designed to
include software or other intellectual property licensed from third parties,
including “Open Source” software. At least one intellectual property rights
holder has alleged that it holds the rights to software traditionally viewed as
Open Source. In addition, United States courts have not interpreted the terms of
many open source licenses, and there is a risk that such licenses could be
construed in a manner that could impose unanticipated conditions or restrictions
on our ability to commercialize our appliances. We could be required to seek
licenses from third parties in order to continue offering our software, to
re-engineer our software, to discontinue the sale of our software in the event
re-engineering cannot be accomplished on a timely basis or to litigate any
disputes relating to our use of open source software, any of which could harm
our business. There can be no assurance that the necessary licenses would be
available on acceptable terms, if at all. The inability to obtain certain
licenses or other rights or to obtain such licenses or rights on favorable
terms, or the need to engage in litigation regarding these matters, could have a
material adverse effect on our business, operating results, and financial
condition. Moreover, the inclusion in our products of software or other
intellectual property licensed from third parties on a nonexclusive basis could
limit our ability to protect our proprietary rights in our
products.




The
loss of any of our key personnel could harm our business.




Our
success depends upon the continued contributions of our key employees, many of
whom would be extremely difficult to replace. We do not have key person life
insurance on any of our personnel. Worldwide competition for skilled employees
in the network storage software industry is extremely intense. If we are unable
to retain existing employees or to hire and integrate new employees, our
business, financial condition and operating results could suffer. In addition,
companies whose employees accept positions with competitors often claim that the
competitors have engaged in unfair hiring practices. We may be the subject of
such claims in the future as we seek to hire qualified personnel and could incur
substantial costs defending ourselves against those claims.




We
may not successfully integrate the products, technologies or businesses from, or
realize the intended benefits of acquisitions.





We have
made, and may continue to make, acquisitions of other companies or their assets.
Integration of the acquired products, technologies and businesses, could divert
management’s time and resources. Further, we may not be able to properly
integrate the acquired products, technologies or businesses, with our existing
products and operations, train, retain and motivate personnel from the acquired
businesses, or combine potentially different corporate cultures. If we are
unable to fully integrate the acquired products, technologies or businesses, or
train, retain and motivate personnel from the acquired businesses, we may not
receive the intended benefits of the acquisitions, which could harm our
business, operating results and financial condition.





If
actual results or events differ materially from our estimates and assumptions,
our reported financial condition and results of operations for future periods
could be materially affected.





The
preparation of consolidated financial statements and related disclosure in
accordance with generally accepted account principles requires management to
establish policies that contain estimates and assumptions that affect the
amounts reported in the consolidated financial statements and the accompanying
notes. Note 1 to the Consolidated Financial Statements in this Report on Form
10-K describes the significant accounting policies and estimates essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related
disclosures.  We base our estimates on historical experience and
assumptions that we believe to be reasonable under the circumstances. Actual
future results may differ materially from these estimates. We evaluate, on an
ongoing basis, our estimates and assumptions.






21
 Table of Contents




Long
Term Character of Investments





Our
present and future equity investments may never appreciate in value, and are
subject to normal risks associated with equity investments in businesses. These
investments may involve technology risks as well as commercialization risks and
market risks. As a result, we may be required to write down some or all of these
investments in the future.





Unknown
Factors





Additional
risks and uncertainties of which we are unaware or which currently we deem
immaterial also may become important factors that affect us.





Item1B. Unresolved Staff Comments




None




Item2.
            Properties




The
Company’s headquarters are located in an approximately 45,000 square foot
facility located in Melville, New York.  Offices are also leased for
development, sales and marketing personnel, which total an aggregate of
approximately 51,000 square feet in Le Chesnay, France; Taipei and Taichung,
Taiwan; Tokyo, Japan; Beijing, Shenzhen and Shanghai, China; Munich, Germany;
Seoul, Korea; Kuala Lumpur, Malaysia; North Sydney, Australia; London, UK;
Newport Beach, California; and Acton, Massachusetts. Initial lease terms range
from one to eight years, with multiple renewal options.




Item3.
            Legal
      Proceedings




We are
subject to various legal proceedings and claims, asserted or unasserted, which
arise in the ordinary course of business. While the outcome of any such matters
cannot be predicted with certainty, we believe that such matters will not have a
material adverse effect on our financial condition, results of operations, cash
flows or liquidity.





Item4.
            Submission
      of Matters to a Vote of Security
Holders




None




22
 Table of Contents





PART
II


Item5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity
Securities


Market
Information




Our
      Common Stock is listed on The Nasdaq Global Market (“Nasdaq”) under the
      symbol “FALC”. The following table sets forth the range of high and low
      closing sales prices of our Common Stock for the periods indicated as
      reported by Nasdaq:




2007
              
              2006High
              
              Low
              
              High
              
              LowFourth
      Quarter
              
              $
              15.30
              
              
              $
              9.94
              
              
              $
              8.83
              
              
              $
              7.25Third
      Quarter
              
              $
              12.50
              
              
              $
              9.87
              
              
              $
              7.95
              
              
              $
              6.06Second
      Quarter
              
              $
              12.10
              
              
              $
              10.33
              
              
              $
              9.25
              
              
              $
              6.15First
      Quarter
              
              $
              11.23
              
              
              $
              8.13
              
              
              $
              9.78
              
              
              $
              7.54







Holders
of Common Stock




We had
approximately 150 holders of record of Common Stock as of February 22, 2008.
This does not reflect persons or entities that hold Common Stock in nominee or
“street” name through various brokerage firms.




Dividends




We have
not paid any cash dividends on our common stock since inception. We expect to
reinvest any future earnings to finance growth, and therefore do not intend to
pay cash dividends in the foreseeable future. Our board of directors may
determine to pay future cash dividends if it determines that dividends are an
appropriate use of Company capital.




Equity
Compensation Plan Information




The Company currently does not have any
equity compensation plans not approved by security holders.




Plan
      Category
              
              Number
      of Securities to be Issued upon Exercise of Outstanding Options, Warrants
      and Rights (1)
                  (a)
              
              Weighted-Average
      Price of Outstanding Options, Warrants and Rights (1)
                  (b)
              
              Number
      of Securities Remaining Available for Future Issuance Under Equity
      Compensation Plans (Excluding Securities Reflected in Column
      (a)(1)
                  (c)Equity
      compensation plans approved by security holders
              
              
              10,165,024
              
              $
              6.45
              
              
              1,856,526




(1) As of
December 31, 2007 we had 1,856,526 shares of our common stock reserved for
issuance under our stock plans with respect to options (or restricted stock)
that have not been granted. In addition, if, on July 1st of any calendar year in
which our 2006 Incentive Stock Plan (the “2006 Plan”) is in effect, the number
of shares of stock to which




23
 Table of Contents




options
may be granted is less than five percent (5%) of the number of outstanding
shares of stock, then the number of shares of stock available for issuance under
the 2006 Plan shall be increased so that the number equals five percent (5%) of
the shares of stock outstanding. See Note 8 to the consolidated financial
statements for further details.




Common Stock Performance: The
following graph compares, for each of the periods indicated, the percentage
change in the Company’s cumulative total stockholder return on the Company’s
Common Stock with the cumulative total return of a) an index consisting of
Computer Software and Services companies, a peer group index, and b) the Russell
3000 Index, a broad equity market index.











ASSUMES
$100 INVESTED ON DEC. 31, 2002


ASSUMES
DIVIDEND REINVESTED


FISCAL
YEAR ENDING DECEMBER 31, 2007




Fiscal Year Ending2002
              
              
              2003
              
              
              2004
              
              
              2005
              
              
              2006
              
              
              2007FALCONSTOR
      SOFTWARE, INC.
              
              $
              100.00
              
              
              $
              225.26
              
              
              $
              246.65
              
              
              $
              190.46
              
              
              $
              222.94
              
              
              $
              206.19COREDATA
      GROUP INDEX
              
              $
              100.00
              
              
              $
              129.31
              
              
              $
              142.02
              
              
              $
              142.37
              
              
              $
              165.30
              
              
              $
              185.88RUSSELL
      3000 INDEX
              
              $
              100.00
              
              
              $
              128.74
              
              
              $
              141.71
              
              
              $
              147.77
              
              
              $
              168.16
              
              
              $
              179.59


There can
be no assurance that the Common Stock’s performance will continue with the same
or similar trends depicted in the graph above.




24
 Table of Contents





Item6.   Selected Financial
Data




The
selected financial data appearing below have been derived from our audited
consolidated financial statements, and should be read in conjunction with these
consolidated financial statements and the notes thereto and the information
contained in Item 7, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations.”




CONSOLIDATED
STATEMENTS OF OPERATIONS DATA:




Year
      Ended December 31,
                        2007
      (a), (b)
                    
                    
                    Year
      Ended December 31,
                        2006
      (a)
                    
                    
                    Year
      Ended December 31,
                        2005
                    
                    
                    Year
      Ended December 31,
                        2004
                    
                    
                    Year
      Ended December 31,
                        2003(In
      thousands, except per share data)Revenues:Software
      license revenue
                    
                    $
                    53,154
                    
                    
                    $
                    38,317
                    
                    
                    $
                    29,544
                    
                    
                    $
                    21,488
                    
                    
                    $
                    12,251Maintenance
      revenue
                    
                    
                    18,607
                    
                    
                    
                    12,475
                    
                    
                    
                    7,594
                    
                    
                    
                    4,443
                    
                    
                    
                    2,473Software
      services and other revenue
                    
                    
                    5,639
                    
                    
                    
                    4,274
                    
                    
                    
                    3,826
                    
                    
                    
                    2,778
                    
                    
                    
                    2,22077,399
                    
                    
                    
                    55,066
                    
                    
                    
                    40,964
                    
                    
                    
                    28,709
                    
                    
                    
                    16,944Operating
      expenses:Amortization of purchased and capitalized software
                    
                    
                    122
                    
                    
                    
                    362
                    
                    
                    
                    782
                    
                    
                    
                    1,394
                    
                    
                    
                    1,394Cost of maintenance, software services and other revenue
                    
                    
                    11,091
                    
                    
                    
                    9,048
                    
                    
                    
                    6,114
                    
                    
                    
                    4,150
                    
                    
                    
                    2,580Software
      development costs
                    
                    
                    22,405
                    
                    
                    
                    20,022
                    
                    
                    
                    12,039
                    
                    
                    
                    9,050
                    
                    
                    
                    7,068Selling
      and marketing
                    
                    
                    29,656
                    
                    
                    
                    23,713
                    
                    
                    
                    16,109
                    
                    
                    
                    14,277
                    
                    
                    
                    10,967General
      and administrative
                    
                    
                    8,024
                    
                    
                    
                    5,828
                    
                    
                    
                    4,213
                    
                    
                    
                    5,109
                    
                    
                    
                    2,878Litigation
      settlement
                    
                    
                    --
                    
                    
                    
                    799
                    
                    
                    
                    --
                    
                    
                    
                    1,300
                    
                    
                    
                    --Lease
      abandonment charge
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    55071,298
                    
                    
                    
                    59,772
                    
                    
                    
                    39,257
                    
                    
                    
                    35,280
                    
                    
                    
                    25,437Operating
      income (loss)
                    
                    
                    6,101
                    
                    
                    
                    (4,706
                    )
                    
                    
                    1,707
                    
                    
                    
                    (6,571
                    )
                    
                    
                    (8,493
                    )Interest
      and other income
                    
                    
                    2,329
                    
                    
                    
                    1,650
                    
                    
                    
                    705
                    
                    
                    
                    714
                    
                    
                    
                    1,122Impairment
      of long-lived assets
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    35Income
      (loss) before income taxes
                    
                    
                    8,430
                    
                    
                    
                    (3,056
                    )
                    
                    
                    2,412
                    
                    
                    
                    (5,857
                    )
                    
                    
                    (7,336
                    )Provision
      (benefit) for income taxes
                    
                    
                    (4,312
                    )
                    
                    
                    319
                    
                    
                    
                    119
                    
                    
                    
                    32
                    
                    
                    
                    33Net
      income (loss)
                    
                    $
                    12,742
                    
                    
                    $
                    (3,375
                    )
                    
                    $
                    2,293
                    
                    
                    $
                    (5,889
                    )
                    
                    $
                    (7,369
                    )Basic
      net income (loss) per share
                    
                    $
                    0.26
                    
                    
                    $
                    (0.07
                    )
                    
                    $
                    0.05
                    
                    
                    $
                    (0.13
                    )
                    
                    $
                    (0.16
                    )Diluted
      net income (loss) per share
                    
                    $
                    0.24
                    
                    
                    $
                    (0.07
                    )
                    
                    $
                    0.05
                    
                    
                    $
                    (0.13
                    )
                    
                    $
                    (0.16
                    )Basic
      weighted average common shares outstanding
                    
                    
                    49,421
                    
                    
                    
                    48,045
                    
                    
                    
                    47,662
                    
                    
                    
                    46,967
                    
                    
                    
                    45,968Diluted
      weighted average common shares outstanding
                    
                    
                    53,131
                    
                    
                    
                    48,045
                    
                    
                    
                    50,776
                    
                    
                    
                    46,967
                    
                    
                    
                    45,968




(a)
            We
      adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R),
      Share-Based Payments,on January 1, 2006, and recorded $7.9 million and $9.4 million of
      compensation expenses in our consolidated statements of operations for the
      years ended December 31, 2007 and 2006, respectively. See Note 8 to our
      consolidated financial statements for further
  details.




(b)
            During
      2007, we recorded a non-recurring tax benefit of $8.9 million (included
      within our net deferred tax benefit of $4.3 million) primarily due to our
      recognition of a significant portion of our deferred tax assets through a
      reduction in our deferred tax asset valuation allowance. See Note 5 to our
      consolidated financial statements for further
  details.






25
 Table of Contents




CONSOLIDATED
BALANCE SHEET DATA:




December
      31, 2007
              
              
              December
      31, 2006
              
              
              December
      31, 2005
              
              
              December
      31, 2004
              
              
              December
      31, 2003(In
      thousands)Cash
      and cash equivalents and marketable securities
              
              $
              62,904
              
              
              $
              40,960
              
              
              $
              36,631
              
              
              $
              33,973
              
              
              $
              36,685Working
      capital
              
              
              71,845
              
              
              
              46,934
              
              
              
              39,730
              
              
              
              36,452
              
              
              
              39,527Total
      assets
              
              
              115,182
              
              
              
              78,231
              
              
              
              63,974
              
              
              
              56,074
              
              
              
              56,493Long-term
      obligations
              
              
              5,070
              
              
              
              3,783
              
              
              
              2,316
              
              
              
              1,290
              
              
              
              396Stockholders’
      equity
              
              
              87,478
              
              
              
              55,043
              
              
              
              48,658
              
              
              
              46,364
              
              
              
              50,556






26
 Table of Contents




ITEM7.   Management’s Discussion and Analysis of
Financial Condition and Results of Operations





The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations contains “forward-looking statements” within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934.  These forward-looking statements can be
identified by the use of predictive, future-tense or forward-looking
terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “plans,”
“may,” “intends,” “will,” or similar terms.  Investors are cautioned
that any forward-looking statements are not guarantees of future performance and
involve significant risks and uncertainties, and that actual results may differ
materially from those projected in the forward-looking
statements.  The following discussion should be read together with the
consolidated financial statements and notes to those financial statements
included elsewhere in this report.





OVERVIEW




We had
another year of growth and increased scalability in 2007. Each of the measures
we use to determine the success or failure of our business showed improvement on
a year over year basis.




Our
revenues for the full year increased to $77.4 million from $55.1 million in
2006. Our revenues exceeded our projections. The $22.3 million increase is a
forty one percent year over year increase in revenues.  From 2005 to
2006, our revenues had grown thirty four percent.  Revenues from all
of our products increased in 2007. While the majority of our revenues continue
to come from our base VTL and IPStor enterprise software offerings, the
percentage of revenues from our other products increased in 2007.  We
consider this an additional indicator of future growth. We are pleased with the
development of our company and we anticipate further revenue growth in
2008.




Net
income for the year was $12.7 million, compared with a loss of $3.4 million in
2006. Approximately one third of our net income number –  $4.3 million –
was attributable to a net income tax benefit, (which included a non-recurring
$8.9 million tax benefit) which we recorded for the year (this income tax
benefit is discussed below.) Our income before income taxes grew approximately
$11.5 million from the previous year. We had stock-based compensation expense
–  which relates to stock options and restricted stock we grant to
employees, officers and directors as part of our incentive compensation plan,
and to some consultants as payment for services – of $7.9 million in 2007 and
$9.4 million in 2006, which is reflected in the net income number for each
year.




We
look to operating income as another measure of our progress. This number enables
us to measure and to compare our results of operations from one year to the
next. Operating income for 2007 was $6.1 million, compared with a loss of $4.7
million in 2006. These numbers again include stock-based compensation
expense.




Another
important measure of our business is gross margin. Among other things, gross
margin measures our ability to scale our business.  Unlike
manufacturers of hardware, our incremental cost for each additional unit of
software licensed is a small percentage of the software license revenue. Thus,
our gross margins tend to increase as our software license revenue increases. We
incur research and development expenses before the product is offered for
licensing. These expenses consist primarily of personnel costs for engineering
and testing, but also include other items such as the depreciation and
amortization of hardware and software used in development. We also have expenses
for software support, sales and marketing, and general and administrative
functions. Our gross margin for 2007 was 86% compared with 83% for 2006. The
impact of the equity-based compensation expense on gross margin in 2007 and 2006
was equivalent to 1% and 2%, respectively. We believe that our gross margin in
2007 and the increase in our gross margin from 2006 demonstrate that we were
successful in our ability to scale our business.




Operating
margin is a measure of operating efficiency. Our operating margin also
increased.  In 2007, our operating margin was 8%, compared with (9%)
in 2006. The impact of the equity-based compensation expense on operating margin
in 2007 and 2006 was equivalent to 10% and 17%, respectively.




In sum,
each of the key measures of our business – revenues, net income, operating
income, gross margin, and operating margin – increased from 2006 to
2007.




As it has
been in the past, our focus for 2008 will continue to be on managing our
business with a view towards long-term success and growth.  In 2007,
we continued to invest in research and development and other areas to build on
our momentum, to design new products, and to enhance our existing products to
position the Company for future growth. We will continue to invest in these
areas in 2008 and we anticipate that our cost of maintenance, software services
and other revenue, research and development, sales and marketing and general and
administrative expenses will all increase in 2008.




27
 Table of Contents




To
continue to create industry-leading, cutting-edge network storage solutions, we
hired additional software development engineers and quality assurance engineers.
These software engineers design and test the software products that are or will
be sold by our OEM partners and resellers. Continuing to deliver new and
enhanced products to meet the demands of the storage market is necessary if we
are to remain competitive and to continue our growth.




We also
increased our sales force and our technical support team. An increased sales
force should expand the market exposure for our products. The expanded technical
support team responds to questions and technical issues from end users of our
products and from our resellers and OEM partners. Providing top notch technical
support to these groups enhances our ability to continue to make
sales.  End users who are satisfied with our technical support are
more likely to order additional products from us. Resellers and OEM partners who
are happy with our technical support, and whose end users are satisfied, will be
more likely to recommend our current products and less likely to consider other
providers for future products.




The key
factors we look to for our future business prospects continue to
be:




·
            our
      sales pipeline;




·
            our
      ability to establish and to expand relationships with key industry OEMs,
      and sales by those OEMs;




·
            our
      ability to establish and to expand relationships with resellers, and sales
      and re-orders by those resellers;




·
            growth
      in deferred revenue;




·
            re-orders
      from existing customers;




·
            sales
      of our new products, and




·
            the
      growth of the overall market for storage
  solutions.




Our sales
“pipeline” consists of inquiries from end users and resellers for possible
purchases of our products.  Our overall sales pipeline steadily
increased for each quarter of 2007 compared with the corresponding quarter in
2006.




OEM
relationships continue to be important to us for two main reasons:




First,
sales by our OEM partners contribute to our revenues. Overall, revenue from OEMs
accounted for approximately forty eight percent of our revenues in 2007.
Revenues from EMC rose thirty four percent from 2006 to 2007, but the percentage
of our revenues for which EMC was responsible declined to twenty six percent in
2007 from twenty seven percent in 2006. Sun accounted for twelve percent of our
revenues in 2007 and our revenues from Sun in 2007 increased by seventy six
percent over the previous year. We regard the simultaneous year over year
increase in revenues from EMC and year over year decline in the percentage of
our revenues attributable to EMC to be an indicator of the health of our
business. It shows that even as our most significant customer continues to grow
the market for solutions powered by our technology, we are diversifying our
product mix and our sales channels.




We
anticipate that OEMs will again account for over forty percent of our revenues
in 2008. We expect that at least two OEMs will account for at least ten percent
of our revenues in 2007. Accordingly, the loss of these customers would have a
material adverse effect on our business.




Second,
having our products selected by respected, established industry leaders signals
to customers, resellers and other potential OEM partners that our products are
quality products that add value to their enterprise. Before licensing software,
OEM partners typically undertake broad reviews of many of the competing software
solutions available. The choice of our products by major industry participants
validates both the design and the capabilities of the products and our product
roadmaps.




28
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In 2007,
both Sun and EMC launched new ranges of products that incorporate our VTL
technology.   Several of our OEM customers also indicated to us
their intent to offer our Singe Instance Repository (SIR) de-duplication
technology. In 2007, we entered into OEM agreements with other companies,
including companies in Asia and companies focused on the SMB market. We also
renewed or extended agreements with existing OEM partners.  We will
continue to seek additional OEM opportunities in the future.




We do
everything we can to assure that our products meet the needs of our OEM partners
and their customers. However, we cannot control decisions by our OEM partners to
change their product or marketing mix in ways that impact sales of products
licensed by the OEMs from us. Over our history, we have entered into OEM
agreements with two Tier-1 OEM companies, and with another significant company
in the computer, networking and communications products business, only to see
those OEM partners change their strategies and make significant reductions in
their commitments to the products that incorporate our technology.




Resellers
are expected to remain a significant channel for sales of our products. Many
enterprises look to value added resellers or solution providers to assist them
in making their information technology purchases. These resellers typically
review an enterprise’s needs and suggest a hardware, software, or combined
hardware and software solution to fulfill the enterprise’s
requirements.




As
service providers to companies, resellers’ reputations are dependent on
satisfying their customers’ needs efficiently and effectively. Resellers have
wide choices in fulfilling their customers’ needs. If resellers determine that a
product they have been providing to their customers is not functioning as
promised, or is not providing adequate return on investment, or if the customers
are not satisfied with the level of support they are receiving from the
suppliers, the resellers will move quickly to offer different solutions to their
customers. Additional sales by resellers are therefore an important indicator of
our business prospects. Sales from our resellers in the United States rebounded
in 2007 after falling below our expectations in 2006. Increasing sales from
resellers remains an area of focus for us. Steps we have taken to increase sales
from resellers include the addition of sales, marketing and support personnel
focused on those accounts. We also have instituted, and we will be instituting
further, support, training and incentive programs intended to increase sales by
our resellers.




In 2007,
we signed agreements with new resellers worldwide. We also terminated
relationships with resellers who we believed were not properly selling our
products. We will continue to enter into relationships with resellers and to
discontinue relationships with resellers with whom we are not
satisfied.




Our
deferred revenues consist primarily of amounts attributable to future support
and maintenance of our products. The level of deferred revenue is an important
indicator of our success. Maintenance and support for our products is sold for
fixed periods of time. Maintenance and support agreements are typically for one
year, although some agreements are for terms in excess of one
year.  If we do not deliver the support needed by end users of our
products or by our OEM partners and resellers, then they will not renew their
maintenance and support agreements. If end users stop using our products, they
also will not renew their maintenance and support agreements. An increase in
deferred revenues thus indicates growth in our installed base and end user and
OEM satisfaction with our products and our maintenance and support services. Our
deferred revenue increased to $19.0 million as of December 31, 2007, compared
with $15.1 million as of December 31, 2006.  We expect deferred
revenue to continue to grow in 2008.




The level
of re-orders from existing end users of our products is another measure of
customer satisfaction. Information technology professionals will only order
additional products and services for their companies if they determine that the
products have reduced total cost of ownership and have provided a good return on
investment. Re-orders are thus an indication that our products are delivering as
promised and that our support is meeting the end user’s needs. In 2007, many end
users ordered additional copies of our products, or additional products or
ordered additional options. If re-orders decline, it would indicate that future
sales might also decline. As the percentage of our revenues from OEMs increases,
our ability to gauge re-orders decreases because our OEM partners typically do
not provide us with information identifying the end user for each
order.




Consolidation
in the network storage market continued in 2007. The consolidation did not have
a significant impact on our revenue.




29
 Table of Contents




The
storage solutions market continued to grow in 2007. In addition to growth based
on demand for storage server consolidation and replication, there was growth in
backup acceleration.  Given the general downturn in economic activity
at the end of 2007 and the beginning of 2008, we cannot predict whether the
market for network storage solutions will continue to grow in 2008.




We successfully introduced a number of
products in 2007. In the fall of 2007, FalconStor released the first certified
CDP Virtual Appliance for VMware Virtual Infrastructure, complementing our line
of CDP products. This product allows virtual environments to receive the same
level of data protection as physical environments. The release of this product
was followed by the release of a VTL Virtual Appliance, demonstrating our
commitment to providing data protection to all environments whether enterprise
or SMB, physical or virtual, local or remote.




In
addition, FalconStor introduced the SIR de-duplication technology embedded into
a VTL Storage Appliance designed for the SMB and remote office. The VTL Storage
Appliances integrate with VTL Enterprise Edition.




For the
past two years, we have had initiatives in the small/medium business (SMB) and
small office/home office (SOHO) markets. We have experienced some
disappointments in this area, including a change in direction by a significant
OEM partner shortly after a product launch in 2006, and revenues from this
market segment have not been as high as we have anticipated.




We will
continue to target the SMB/SOHO markets in 2008. To this end, in 2007, we signed
several new partners, such as Acer, Inc., V2 Electronics, and Synnex
Corporation, who will either OEM our SMB/SOHO software or who will distribute
our SMB/SOHO software either on a standalone basis or as a part of an appliance.
While we expect revenue growth in 2008 from our SMB/SOHO products, it is too
early to estimate whether revenues from these markets will be significant
contributors to our revenues in 2008.




Another
area of focus in 2007, and one that will remain an area of focus in 2008, was
the China market. In 2007 we expanded our OEM agreement with a Chinese company
that is a leader in telecommunications networks. In early 2007, we signed a
joint development and research agreement with the Computer Network Information
Center, Chinese Academy of Sciences (CNIC, CAS) to establish a laboratory to
develop data protection and remote disaster recovery solutions for the Chinese
government and enterprises with the goal of providing our data protection
services throughout China. We also entered into an OEM agreement with Inspur
Group, the largest server manufacturer and solution provider in China. Inspur
will leverage the FalconStor VirtualTape Library (VTL) technology to deliver
proven, comprehensive, high-performance VTL solutions with efficient data
de-duplication.




Also in
2007 we entered into a joint venture agreement with the Institute of Computing
Technology of the Chinese Academy of Science (CAS) and others to establish a
company that will research, produce, and market enterprise-class Storage,
Archiving and Compliance solutions domestically and internationally. Other
investors in the company, to be known as Tianjin Zhongke Blue Whale Information
Technologies Co., Ltd. (“Blue Whale”), include the Tianjin Hi-Tech Industry Park
Hi-Tech Investment Management Co., Ltd. Blue Whale will be located in the
Tianjin Hi-Tech Industry Park. The joint venture will develop SAN solutions that
leverage the award-winning FalconStor®
IPStor® storage
infrastructure software to augment Blue Whale ́s SAN-based clustered file system
with enterprise class snapshot, replication, and de-duplication
services




As we had
anticipated, we saw the greatest increase in revenues from our VirtualTape
Library software.




We
continue to be pleased with our ability to contain the increase of expenses in
2007. Our operating expenses increased 19% from $59.8 million in 2006 to $71.3
million in 2007. Included in our operating expenses for the years ended December
31, 2007 and 2006 was $7.9 million and $9.4 million, respectively, of
share-based compensation expense. We will continue to invest in infrastructure
and personnel to maintain and enhance our leading edge designs and to support
our customers, but we will continue to do so in a controlled, cost-effective
manner.




As
mentioned above, our net income for 2007 was increased by a non-recurring tax
benefit of $8.9 million (included within our net tax benefit of $4.3 million)
primarily due to our recognition of a significant portion of our deferred tax
assets through a reduction in our deferred tax asset valuation allowance as a
result of our cumulative positive operating results over the past three years
and projections for taxable income in the future.




30
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In
addition, during 2007, we received the benefit of net operating loss
carryforwards, which reduced the amount of income taxes that we would have been
required to pay. The availability of these net operating losses are limited. As
of December 31, 2007, we had approximately $5.1 million of U.S. Federal net
operating losses available for use to offset future taxable income. Although
there can be no assurance, we anticipate that our taxable income will be
significantly in excess of this amount and that we will have a material tax
liability in the future.




We also
expect to continue to be affected by seasonality of the information technology
business on a quarterly basis. Historically, information technology spending has
been higher in the fourth and second quarters of each calendar year, and
somewhat slower in the other quarters, particularly the first
quarter.  Our quarterly results reflected this seasonality in 2007,
and we anticipate that our quarterly results for 2008 will show the effects of
seasonality as well.




Accounting
rules relating to share-based compensation expense continued to have a negative
impact on our earnings in 2007. On an on-going basis we weigh the impact of the
expense on our consolidated financial statements against the impact of
discontinuing the grant of equity-based compensation to our worldwide
workforce.  It continues to be our view that the opportunity to
participate in the growth of our Company is an important motivating factor for
our current employees and a valuable recruiting tool for new employees. We will
thus continue to apply the criteria and the methodology we have used in the past
to determine grants of stock options or other equity-based compensation to our
employees. For the management of our business and the review of our progress, we
will continue to look to our results before share-based compensation expense. We
will use these non-GAAP financial measures in making operating decisions because
they measure the results of our day-to-day operations and because they provide a
more consistent basis for evaluating and comparing our results across different
periods.




Our
critical accounting policies and estimates are those related to revenue
recognition, accounts receivable allowances, accounting for share-based
compensation and deferred income taxes. As described in Note 1 to our
consolidated financial statements, we recognize revenue in accordance with the
provisions of Statement of Position 97-2, Software Revenue Recognition,
as amended. Software license revenue is recognized only when pervasive evidence
of an arrangement exists and the fee is fixed and determinable, among other
criteria. An arrangement is evidenced by a signed customer contract for
nonrefundable royalty advances received from OEMs or a customer purchase order
or a royalty report summarizing software licenses resold by an OEM, distributor
or solution provider to an end user. The software license fees are fixed and
determinable as our standard payment terms generally range from 30 to 90 days,
depending on regional billing practices. When a customer licenses software
together with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value.




We review
accounts receivable to determine which are doubtful of collection. In making the
determination of the appropriate allowance for uncollectible accounts and
returns, we consider historical return rates, specific past due accounts,
analysis of our accounts receivable aging, customer payment terms, historical
collections, write-offs and returns, changes in customer demand and
relationships, concentrations of credit risk and customer credit worthiness.
Historically, we have experienced a somewhat consistent level of write-offs and
returns as a percentage of revenue due to our customer relationships, contract
provisions and credit assessments. Changes in the product return rates, credit
worthiness of customers, general economic conditions and other factors may
impact the level of future write-offs, revenues and our general and
administrative expenses.




With the
adoption of SFAS No. 123(R) on January 1, 2006, the Company is required to
record the fair value of share-based compensation awards as an expense. In order
to determine the fair value of stock options on the date of grant, the Company
applies the Black-Scholes option-pricing model. Inherent in this model are
assumptions related to expected stock-price volatility, option life, risk-free
interest rate and dividend yield. While the risk-free interest rate and dividend
yield are less subjective assumptions, typically based on factual data derived
from public sources, the expected stock-price volatility and expected term
assumptions require a greater level of judgment. We estimate expected
stock-price volatility based primarily on a simple average historical volatility
of the underlying stock over a period equal to the expected term of the option,
but also consider whether other factors are present that indicate that exclusive
reliance on historical volatility may not be a reliable indicator of expected
volatility. We estimate expected forfeiture rates based on our review of recent
forfeiture activity and estimated future employee turnover. We may adjust
share-based compensation expense on a quarterly basis for changes to our
estimate of expected equity award forfeitures based on this review and recognize
the effect of adjusting the forfeiture rate in the period in which we revised
the forfeiture estimate. With regard to our estimate of expected term, as
adequate information with respect to historical share option exercise experience
is not available, we primarily consider the vesting term and original
contractual term of the options granted.




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 Table of Contents




Consistent
with the provisions of SFAS No. 109, Accounting for Income Taxes,
we regularly estimate our ability to recover deferred income taxes, and report
such assets at the amount that is determined to be more-likely-than-not
recoverable. This evaluation considers several factors, including an estimate of
the likelihood of generating sufficient taxable income in future periods over
which temporary differences reverse, the expected reversal of deferred tax
liabilities, past and projected taxable income, and available tax planning
strategies. During 2007, as discussed above and in more detail in Note 5 to our
consolidated financial statements, we recorded a net deferred tax benefit of
$4,312,036 primarily as a result of our recognition of a significant portion of
our deferred tax assets through a reduction in our deferred tax asset valuation
allowances. As of December 31, 2007, we recorded $9.8 million of deferred tax
assets, net of $3.6 million of valuation allowances. Finally, we adopted FASB
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, (“FIN 48”), on January 1, 2007.We are required to
assesswhether tax
benefits claimed or expected to be claimed on a tax return should be recorded in
the financial statements. Under FIN 48, we may recognize the tax benefit from an
uncertain tax position only if it meets the “more likely than not” threshold
that the position will be sustained on examination by the taxing authority,
based on the technical merits of the position. The tax benefits recognized in
the financial statements from such a position should be measured based on the
largest benefit that has a greater than fifty percent likelihood of being
realized upon ultimate settlement. The adoption of FIN 48 did not result in any
adjustment to the recognized benefits from our uncertain tax
positions.




RESULTS
OF OPERATIONS – FOR THE YEAR ENDED DECEMBER 31, 2007 COMPARED WITH THE YEAR
ENDED DECEMBER 31, 2006




Revenues for the year ended December 31,
2007 increased 41% to $77.4 million compared with $55.1 million for the year
ended December 31, 2006. Our operating expenses increased 19% from $59.8 million
in 2006 to $71.3 million in 2007. Included in our operating expenses for the
years ended December 31, 2007 and 2006 were $7.9 million and $9.4 million,
respectively, of share-based compensation expense in accordance with SFAS No.
123(R). Net income for the year ended December 31, 2007 was $12.7 million
compared with a net loss of $3.4 million for the year ended December 31, 2006.
Included in our net income for the year ended December 31, 2007, was an income
tax benefit of $4.3 million, that primarily consisted of a reversal of certain
deferred tax asset valuation allowances as a result of our continuing positive
operating results and financial projections. Included in our net loss for the
year ended December 31, 2006, were (i) a litigation settlement charge of $0.8
million relating to a contingent purchase price dispute associated with an
acquisition we made in 2002, and (ii) an income tax provision of $ 0.3 million.
The growth in revenues was due to significant increases in our software license,
maintenance revenues and software services and other revenues.  The
increase in revenues was primarily driven by increases in (i) demand for our
network storage solution software, (ii) maintenance revenue from new and
existing customers and (iii) sales from our resellers and OEM partners. Revenue
contribution from our OEM partners increased in absolute dollars and as a
percentage of our total revenue for the year ended December 31, 2007, as
compared to the same period in 2006. Revenue from resellers and distributors
also increased in absolute dollars for the year ended December 31, 2007, as
compared with the same period in 2006. Expenses increased in all aspects of our
business to support our continued growth. In support of our continued growth and
expansion both domestically and internationally, we increased our worldwide
headcount to 414 employees as of December 31, 2007 as compared with 340
employees as of December 31, 2006. Finally, we continue to invest in our
infrastructure by increasing our capital expenditures particularly with
purchases of equipment for support of our existing and future product
lines.




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 Table of Contents


Revenues




Year
      Ended December 31,2007
              
              
              2006Revenues:Software
      license revenue
              
              $
              53,153,980
              
              
              $
              38,317,352Maintenance
      revenue
              
              
              18,606,591
              
              
              
              12,475,342Software
      services and other revenue
              
              
              5,638,651
              
              
              
              4,273,334Total
      Revenues
              
              $
              77,399,222
              
              
              $
              55,066,028Year-over-year
      Percentage GrowthSoftware
      license revenue
              
              
              39
              %
              
              
              30
              %Maintenance
      revenue
              
              
              49
              %
              
              
              64
              %Software
      services and other revenue
              
              
              32
              %
              
              
              12
              %Total
      percentage growth
              
              
              41
              %
              
              
              34
              %





Software
license revenue





Software
license revenue is comprised of software licenses sold through our OEMs,
value-added resellers and distributors to end-users and, to a lesser extent,
directly to end users.  These revenues are recognized when, among
other requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer.  We sometimes receive nonrefundable royalty
advances and engineering fees from some of our OEM partners.  These
arrangements are evidenced by a signed customer contract, and the revenue is
recognized when the software product master is delivered and accepted, and the
engineering services, if any, have been performed.




Software
license revenue increased 39% from $38.3 million for the year ended December 31,
2006 to $53.2 million for the year ended December 31, 2007. Software license
revenue represented 69% and 70% of our total revenues for the years ended
December 31, 2007 and 2006, respectively.  As a result of broader
market acceptance of our software applications and increased demand for our
products from our expanding base of customers, we continue to experience
increased sales from both our OEM and reseller partners, which were the primary
drivers of the increase in software license revenue. Software license revenue
increased from both our OEM partners and from our resellers. Revenue from our
OEM partners increased as a percentage of total revenue. We expect our software
license revenue to continue to grow in future periods.




Maintenance,
software services and other revenue





Maintenance,
software services and other revenues are comprised of software maintenance and
technical support, professional services primarily related to the implementation
of our software, engineering services, and sales of computer hardware. Revenue
derived from maintenance and technical support contracts is deferred and
recognized ratably over the contractual maintenance term. Professional services
revenue is recognized in the period that the related services are performed.
Revenue from engineering services is primarily related to customizing software
product masters for some of our OEM partners. Revenue from engineering services
is recognized in the period in which the services are
completed.  During 2007 and 2006, we had transactions in which we
purchased hardware and bundled this hardware with our software and sold this
bundled solution to our customer base. A portion of the contractual fees is
recognized as revenue when the hardware or software is delivered to the customer
based on the relative fair value of the delivered element(s). Maintenance
revenues increased 49% from $12.5 million for the year ended December 31, 2006
to $18.6 million for the year ended December 31, 2007. Software services and
other revenue increased 32% from $4.3 million for the year ended December 31,
2006 to $5.6 million for the year ended December 31, 2007.




The major
factor behind the increase in maintenance, software services and other revenue
was an increase in the number of maintenance and technical support contracts,
professional services contracts and bundled hardware solutions we sold. As we
are in business longer, and as we license more software to new customers and
grow our installed




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 Table of Contents




customer
base, we expect these revenues will continue to increase. Maintenance revenues
increased primarily because  (i) the majority of our new customers
purchase maintenance and support contracts, and (ii) the majority of our growing
existing customer base renewed their maintenance and support contracts after
their initial contracts expired. The increase in software services and other
revenue was partially attributable to our hardware sales, which increased from
$2.6 million in 2006 to $3.4 million in 2007. This increase was the result of an
increase in demand from our customer base for bundled solutions, in which we
purchase hardware and bundle this hardware with our software solutions. Growth
in our professional services sales, which increased from $1.7 million in 2006 to
$2.3 million in 2007, also contributed to the increase in software services and
other revenues. This increase in professional services revenue was related to
the increase in our software license customers who elected to purchase
professional services. We expect maintenance, software services and other
revenues to continue to increase.





Cost
of Revenues




Year
      Ended December 31,2007
                
                
                2006Cost
      of Revenue:Amortization
      of purchased and capitalized software
                
                $
                122,560
                
                
                $
                362,159Cost
      of maintenance, software services and other revenue
                
                
                11,091,375
                
                
                
                9,048,354Total
      Cost of Revenues
                
                $
                11,213,935
                
                
                $
                9,410,513Gross
      Profit:Cost
      of Revenues
                
                $
                11,213,935
                
                
                $
                9,410,513Gross
      Profit
                
                $
                66,185,287
                
                
                $
                45,655,515Gross
      Profit Growth Rate
                
                
                45
                %
                
                
                34
                %Gross
      Margin:Gross
      profit
                
                $
                66,185,287
                
                
                $
                45,655,515Gross
      Margin
                
                
                86
                %
                
                
                83
                %


Amortization
of purchased and capitalized software





To remain
successful in the network storage solutions market, we must continually upgrade
our software by enhancing the existing features of our products and by adding
new features and products. We often evaluate whether to develop these new
offerings in-house or whether we can achieve a greater return on investment by
purchasing or licensing software from third parties. Based on our evaluations we
have purchased or licensed software for resale since 2001. As of December 31,
2007 and 2006, we had $0.2 million and $0.2 million, respectively, of purchased
software licenses, net of accumulated amortization of $5.1 million and $5.0
million, respectively, that is being amortized over three years. For each of the
years ended December 31, 2007 and 2006, the total amortization cost recorded was
less than 1% of total revenues. We will continue to evaluate third party
software licenses and may make additional purchases from time to time, which
would impact the amount we record as amortization expense in future
periods.





Cost
of maintenance, software services and other revenue





Cost of
maintenance, software services and other revenues consists primarily of
personnel and other costs associated with providing software implementations,
technical support under maintenance contracts, training, and share-based
compensation expense associated with SFAS No. 123(R). Cost of maintenance,
software services and other revenues also includes the cost of hardware
purchased that was resold.Cost of maintenance,
software services and other revenues for the year ended December 31, 2007
increased by 23% to $11.1 million compared with $9.0 million for the year ended
December 31, 2006. The increase in cost of maintenance, software services and
other revenue was primarily due to (i) the increased numberof transactions in which
we bundled purchased hardware with our software and sold the bundled solution,
resulting in the increase of associated hardware costs from $1.8 million for the
year ended December 31, 2006 to $2.3 million for the year ended December 31,
2007, and (ii) the increase in personnel and related costs for the year ended
December 31, 2007 as compared with the same period in 2006.  As a
result of our increased sales from maintenance and support contracts, we hired
additional employees to provide technical support. Consequently, our cost of
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenues from these services also increase.




34
 Table of Contents




Gross
profit increased  $20.5 million from $45.7 million for the year ended
December 31, 2006 to $66.2 million for the year ended December 31, 2007. Gross
margins increased from 83% for the year ended December 31, 2006 to 86% for the
year ended December 31, 2007. The increase in our gross profit and corresponding
gross margins was primarily due to our continued revenue growth and to our
continued focus on our cost structure. Generally, our gross margins may
fluctuate based on several factors, including (i) revenue growth levels, (ii)
changes in personnel headcount and related costs, and (iii) our product
offerings and service mix of sales. Share-based compensation expense included in
the cost of maintenance, software services and other revenue decreased in
absolute dollars to $1.0 million from $1.3 million for the years ended December
31, 2007 and 2006, respectively. Share-based compensation expense was equal to
1% and 2% of revenue for the years ended December 31, 2007 and 2006,
respectively.





Software
Development Costs




Software
development costs consist primarily of personnel costs for product development
personnel, share-based compensation expense associated with SFAS No. 123(R), and
other related costs associated with the development of new products,
enhancements to existing products, quality assurance and
testing.  Software development costs increased 12% to $22.4 million
for the year ended December 31, 2007 from $20.0 million in the same period in
2006. The major contributing factors to the increase in software development
costs were higher salary and personnel related costs as a result of increased
headcount to enhance and test our core network storage software product and to
develop new innovative features and options. Share-based compensation expense
included in software development costs decreased in absolute dollars to $3.3
million from $4.3 million for the years ended December 31, 2007 and 2006,
respectively. Share-based compensation expense included in software development
costs was equal to 4% and 8% of revenue for the years ended December 31, 2007
and 2006, respectively. We intend to continue recruiting and hiring product
development personnel to support our software development process.




Selling
and Marketing




Selling
and marketing expenses consist primarily of sales and marketing personnel and
related costs, share-based compensation expense associated with SFAS No. 123(R),
travel, public relations expense, marketing literature and promotions,
commissions, trade show expenses, and the costs associated with our foreign
sales offices. Selling and marketing expenses increased 25% to $29.7 million for
the year ended December 31, 2007 from $23.7 million for the year ended December
31, 2006. The increase in selling and marketing expenses was primarily due to
(i) higher commissions paid as a result of our 41% increase in revenue, (ii)
higher salary and personnel related costs as a result of increased sales and
marketing headcount and (iii) higher advertising and marketing related expenses
as a result of our new product offerings/enhancements and related advertising
and marketing of such product(s). Share-based compensation expense included in
selling and marketing decreased in absolute dollars to $2.6 million from $2.8
million for the years ended December 31, 2007 and 2006, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 3% and 5% of revenue for the years ended December 31, 2007 and 2006,
respectively. In addition, we continued to hire new sales and sales support
personnel and to expand our worldwide presence to accommodate our anticipated
revenue growth. We anticipate that as we continue to grow sales, our sales and
marketing expenses will continue to increase in support of such sales
growth.




General
and Administrative




General
and administrative expenses consist primarily of personnel costs of general and
administrative functions, share-based compensation expense associated with SFAS
No. 123(R), public company related costs, directors and officers insurance,
legal and professional fees, and other general corporate overhead
costs.  General and administrative expenses increased 38% to $8.0
million for the year ended December 31, 2007 from $5.8 million for the year
ended December 31, 2006. The increase in general and administrative expenses was
primarily due to (i) higher professional fees as a result various tax related
activities which commenced for fiscal year 2007, and (ii) increased compensation
and personnel related costs as a result of increased headcount to support our
general and administrative needs. Share-based compensation expense included in
general and administrative expenses increased in absolute dollars to $1.0
million from $0.9 million for the years ended December 31, 2007 and 2006,
respectively. Share-based compensation expense included in general and
administrative expenses was equal to 1% and 2% of revenue for the years ended
December 31, 2007 and 2006, respectively.  Additionally, as our
revenue and number of employees increase, our legal and professional fees and
other general corporate overhead costs have increased and are likely to continue
to increase.




35
 Table of Contents




Litigation
Settlement Charge




In
January 2007, we resolved claims brought against us by two former shareholders
of IP Metrics, Inc. (“IP Metrics”). When we purchased IP Metrics in July 2002,
part of the contractual consideration was payments to be made in 2003 and 2004
to the former IP Metrics shareholders based on sales of IP Metrics products
and/or payments to be made if certain events occurred. We made payments to all
four former shareholders in 2003 and 2004. Two of the former shareholders
alleged that they were entitled to additional payments based on the alleged
occurrence of certain contingent events and they brought an action against us.
This action was resolved in January 2007 without any admission of liability, by
the payment of an additional $0.8 million to the two former shareholders. This
amount was recorded as an operating expense as of December 31, 2006. All claims
in the lawsuit have since been dismissed.





Interest
and Other Income




We invest
our cash, cash equivalents and marketable securities in government securities
and other low risk investments. As of December 31, 2007, our cash, cash
equivalents and marketable securities totaled $62.9 million as compared with
$41.0 million as of December 31, 2006. Interest and other income increased to
$2.3 million for the year ended December 31, 2007 compared with $1.7 million for
the year ended December 31, 2006. The higher average cash balance invested
during 2007 as compared with 2006 resulted in increased interest income. The
interest income in both 2007 and 2006 was offset partially by other
non-operating expenses.




Income
Taxes




For the
year ended December 31, 2007, our provision for income taxes included a net
deferred tax benefit of $4.3 million primarily related to a substantial reversal
of our deferred income tax valuation allowance. Also included in our provision
for income taxes were U.S. and foreign taxes, state income taxes and U.S.
federal alternative minimum taxes. During the year ended December 31, 2006, we
maintained a full valuation allowance against our deferred tax assets due to our
prior history of cumulative pre-tax losses and uncertainty about the timing of
and ability to generate taxable income in the future and our assessment that the
realization of the deferred tax assets did not meet the "more likely than not"
criterion under SFAS No. 109. During the year ended December 31, 2007, based
upon our generation of cumulative taxable income over the past three years and
our expectations for taxable income in future years, we determined that a
significant portion of our deferred tax assets were "more likely than not"
realizable. Accordingly, we recognized a significant portion of our deferred tax
assets through a reduction in our deferred tax asset valuation allowance of
approximately $8.9 million. As of December 31, 2007, our deferred tax asset, net
of a valuation allowance was $9.8 million. We have approximately an additional
$5.1 million of federal net operating loss carryforwards available to offset
future taxable income. These net operating loss carryforwards relate to excess
compensation deductions from exercises of stock options and the resulting
benefits will be credited to additional-paid-in-capital when
realized.




For the
year ended December 31, 2006, our provision for income taxes consisted of U.S.
taxes, foreign taxes, U.S. federal alternative minimum taxes and state minimum
taxes that were expected to be incurred primarily as a result of the limitations
on our ability to utilize net operating losses under the alternative minimum tax
system and the non-deductibility of certain share-based compensation expense for
income tax purposes that had been recognized for financial statement purposes
and foreign taxes.





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RESULTS OF OPERATIONS – FOR THE YEAR
ENDED DECEMBER 31, 2006 COMPARED WITH THE YEAR ENDED DECEMBER 31,
2005




Revenues




Year
      Ended December 31,2006
              
              
              2005Revenues:Software
      license revenue
              
              $
              38,317,352
              
              
              $
              29,544,467Maintenance
      revenue
              
              
              12,475,342
              
              
              
              7,593,804Software
      services and other revenue
              
              
              4,273,334
              
              
              
              3,825,832Total
      Revenues
              
              $
              55,066,028
              
              
              $
              40,964,103Year-over-year
      Percentage GrowthSoftware
      license revenue
              
              
              30
              %
              
              
              37
              %Maintenance
      revenue
              
              
              64
              %
              
              
              71
              %Software
      services and other revenue
              
              
              12
              %
              
              
              38
              %Total
      percentage growth
              
              
              34
              %
              
              
              43
              %




Software
license revenue





Software license revenue increased 30%
to $38.3 million in 2006 from $29.5 million in 2005.  Increased market
acceptance and demand for our product and increased sales from our resellers and
OEM partners were the primary drivers of the increase in software license
revenue. Revenues from our OEM partners increased as a percentage of total
revenue.





Maintenance,
software services and other revenue





Maintenance
revenues increased 64% from $7.6 million for the year ended December 31, 2005 to
$12.5 million for the year ended December 31, 2006. Software services and other
revenue increased 12% from $3.8 million for the year ended December 31, 2005 to
$4.3 million for the year ended December 31, 2006. The major factor behind the
increase in maintenance revenue was an increase in the number of maintenance and
technical support contracts we sold. As a result of being in business longer,
and as we license more software, we continue to experience increases in
maintenance revenues. The majority of our new customers purchase maintenance and
support and most customers renew their maintenance and support after their
initial contracts expire. The increase in software services and other revenue
was partially attributable to our hardware sales, which increased from $2.3
million in 2005 to $2.6 million in 2006. This increase was the result of an
increase in demand from our customers for bundled solutions. Growth in our
professional services sales, which increased from $1.5 million in 2005 to $1.7
million in 2006, also contributed to the increase in software services and other
revenues. This increase in professional services revenue was related to the
increase in our software license customers who elected to purchase professional
services.




37
 Table of Contents




Cost
of Revenues




Year
      Ended December 31,2006
              
              
              2005Cost
      of Revenue:Amortization
      of purchased and capitalized software
              
              $
              362,159
              
              
              $
              781,500Cost
      of maintenance, software services and other revenue
              
              
              9,048,354
              
              
              
              6,114,112Total
      Cost of Revenues
              
              $
              9,410,513
              
              
              $
              6,895,612Gross
      Profit:Cost
      of Revenues
              
              $
              9,410,513
              
              
              $
              6,895,612Gross
      Profit
              
              $
              45,655,515
              
              
              $
              34,068,491Gross
      Profit Growth Rate
              
              
              34
              %
              
              47
              %Gross
      Margin:Gross
      profit
              
              $
              45,655,515
              
              
              $
              34,068,491Gross
      Margin
              
              
              83
              %
              
              
              83
              %




Amortization
of purchased and capitalized software





As of
December 31, 2006 and 2005, we had $0.2 million and $0.4 million, respectively,
of purchased software licenses, net of accumulated amortization of $5.0 million
and $4.6 million, respectively, that is being amortized over three years. For
the years ended December 31, 2006 and 2005, we recorded $0.4 million and $0.8
million, respectively, of amortization related to these purchased software
licenses.





Cost
of maintenance, software services and other revenue





Cost of
maintenance, software services and other revenues for the year ended December
31, 2006 increased by 48% to $9.0 million compared with $6.1 million for the
year ended December 31, 2005. The increase in cost of maintenance, software
services and other revenue was partially due to (i) $1.3 million of share-based
compensation expense associated with the implementation of SFAS No. 123(R), (ii)
the increased numberof transactions in which
we bundled purchased hardware with our software and sold the bundled solution,
resulting in the increase of associated hardware costs from $1.5 million for the
year ended December 31, 2005 to $1.8 million for the year ended December 31,
2006, and (ii) the increase in personnel and related costs for the year ended
December 31, 2006 as compared with the same period in 2005. There was no
share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the year ended December 31,
2005.





Gross
profit increased $11.6 million from $34.1 million for the year ended December
31, 2005 to $45.7 million for the year ended December 31, 2006. Gross margins
remained consistent at 83% for both December 31, 2006 and 2005, despite the
inclusion of share-based payment compensation expense in the cost of
maintenance, software services and other revenue for the year ended December 31,
2006. Share-based compensation expense included in the cost of maintenance,
software services and other revenue for the year ended December 31, 2006 was
$1.3 million, or 2% of total revenue.






38
 Table of Contents





Software
Development Costs




Software
development costs for the year ended December 31, 2006 increased by 66% to $20.0
million compared with $12.0 million for the year ended December 31, 2005. The
major contributing factor to the increase in software development costs was $4.3
million of share-based compensation expense associated with the implementation
of SFAS No. 123(R). There was no share-based compensation expense included in
software development costs for the year ended December 31, 2005. Additionally,
the increase is also due to the increase in personnel and related costs for the
purpose of  (i) to enhance and test our core network storage software
product, (ii) develop new innovative features and options, and (iii) to test and
integrate our software with our OEM partners’ products.




Selling
and Marketing




Selling
and marketing expenses increased 47% to $23.7 million for the year ended
December 31, 2006 from $16.1 million for the year ended December 31, 2005. The
increase in selling and marketing expenses was partially due to $2.8 million of
share-based compensation expense associated with the implementation of SFAS No.
123(R). There was insignificant share-based compensation expense included in
selling and marketing expenses for the year ended December 31,
2005.  In addition, we continued to hire new sales and sales support
personnel and to expand our worldwide presence to accommodate our revenue
growth. As a result of the increase in revenue and interest in our software, our
commission expense and travel expenses also increased. We believe that to
continue to grow sales, our sales and marketing expenses will continue to
increase.




General
and Administrative




General
and administrative expenses increased 38% to $5.8 million for the year ended
December 31, 2006 from $4.2 million for the year ended December 31, 2005. The
increase in general and administrative expenses was primarily due to $0.9
million of share-based compensation expense associated with the implementation
of SFAS No. 123(R). There was no share-based compensation expense included in
general and administrative expense for the year ended December 31,
2005.  Additionally, as our revenue and number of employees increase,
our legal and professional fees and other general corporate overheard costs have
increased to support our general and administrative needs.




Litigation
Settlement Charge




In
January 2007, we resolved claims brought against us by two former shareholders
of IP Metrics, Inc. (“IP Metrics”). When we purchased IP Metrics in July 2002,
part of the contractual consideration was payments to be made in 2003 and 2004
to the former IP Metrics shareholders based on sales of IP Metrics products
and/or payments to be made if certain events occurred. We made payments to all
four former shareholders in 2003 and 2004. Two of the former shareholders
alleged that they were entitled to additional payments based on the alleged
occurrence of certain contingent events and they brought an action against us.
This action was resolved in January 2007 without any admission of liability, by
the payment of an additional $0.8 million to the two former shareholders. This
amount was recorded as an operating expense as of December 31, 2006. All claims
in the lawsuit have since been dismissed.





Interest
and Other Income




We invest
our cash, cash equivalents and marketable securities in government securities
and other low risk investments. Interest and other income increased to $1.7
million for the year ended December 31, 2006 compared with $0.7 million for the
year ended December 31, 2005. This increase is primarily due to a higher average
cash balance and higher interest rates.




Income
Taxes




For the
years ended December 31, 2006 and 2005, our provision for income taxes consisted
of U.S. taxes, foreign taxes, U.S. federal alternative minimum taxes and state
minimum taxes that were expected to be incurred primarily as a result of the
limitations on our ability to utilize net operating losses under the alternative
minimum tax system and the non-deductibility of certain share-based compensation
expense for income tax purposes that had been recognized for financial statement
purposes and foreign taxes. As of December 31, 2006, we maintained a full
valuation allowance against our deferred tax assets due to our prior history of
pre-tax losses and uncertainty about the timing of and ability to generate
taxable income in the future and our assessment that the realization of the
deferred tax assets did not meet the "more likely than not" criterion under SFAS
No. 109. For the year ended December 31, 2005, our pre-tax income was
substantially offset by available net operating losses.






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 Table of Contents




LIQUIDITY
AND CAPITAL RESOURCES




Cash flow
information is as follows:




Year
      Ended December 31,2007
              
              
              2006
              
              
              2005Cash
      provided by (used in):Operating
      activities
              
              $
              16,588,539
              
              
              $
              8,162,783
              
              
              $
              6,485,677Investing
      activities
              
              
              (12,357,286
              )
              
              
              (11,329,412
              )
              
              
              (2,792,194
              )Financing
      activities
              
              
              11,803,544
              
              
              
              399,818
              
              
              
              24,385Effect
      of exchange rate changes
              
              
              79,543
              
              
              
              74,847
              
              
              
              (405,468
              )Net
      increase (decrease) in cash and cash equivalents
              
              $
              16,114,340
              
              
              $
              (2,691,964
              )
              
              $
              3,312,400




Our
principal sources of liquidity are cash flows generated from operations and our
cash, cash equivalents, and marketable securities balances. Our total cash and
cash equivalents and marketable securities balance as of December 31, 2007
increased by $21.9 million to $62.9 million from $41.0 million as of December
31, 2006. Cash and cash equivalents totaled $32.2 million and marketable
securities totaled $30.7 million at December 31, 2007. As of December 31, 2006,
we had $16.1 million in cash and cash equivalents and $24.9 million in
marketable securities.




In 2007,
we continued making investments in our infrastructure to support our current and
long-term growth. We increased the total number of employees in 2007 and we
increased our investments in property and equipment to support our growth. As we
continue to grow, we will continue to make investments in property and equipment
and we will need to continue to increase our headcount. In the past, we have
also used cash to purchase software licenses and to make acquisitions. We will
continue to evaluate potential software license purchases and acquisitions and
if the right opportunity presents itself we may continue to use our cash for
these purposes. However, as of the date of this filing, we have no agreements,
commitments or understandings with respect to any such
acquisitions.




We
currently do not have any debt and our only significant commitments are related
to our office leases.




In
October 2001, our Board of Directors authorized the repurchase of up to two
million shares of our outstanding common stock. During 2007, we repurchased
318,900 shares at an aggregate purchase price of $3.3 million. During 2006 we
repurchased 315,600 shares at an aggregate purchase price of $2.1 million. Since
October 2001, we have repurchased a total of 1,184,100 shares at an aggregate
purchase price of $9.1 million. As of December 31, 2007, we had the ability to
purchase an additional 815,900 shares of our common stock based upon our
judgment and market conditions.




On
February 6, 2008, our Board of Directors increased the authorization to
repurchase our outstanding common stock from two million to five million
shares.




Net cash
provided by operating activities totaled $16.6 million for the year ended
December 31, 2007, compared with net cash provided by operating activities of
$8.2 million for the year ended December 31, 2006 and net cash provided by
operating activities of $6.5 million for the year ended December 31, 2005. The
increase in net cash provided by operating activities during 2007, as compared
with 2006 and 2005, was primarily related to the growth in our net income
adjusted for: (i) the impact of non-cash charges, particularly relating to
stock-based compensation, depreciation and amortization and provision for
doubtful accounts; and (ii) adjustments for net changes in operating assets and
liabilities, particularly changes in our accounts receivable and our deferred
revenues. These amounts were primarily offset by the adjustment for the impact
from the tax benefits recognized as a result of excess stock-based compensation
deductions and exercises of stock options. SFAS No. 123(R) requires tax benefits
relating to excess stock-based compensation deductions to be presented as cash
outflows from operating activities. We recognized tax benefits related to
stock-based compensation deductions of $5.1 million for the year ended December
31, 2007. There were insignificant adjustments for the impact of non-cash income
tax benefits for the years ended December 31, 2006 and 2005. There were
insignificant adjustments for the impact of non-cash share-based compensation
expense for the year ended December 31, 2005.




Net cash
used in investing activities was $12.4 million in 2007 compared with net cash
used in investing activities of $11.3 million in 2006 and net cash used in
investing activities of $2.8 million in 2005. Included in investing activities
for each year are the sales and purchases of our marketable securities. These
represent the sales, maturities and reinvesting of our marketable
securities.  The net cash used in investing activities from the net
purchase of securities was $5.7 million in 2007 and $7.0 million in 2006 and the
net cash provided by investing activities from the net sale of securities was
$0.6 million in 2005. These amounts will fluctuate from year to year depending
on the maturity dates of our marketable securities. The cash used to purchase
property and equipment was $5.5 million, $3.7 million and $3.2 million in 2007,
2006 and 2005, respectively. The cash used to purchase software licenses were
$0.2 million, $0.2 million and $0.1 million in 2007, 2006 and 2005,
respectively. We continually evaluate potential software licenses and we may
continue to make similar investments if we find opportunities that would benefit
our business. We anticipate continued capital expenditures as we continue to
invest in our infrastructure to support our ongoing growth and expansion both
domestically and internationally.




Net cash
provided by financing activities was $11.8 million in 2007, $0.4 million in
2006, and $24,000 in 2005. Cash inflows from financing activities primarily
results from the proceeds received from the exercise of stock options. We
received proceeds from the exercise of stock options of $10.0 million in 2007,
$2.5 million in 2006, and $1.9 million in 2005. During 2007, cash inflows from
financing activities was also impacted by the tax benefits recognized as a
result of excess stock-based compensation deductions and exercises of stock
options. SFAS No. 123(R) requires tax benefits relating to excess stock-based
compensation deductions be presented as cash inflows from financing activities.
We recognized tax benefits related to stock-based compensation deductions of
$5.1 million and $46,000 in 2007 and 2006, respectively. There were no tax
benefits related to stock-based compensation deductions recognized in 2005. Cash
outflows from financing activities result from the repurchase of our outstanding
common stock. As of December 31, 2007, we have repurchased a total of 1,184,100
shares of our common stock under a repurchase program authorized by our Board of
Directors. We repurchased 318,900 shares of our common stock for $3.3 million in
2007, 315,600 shares of our common stock for $2.1 million in 2006, and 272,500
shares of our common stock for $1.9 million in 2005.






40
 Table of Contents




As of
December 31, 2007, we had $8.4 million of auction rate securities included
within our portfolio of marketable securities. Of this amount, subsequent to
December 31, 2007, we have sold $6.9 million, at par value. Accordingly, as of
March 7, 2008, we have $1.5 million of auction rate securities remaining. We
intend to sell these securities in 2008. Although there can be no assurance that
we will be able to sell these securities at par value, we do not believe that
the remaining market risk will be significant to our liquidity or financial
position in the future.




In
connection with our acquisition of IP Metrics in July 2002, we were required to
make cash payments to the former shareholders of IP Metrics, which were
contingent on the level of revenues from IP Metrics products for a period of
twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. In 2006, we recorded a
litigation settlement expense of $0.8 million relating to a contingent purchase
price dispute with two former shareholders of IP Metrics. This settlement was
paid out in the first quarter of 2007.




The
Company’s only significant commitments relate to its operating leases. The
Company has an operating lease covering its primary office facility that expires
in February 2012. The Company also has several operating leases related to
offices in foreign countries. The expiration dates for these leases range from
2008 through 2015. The following is a schedule of future minimum lease payments
for all operating leases as of December 31, 2007:






Year ending December
      312008
              $
      2,265,0492009
              2,093,7372010
              1,654,5982011
              1,394,3652012
              376,883Thereafter
              419,133$
8,203,765






41
 Table of Contents




We
believe that our current balance of cash, cash equivalents and marketable
securities, and expected cash flows from operations will be sufficient to meet
our cash requirements for at least the next twelve months. However, any
projections of future cash needs and cash flows are subject to substantial
uncertainty. See Item 1A of Part I, “Risk Factors.”




Off-Balance
Sheet Arrangements




As of
December 31, 2007 and 2006, we had no off-balance sheet
arrangements.




Critical
Accounting Policies and Estimates




Our critical accounting policies and
estimates are those related to revenue recognition, accounts receivable
allowances, deferred income taxes and accounting for share-based compensation
expense.




Revenue Recognition. We
recognize revenue in accordance with the provisions of Statement of Position
97-2, Software Revenue
Recognition, as amended.  Software license revenue is
recognized only when pervasive evidence of an arrangement exists and the fee is
fixed and determinable, among other criteria.  An arrangement is
evidenced by a signed customer contract for nonrefundable royalty advances
received from OEMs or a customer purchase order or a royalty report summarizing
software licenses sold for each software license resold by an OEM, distributor
or solution provider to an end user. The software license fees are fixed and
determinable as our standard payment terms range from 30 to 90 days, depending
on regional billing practices, and we have not provided any of our customers
extended payment terms.  When a customer licenses software together
with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.




Accounts Receivable. We review
accounts receivable to determine which are doubtful of collection.  In
making the determination of the appropriate allowance for uncollectible accounts
and returns, we (i) consider historical return rates, (ii) specific past due
accounts, (iii) analysis of our accounts receivable aging, (iv) customer payment
terms, (v) historical collections, write-offs and returns, (vi) changes in
customer demand and relationships, and (vii) concentrations of credit risk and
customer credit worthiness.  Historically, we have experienced a
somewhat consistent level of write-offs and returns as a percentage of revenue
due to our customer relationships, contract provisions and credit
assessments.  Changes in the product return rates; credit worthiness
of customers, general economic conditions and other factors may impact the level
of future write-offs, revenues and our general and administrative expenses.





Deferred Income Taxes.Consistent
with the provisions of SFAS No. 109, we regularly estimate our ability to
recover deferred income taxes, and report such deferred tax assets at the amount
that is determined to be more-likely-than-not recoverable, and we have to
estimate our income taxes in each of the taxing jurisdictions in which we
operate. This process involves estimating our current tax expense together with
assessing any temporary differences resulting from the different treatment of
certain items, such as the timing for recognizing revenue and expenses for tax
and accounting purposes, as well as estimating foreign tax credits. These
differences may result in deferred tax assets and liabilities, which are
included in our consolidated balance sheet. We are required to assess the
likelihood that our deferred tax assets, which include net operating loss carry
forwards and temporary differences that are expected to be deductible in future
years, will be recoverable from future taxable income or other tax planning
strategies. If recovery is not likely, we have to provide a valuation allowance
based on our estimates of future taxable income in the various taxing
jurisdictions, and the amount of deferred taxes that are ultimately realizable.
The provision for current and deferred taxes involves evaluations and judgments
of uncertainties in the interpretation of complex tax regulations. This
evaluation considers several factors, including an estimate of the likelihood of
generating sufficient taxable income in future periods, the effect of temporary
differences, the expected reversal of deferred tax liabilities, past and
projected taxable income, and available tax planning strategies. During the year
ended December 31, 2007, based on positive evidence from our earnings trends, we
recognized a significant portion of our deferred tax assets through a reduction
in our deferred tax asset valuation allowance of approximately $8.9 million. As
of December 31, 2007, our deferred tax asset, net of a valuation allowance, was
$9.8 million. As of December 31, 2006, we maintained a full valuation allowance
against our deferred tax assets due to our prior history of pre-tax losses and
uncertainty about the timing of and ability to generate taxable income in the
future and our assessment that the realization of the deferred tax assets did
not meet the "more likely than not" criterion under SFAS No. 109.








42
 Table of Contents





Accounting for Share-Based
Payments. As discussed further in Note (8) Share-Based Payment
Arrangements, to our consolidated financial statements, we adopted SFAS
No. 123(R) on January 1, 2006 using the modified prospective
method.





We have
used and expect to continue to use the Black-Scholes option-pricing model to
compute the estimated fair value of share-based compensation expense. The
Black-Scholes option-pricing model includes assumptions regarding dividend
yields, expected volatility, expected option term and risk-free interest rates.
The assumptions used in computing the fair value of share-based compensation
expense reflect our best estimates, but involve uncertainties relating to market
and other conditions, many of which are outside of our control. We estimate
expected volatility based primarily on historical daily price changes of our
stock and other factors. Additionally, we estimate forfeiture rates based
primarily upon historical experiences, adjusted when appropriate for known
events or expected trends. We may adjust share-based compensation expense on a
quarterly basis for changes to our estimate of expected equity award forfeitures
based on our review of these events and trends, and recognize the effect of
adjusting the forfeiture rate for all expense amortization after January 1,
2006 in the period in which we revised the forfeiture estimate. If other
assumptions or estimates had been used, the share-based compensation expense
that was recorded for the years ended December 31, 2007 and 2006 could have been
materially different. Furthermore, if different assumptions or estimates are
used in future periods, share-based compensation expense could be materially
impacted in the future.





Impact of Recently Issued Accounting
Pronouncements





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. We are currently evaluating the potential impact,
if any, of the adoption of SFAS No. 141(R) on our consolidated financial
statements.




In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. We are currently evaluating the
potential impact, if any, of the adoption of SFAS No. 160 on our consolidated
financial statements.




In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities – Including an amendment of FASB Statement No.
115.SFAS No. 159 permits entities to choose to measure
eligible items at fair value at specified election dates and to report
unrealized gains and losses on items for which the fair value option has been
elected in earnings at each subsequent reporting date. SFAS No. 159 is effective
for fiscal years beginning after November 15, 2007. We are currently evaluating
the potential impact, if any, of the provisions of SFAS No. 159 on our
consolidated financial statements.




In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, to
clarify the definition of fair value, establish a framework for measuring fair
value and expand the disclosures on fair value measurements. SFAS No. 157
defines fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at
the measurement date (an exit price). SFAS No. 157 also stipulates that, as a
market-based measurement, fair value should be determined based on the
assumptions that market participants would use in pricing the asset or
liability, and establishes a fair value hierarchy that distinguishes between (a)
market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). Adoption was originally required as of the beginning of
the first fiscal year that begins after November 15, 2007. The FASB subsequently
deferred the adoption of SFAS No. 157 for nonfinancial assets and liabilities to
the fiscal year beginning after November 15, 2008. We are currently evaluating
the potential impact, if any, of the provisions of SFAS No. 157 on our
consolidated financial statements.




43
 Table of Contents




Item7A.  Qualitative and
Quantitative Disclosures About Market Risk




Interest Rate Risks. Our
return on our investments in cash, cash equivalents and marketable securities
which aggregated to $62.9 million as of December 31, 2007, is subject to
interest rate risks. We regularly assess these risks and have established
policies and business practices to manage the market risk of our marketable
securities. If interest rates were to change by 10% from the levels at December
31, 2007, the effect on our financial results would be
insignificant





Foreign Currency Risk. We
have several offices outside the United States. Accordingly, we are subject to
exposure from adverse movements in foreign currency exchange rates. The effect
of foreign currency exchange rate fluctuations have not been material since our
inception. If foreign currency exchange rates were to change by 10% from the
levels at December 31, 2007, the effect on our other comprehensive income would
be insignificant. We do not use derivative financial instruments to limit our
foreign currency risk exposure.







Item8.
            Financial
      Statements and Supplementary Data




Index
      to Consolidated Financial Statements
              Page
 Reports
      of Independent Registered Public Accounting Firm
              45Consolidated
      Balance Sheets as of December 31, 2007 and 2006
              47Consolidated
      Statements of Operations for the years ended December 31, 2007, 2006 and
      2005
              48Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the
      years Ended December 31, 2007, 2006 and 2005
              49Consolidated
      Statements of Cash Flows for the years ended December 31, 2007, 2006 and
      2005
              50Notes
      to Consolidated Financial Statements
              52
 
  44
 Table of Contents




Report
of Independent Registered Public Accounting Firm







The Board
of Directors and Stockholders


FalconStor
Software, Inc.:





We have
audited the accompanying consolidated balance sheets of FalconStor Software,
Inc. and subsidiaries as of December 31, 2007 and 2006, and the related
consolidated statements of operations, stockholders’ equity and comprehensive
income (loss), and cash flows for each of the years in the three-year period
ended December 31, 2007.  These consolidated financial statements are
the responsibility of the Company’s management.  Our responsibility is
to express an opinion on these consolidated financial statements based on our
audits.





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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of FalconStor Software, Inc.
and subsidiaries as of December 31, 2007 and 2006, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2007, in conformity with U.S. generally accepted accounting
principles.





As
discussed in the notes to the consolidated financial statements, the Company
adopted the provisions of Statement of Financial Accounting Standards No. 123
(Revised 2004), “Share-Based Payment”, as of January 1, 2006.





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of FalconStor Software, Inc.
and subsidiaries' internal control over financial reporting as of December 31,
2007, based on criteria established in Internal
Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), and our report, dated March 12,
2008, expressed an unqualified opinion on the effective operation of internal
control over financial reporting.







/s/
KPMG LLP




Melville,
New York,


March 12,
2008









45
 Table of Contents






Report
of Independent Registered Public Accounting Firm









The Board
of Directors and Stockholders


FalconStor
Software, Inc.:





We have
audited FalconStor Software, Inc. and subsidiaries’ internal control over
financial reporting as of December 31, 2007, based on criteria established in
Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). FalconStor Software, Inc.'s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying Management's Report on Internal Control
Over Financial Reporting.  Our responsibility is to express an opinion
on the Company’s internal control over financial reporting based on our
audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.





A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





In our
opinion, FalconStor Software, Inc. and subsidiaries maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2007, based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of FalconStor
Software, Inc. and subsidiaries as of December 31, 2007 and 2006, and the
related consolidated statements of operations, stockholders’ equity and
comprehensive income (loss), and cash flows for each of the years in the
three-year period ended December 31, 2007, and our report dated March 12, 2008,
expressed an unqualified opinion on those consolidated financial
statements.





/s/  KPMG
LLP





Melville,
New York


March 12,
2008








46
 Table of Contents











FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS




December
      31,2007
              
              
              2006AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              32,219,349
              
              
              $
              16,105,009Marketable
      securities
              
              
              30,684,206
              
              
              
              24,854,579Accounts
      receivable, net of allowances of $8,780,880
                and  $6,016,298, respectively
              
              
              26,141,636
              
              
              
              24,134,257Prepaid
      expenses and other current assets
              
              
              1,625,417
              
              
              
              1,244,937Deferred
      tax assets, net
              
              
              3,807,325
              
              
              
              -Total
      current assets
              
              
              94,477,933
              
              
              
              66,338,782Property
      and equipment, net of accumulated depreciation of
                $13,861,313 and $10,221,780, respectively
              
              
              7,945,258
              
              
              
              5,960,317Deferred
      tax assets, net
              
              
              5,969,778
              
              
              
              -Other
      assets, net
              
              
              2,831,878
              
              
              
              2,011,433Goodwill
              
              
              3,512,796
              
              
              
              3,512,796Other
      intangible assets, net
              
              
              443,909
              
              
              
              407,316Total
      assets
              
              $
              115,181,552
              
              
              $
              78,230,644Liabilities
      and Stockholders' EquityCurrent
      liabilities:Accounts
      payable
              
              $
              1,779,720
              
              
              $
              1,432,510Accrued
      expenses
              
              
              6,711,231
              
              
              
              6,505,536Deferred
      revenue, net
              
              
              14,142,145
              
              
              
              11,466,552Total
      current liabilities
              
              
              22,633,096
              
              
              
              19,404,598Other
      long-term liabilities
              
              
              251,094
              
              
              
              137,317Deferred
      revenue, net
              
              
              4,818,985
              
              
              
              3,645,482Total
      liabilities
              
              
              27,703,175
              
              
              
              23,187,397Commitments
      and ContingenciesStockholders'
      equity:Preferred
      stock - $.001 par value, 2,000,000 shares authorized, none
      issued
              
              
              --
              
              
              
              --Common
      stock - $.001 par value, 100,000,000 shares authorized,
                51,340,268 and 49,085,539 shares issued, respectively and 50,156,168
                and 48,220,339 shares outstanding, respectively
              
              
              51,340
              
              
              
              49,086Additional
      paid-in capital
              
              
              122,294,782
              
              
              
              99,282,308Accumulated
      deficit
              
              
              (25,292,001
              )
              
              
              (38,033,857
              )Common
      stock held in treasury, at cost (1,184,100 and 865,200 shares,
      respectively)
              
              
              (9,053,824
              )
              
              
              (5,780,163
              )Accumulated
      other comprehensive loss, net
              
              
              (521,920
              )
              
              
              (474,127
              )Total
      stockholders' equity
              
              
              87,478,377
              
              
              
              55,043,247Total
      liabilities and stockholders' equity
              
              $
              115,181,552
              
              
              $
              78,230,644




See
accompanying notes to consolidated financial statements.






47
 Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES




CONSOLIDATED
STATEMENTS OF OPERATIONS






Years
      Ended December 31,2007
            
            
            2006
            
            
            2005Revenues:Software
      license revenue
            
            $
            53,153,980
            
            
            $
            38,317,352
            
            
            $
            29,544,467Maintenance
      revenue
            
            
            18,606,591
            
            
            
            12,475,342
            
            
            
            7,593,804Software
      services and other revenue
            
            
            5,638,651
            
            
            
            4,273,334
            
            
            
            3,825,83277,399,222
            
            
            
            55,066,028
            
            
            
            40,964,103Operating
      expenses:Amortization
      of purchased and capitalized software
            
            
            122,560
            
            
            
            362,159
            
            
            
            781,500Cost
      of maintenance, software services and other revenue
            
            
            11,091,375
            
            
            
            9,048,354
            
            
            
            6,114,112Software
      development costs
            
            
            22,405,058
            
            
            
            20,021,899
            
            
            
            12,039,488Selling
      and marketing
            
            
            29,656,034
            
            
            
            23,712,488
            
            
            
            16,109,440General
      and administrative
            
            
            8,023,562
            
            
            
            5,828,150
            
            
            
            4,212,769Litigation
      settlement
            
            
            -
            
            
            
            799,317
            
            
            
            --71,298,589
            
            
            
            59,772,367
            
            
            
            39,257,309Operating
      income (loss)
            
            
            6,100,633
            
            
            
            (4,706,339
            )
            
            
            1,706,794Interest
      and other income, net
            
            
            2,329,187
            
            
            
            1,650,284
            
            
            
            705,063Income
      (loss) before income taxes
            
            
            8,429,820
            
            
            
            (3,056,055
            )
            
            
            2,411,857Provision
      (benefit) for income taxes
            
            
            (4,312,036
            )
            
            
            318,473
            
            
            
            118,750Net
      income (loss)
            
            $
            12,741,856
            
            
            $
            (3,374,528
            )
            
            $
            2,293,107Basic
      net income (loss) per share
            
            $
            0.26
            
            
            $
            (0.07
            )
            
            $
            0.05Diluted
      net income (loss) per share
            
            $
            0.24
            
            
            $
            (0.07
            )
            
            $
            0.05Basic
      weighted average common shares outstanding
            
            
            49,420,848
            
            
            
            48,044,946
            
            
            
            47,662,446Diluted
      weighted average common shares outstanding
            
            
            53,130,903
            
            
            
            48,044,946
            
            
            
            50,776,396





See
accompanying notes to consolidated financial statements.











48


FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES




CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)




Accumulatedothercompre-Additional
              
              
              
              
              
              
              
              
              hensive
              
              
              Total
              
              
              Compre-Common
              
              
              paid-in
              
              
              Accumulated
              
              
              Treasury
              
              
              income
              
              
              stockholders'
              
              
              hensivestock
              
              
              capital
              
              
              deficit
              
              
              stock
              
              
              (loss)
              
              
              equity
              
              
              income
      (loss)Balance,
      December 31, 2004
              
              $
              47,769
              
              
              $
              85,400,740
              
              
              $
              (36,952,436
              )
              
              $
              (1,714,775
              )
              
              $
              (417,348
              )
              
              $
              46,363,950Issuance
      of stock options to
                non-employees
              
              
              –
              
              
              
              (32,860
              )
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (32,860
              )
              
              
              –Exercise
      of stock options, including
                tax benefit
              
              
              673
              
              
              
              1,974,867
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              1,975,540
              
              
              
              –Net
      income
              
              
              –
              
              
              
              –
              
              
              
              2,293,107
              
              
              
              –
              
              
              
              –
              
              
              
              2,293,107
              
              
              
              2,293,107Acquisition
      of treasury stock
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (1,918,155
              )
              
              
              –
              
              
              
              (1,918,155
              )
              
              
              –Change
      in unrealized losses on
                marketable securities, net
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              218,523
              
              
              
              218,523
              
              
              
              218,523Foreign
      currency translation
                adjustment
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (241,998
              )
              
              
              (241,998
              )
              
              
              (241,998
              )Balance,
      December 31, 2005
              
              $
              48,442
              
              
              $
              87,342,747
              
              
              $
              (34,659,329
              )
              
              $
              (3,632,930
              )
              
              $
              (440,823
              )
              
              $
              48,658,107
              
              
              $
              2,269,632Exercise
      of stock options, including
                tax benefit
              
              
              644
              
              
              
              2,546,407
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              2,547,051
              
              
              
              –Issuance
      of stock options to
                non-employees
              
              
              –
              
              
              
              17,914
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              17,914
              
              
              
              –Share-based
      compensation
              
              
              –
              
              
              
              9,375,240
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              9,375,240Net
      loss
              
              
              –
              
              
              
              –
              
              
              
              (3,374,528
              )
              
              
              –
              
              
              
              –
              
              
              
              (3,374,528
              )
              
              
              (3,374,528
              )Acquisition
      of treasury stock
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (2,147,233
              )
              
              
              –
              
              
              
              (2,147,233
              )
              
              
              –Adjustment
      to initially apply SFAS
                No. 158, net of tax (Note 11)
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (87,482
              )
              
              
              (87,482
              )
              
              
              (87,482
              )Change
      in unrealized losses on
                marketable securities, net
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              25,800
              
              
              
              25,800
              
              
              
              25,800Foreign
      currency translation
                adjustment
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              28,378
              
              
              
              28,378
              
              
              
              28,378Balance,
      December 31, 2006
              
              $
              49,086
              
              
              $
              99,282,308
              
              
              $
              (38,033,857
              )
              
              $
              (5,780,163
              )
              
              $
              (474,127
              )
              
              $
              55,043,247
              
              
              $
              (3,407,832
              )Exercise
      of stock options
              
              
              2,254
              
              
              
              10,004,920
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              10,007,174
              
              
              
              –Tax
      benefit from stock option
                exercises
              
              
              
              
              
              
              5,070,031
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,070,031Issuance
      of stock options to
                non-employees
              
              
              –
              
              
              
              209,218
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              209,218
              
              
              
              –Share-based
      compensation
              
              
              –
              
              
              
              7,728,305
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              7,728,305Net
      Income
              
              
              –
              
              
              
              –
              
              
              
              12,741,856
              
              
              
              –
              
              
              
              –
              
              
              
              12,741,856
              
              
              
              12,741,856Acquisition
      of treasury stock
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (3,273,661
              )
              
              
              –
              
              
              
              (3,273,661
              )
              
              
              –Minimum
      pension liability
                adjustment, net (Note 11)
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (115,925
              )
              
              
              (115,925
              )
              
              
              (115,925
              )Change
      in unrealized gains / losses on
                marketable securities, net
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              66,975
              
              
              
              66,975
              
              
              
              66,975Foreign
      currency translation
                adjustment
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              1,157
              
              
              
              1,157
              
              
              
              1,157Balance,
      December 31, 2007
              
              $
              51,340
              
              
              $
              122,294,782
              
              
              $
              (25,292,001
              )
              
              $
              (9,053,824
              )
              
              $
              (521,920
              )
              
              $
              87,478,377
              
              
              $
              12,694,063


See
accompanying notes to consolidated financial statements.




49
 Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES




CONSOLIDATED
STATEMENTS OF CASH FLOWS




Years
      Ended December 31,2007
            
            
            2006
            
            
            2005Cash
      flows from operating activities:Net
      income (loss)
            
            $
            12,741,856
            
            
            $
            (3,374,528
            )
            
            $
            2,293,107Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Depreciation
      and amortization
            
            
            3,917,484
            
            
            
            3,581,451
            
            
            
            3,505,562Share-based
      payment employee compensation
            
            
            7,728,305
            
            
            
            9,375,240
            
            
            
            -Non-cash
      professional services expenses
            
            
            209,218
            
            
            
            17,914
            
            
            
            (32,860
            )Realized
      (gain)/loss on marketable securities
            
            
            (24,928
            )
            
            
            28,854
            
            
            
            270,026Impairment
      (gain on sale) of cost method investment(s)
            
            
            124,038
            
            
            
            (3,112
            )
            
            
            -Realized
      gain on sale of warrants
            
            
            -
            
            
            
            (38,378
            )
            
            
            -Tax
      benefit from stock option exercises
            
            
            (5,070,031
            )
            
            
            (45,895
            )
            
            
            33,000Provision
      for returns and doubtful accounts
            
            
            5,041,216
            
            
            
            4,765,148
            
            
            
            4,340,102Deferred
      income taxes
            
            
            (9,837,482
            )
            
            
            -
            
            
            
            -Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            (7,033,855
            )
            
            
            (13,704,152
            )
            
            
            (9,274,971
            )Prepaid
      expenses and other current assets
            
            
            (367,972
            )
            
            
            (326,695
            )
            
            
            (291,693
            )Other
      assets
            
            
            (129,459
            )
            
            
            122,098
            
            
            
            (50,401
            )Accounts
      payable
            
            
            300,766
            
            
            
            254,211
            
            
            
            354,471Accrued
      expenses and other liabilities
            
            
            5,139,110
            
            
            
            2,018,002
            
            
            
            1,104,416Deferred
      revenue
            
            
            3,850,273
            
            
            
            5,492,625
            
            
            
            4,234,918Net
      cash provided by operatingActivities
            
            
            16,588,539
            
            
            
            8,162,783
            
            
            
            6,485,677Cash
      flows from investing activities:Purchase
      of marketable securities
            
            
            (110,825,016
            )
            
            
            (78,776,443
            )
            
            
            (61,264,424
            )Sale
      of marketable securities
            
            
            105,156,272
            
            
            
            71,752,493
            
            
            
            61,867,854Sale
      of cost method investment
            
            
            -
            
            
            
            96,755
            
            
            
            -Purchase
      of cost method investments
            
            
            (923,636
            )
            
            
            (198,117
            )
            
            
            -Purchase
      of warrants
            
            
            -
            
            
            
            (635,000
            )
            
            
            -Sale
      of warrants
            
            
            -
            
            
            
            673,378
            
            
            
            -Purchase
      of property and equipment
            
            
            (5,510,953
            )
            
            
            (3,693,756
            )
            
            
            (3,161,383
            )Purchase
      of software licenses
            
            
            (185,000
            )
            
            
            (173,431
            )
            
            
            (108,000
            )Purchase
      of intangible assets
            
            
            (266,401
            )
            
            
            (373,229
            )
            
            
            (126,241
            )Refund
      of security deposits
            
            
            197,448
            
            
            
            (2,062
            )
            
            
            -Net
      cash used in investingActivities
            
            
            (12,357,286
            )
            
            
            (11,329,412
            )
            
            
            (2,792,194
            )Cash
      flows from financing activities:Proceeds
      from exercise of stock options
            
            
            10,007,174
            
            
            
            2,501,156
            
            
            
            1,942,540Payments
      to acquire treasury stock
            
            
            (3,273,661
            )
            
            
            (2,147,233
            )
            
            
            (1,918,155
            )Tax
      benefit from stock option exercises
            
            
            5,070,031
            
            
            
            45,895
            
            
            
            -Net
      cash provided by financing activities
            
            
            11,803,544
            
            
            
            399,818
            
            
            
            24,385Effect
      of exchange rate changes
            
            
            79,543
            
            
            
            74,847
            
            
            
            (405,468
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            16,114,340
            
            
            
            (2,691,964
            )
            
            
            3,312,400Cash
      and cash equivalents, beginning of year
            
            
            16,105,009
            
            
            
            18,796,973
            
            
            
            15,484,573Cash
      and cash equivalents, end of year
            
            $
            32,219,349
            
            
            $
            16,105,009
            
            
            $
            18,796,973Cash
      paid for income taxes
            
            $
            273,631
            
            
            $
            79,501
            
            
            $
            21,583




The
Company did not pay any interest for the three years ended December 31,
2007.





See accompanying notes to consolidated
financial statements.






50
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FALCONSTOR SOFTWARE, INC. AND
SUBSIDIARIES




Notes
to Consolidated Financial Statements




December
31, 2007






(1)
Summary of Significant Accounting Policies




(a)
              The
      Company and Nature of Operations


FalconStor
Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures
and sells network storage software solutions and provides the related
maintenance, implementation and engineering services.




(b)
            Principles
      of Consolidation




The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries.  All significant intercompany balances and
transactions have been eliminated in consolidation.




(c)
            Use
      of Estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles 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.  The Company’s significant estimates include those related to
revenue recognition, accounts receivable allowances, share-based payment
compensation and deferred income taxes. Actual results could differ from those
estimates.




(d)
            Cash Equivalents and
      Marketable Securities




The
Company considers all highly liquid investments with maturities of three months
or less when purchased to be cash equivalents. Cash equivalents, consisting of
money market funds and commercial paper, amounted to approximately $21.3 million
and $11.5 million at December 31, 2007 and 2006,
respectively.  Marketable securities at December 31, 2007 and 2006
amounted to $30.7 million and $24.9 million, respectively, and consisted of
corporate bonds, government securities and certificate of deposits, which are
classified as available for sale, and accordingly, unrealized gains and losses
on marketable securities are reflected as a component of accumulated other
comprehensive loss in stockholders’ equity.




(e)
            Revenue
      Recognition




The
Company recognizes revenue from software licenses in accordance with Statement
of Position (“SOP”) 97-2, Software Revenue Recognition,
as amended by SOP 98-4 and SOP 98-9, and related interpretations to determine
the recognition of revenue. Accordingly, revenue for software licenses is
recognized when persuasive evidence of an arrangement exists, the fee is fixed
and determinable and the software is delivered and collection of the resulting
receivable is deemed probable. Software delivered to a customer on a trial basis
is not recognized as revenue until a permanent key code is delivered to the
customer. Reseller customers typically send the Company a purchase order only
when they have an end user identified. When a customer licenses software
together with the purchase of maintenance, the Company allocates a portion of
the fee to maintenance for its fair value. Software maintenance fees are
deferred and recognized as revenue ratably over the term of the contract. The
long-term portion of deferred revenue relates to maintenance contracts with
terms in excess of one year. The cost of providing technical support is included
in cost of maintenance, software service and other revenues. The Company
provides an allowance for software product returns as a reduction of revenue,
based upon historical experience and known or expected trends.







51
 Table of Contents






Revenues
associated with software implementation and software engineering services are
recognized as the services are performed.  Costs of providing these
services are included in cost of revenues.




The
Company has entered into various distribution, licensing and joint promotion
agreements with OEMs and distributors, whereby the Company has provided to the
reseller a non-exclusive software license to install the Company’s software on
certain hardware or to resell the Company’s software in exchange for payments
based on the products distributed by the OEM or
distributor.  Nonrefundable advances and engineering fees received by
the Company from an OEM are recorded as deferred revenue and recognized as
revenue when related software engineering services, if any, are complete and the
software product master is delivered and accepted.




The
Company has transactions in which it purchases hardware and bundles this
hardware with the Company’s software and sells the bundled solution to its
customer. Since the software is not essential for the functionality of the
equipment included in the Company’s bundled solutions, and both the hardware and
software have stand alone value to the customer, a portion of the contractual
fees is recognized as revenue when the software or hardware is delivered based
on the relative fair value(s) of the delivered element(s).




(f)
            Property
      and Equipment




Property
and equipment are recorded at cost. Depreciation is recognized using the
straight-line method over the estimated useful lives of the assets (3 to 7
years). Leasehold improvements are amortized on a straight-line basis over the
term of the respective leases or over their estimated useful lives, whichever is
shorter.




(g)
            Goodwill
      and Other Intangible Assets




Goodwill
represents the excess of the purchase price over the estimated fair value of net
tangible and identifiable intangible assets acquired in business combinations.
Consistent with Statement of Financial Accounting Standards (“SFAS”) 142, Goodwill and Other Intangible
Assets, the Company does not amortize goodwill, but instead tests the
balance for impairment annually on December 31st of each
year, and more frequently if events or changes in circumstances indicate that
goodwill may be impaired.  Identifiable intangible assets are
amortized over a three-year period using the straight-line method. Amortization
expense was $229,808, $182,777 and $216,997 for 2007, 2006 and 2005,
respectively.  The gross carrying amount and accumulated amortization
of other intangible assets as of December 31, 2007 and December 31, 2006 are as
follows:




December
      31,
                2007
              
              
              December 31,
                  2006Patents:Gross
      carrying amount
              
              $
              1,289,494
              
              
              $
              1,023,093Accumulated
      amortization
              
              
              (845,585
              )
              
              
              (615,777
              )Net carrying amount
              
              $
              443,909
              
              
              $
              407,316




(h)
            Software
      Development Costs and Purchased Software
  Technology




In
accordance with the provisions of SFAS No. 86, Accounting for the Costs of Software
to be Sold, Leased or Otherwise Marketed, costs associated with the
development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility of the product
has been established. Based on the Company’s product development process,
technological feasibility is established upon completion of a working model.
Amortization of software development costs is recorded at the greater of
straight line over three years or the ratio of current revenue of the related
products to total current and anticipated future revenue of these
products.






52
 Table of Contents




Purchased software technology of
$246,017 and $183,578, net of accumulated amortization of $5,131,414 and
$5,008,853, is included in other assets in the balance sheets as of December 31,
2007 and December 31, 2006, respectively. Amortization expense was $122,560,
$362,159 and $781,500 for the years ended December 31, 2007, 2006 and 2005,
respectively. Amortization of purchased software technology is recorded at the
greater of the straight line basis over the products estimated remaining life or
the ratio of current period revenue of the related products to total current and
anticipated future revenue of these products.




As of
December 31, 2007, amortization expense for existing identifiable intangible
assets and purchased software technology is expected to be $376,445, $227,190,
and $86,291 for the years ended December 31, 2008, 2009 and 2010,
respectively.  Such assets will be fully amortized at December 31,
2010.




(i)
            Income
      Taxes




Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be realized or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. In determining the period in which related tax benefits are
realized for book purposes, excess share-based compensation deductions included
in net operating losses are realized after regular net operating losses are
exhausted. The Company recognizes interest and penalties accrued related to
unrecognized tax benefits as part of income tax expense in its consolidated
statements of operations.




On
January 1, 2007, the Company adopted Financial Accounting Standards Board
(“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, (“FIN 48”). FIN 48 is an interpretation of SFAS Statement No. 109,
Accounting for Income
Taxes, and addresses the determination of whether tax benefits claimed or
expected to be claimed on a tax return should be recorded in the financial
statements.  Under FIN 48, the Company may recognize the tax benefit
from an uncertain tax position only if it meets the “more likely than not”
threshold that the position will be sustained on examination by the taxing
authority, based on the technical merits of the position. The tax benefits
recognized in the financial statements from such a position should be measured
based on the largest benefit that has a greater than fifty percent likelihood of
being realized upon ultimate settlement. FIN 48 also provides guidance on
de-recognition, classification, interest and penalties on income taxes,
accounting in interim periods, and also requires increased disclosures. The
adoption of FIN 48 did not result in any adjustment to the recognized benefits
from the Company’s uncertain tax positions. See footnote No. 5 Income Taxes for additional
information.




(j)
            Long-Lived
      Assets




The
Company reviews its long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of the asset may not be
recoverable.  If the sum of the expected future cash flows,
undiscounted and without interest is less than the carrying amount of the asset,
an impairment loss is recognized as the amount by which the carrying amount of
the asset exceeds its fair value.




(k)
            Share-Based
      Payments





Effective
January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), Share-Based Payment, which
establishes the accounting for transactions in which an entity exchanges its
equity instruments for goods or services. Under the provisions of SFAS No.
123(R), share-based compensation expense is measured at the grant date, based on
the fair value of the award, and is recognized as an expense over the requisite
employee service period (generally the vesting period) for awards expected to
vest. The Company adopted SFAS No. 123(R) using the modified prospective
method and, as a result, periods prior to January 1, 2006 have not been
restated. The Company estimates the fair value of share-based payments using the
Black-Scholes option-pricing model. The fair value of stock awards is determined
based on the number of shares granted and the quoted price of the Company’s
common stock. Such value is recognized as expense over the service period, net
of estimated forfeitures. The estimation of stock awards that will ultimately
vest requires judgment, and to the extent actual results or updated estimates
differ from the Company’s current estimates, such amounts will be recorded as a
cumulative adjustment in the period estimates are revised. The Company considers
many factors when estimating expected forfeitures, including types of awards,
employee class, and historical experience. Actual results and future estimates
may differ substantially from the Company’s current estimates. Stock option
exercises and restricted stock awards are expected to be fulfilled with new
shares of common stock.






53
 Table of Contents





The
Company accounts for stock option grants to non-employees in accordance with
SFAS No. 123(R), and Emerging Issues Task Force (“EITF”) Issue
No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services, which require that the fair value of
these instruments be recognized as an expense over the period in which the
related services are rendered.





Prior to
the adoption of SFAS No. 123 (R), the Company accounted for stock-based
compensation using the intrinsic-value based method under Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations, and provided applicable pro-forma
disclosures required by SFAS No. 123, Accounting for Stock-Based
Compensation. Accordingly, prior to 2006, the Company recorded employee
stock-based compensation expense only if, on the date of grant, the market price
of the underlying stock on the date of grant exceeded the exercise
price.





(l)
            Financial
      Instruments





As of
December 31, 2007 and 2006, the fair value of the Company’s financial
instruments including cash and cash equivalents, accounts receivable, accounts
payable and accrued expenses, approximates book value due to the short maturity
of these instruments.





(m)
            Foreign
      Currency





Assets
and liabilities of foreign operations are translated at rates of exchange at the
end of the period, while results of operations are translated at average
exchange rates in effect for the period.  Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders’ equity.  Realized gains and losses
from foreign currency transactions are included in the statements of operations
within interest and other income, net.  Such amounts have historically
not been material.





(n)
            Earnings
      Per Share (EPS)





Basic EPS
is computed based on the weighted average number of shares of common stock
outstanding.  Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to the net loss for the year ended December 31, 2006, all
common stock equivalents for the period was excluded from diluted net loss per
share. As of December 31, 2007, 2006 and 2005, potentially dilutive common stock
equivalents included 6,454,969, 11,810,975, and 7,698,795 stock options and
shares of restricted stock outstanding, respectively. As of December 31, 2006
and 2005, potentially dilutive common stock equivalents included 750,000
warrants outstanding.





The
following represents a reconciliation of the numerators and denominators of the
basic and diluted earnings per share (“EPS”) computation:





Year
      Ended December 31, 2007
              
              
              Year
      Ended December 31, 2006
              
              
              Year
      Ended December 31, 2005Net
      Income
              
              
              Shares
              
              
              Per
      Share
              
              
              Net
      Income
              
              
              Shares
              
              
              Per
      Share
              
              
              Net
      Income
              
              
              Shares
              
              
              Per
      Share(Numerator)
              
              
              (Denominator)
              
              
              Amount
              
              
              (Numerator)
              
              
              (Denominator)
              
              
              Amount
              
              
              (Numerator)
              
              
              (Denominator)
              
              
              AmountBasic
      EPS
              
              $
              12,741,856
              
              
              
              49,420,848
              
              
              $
              0.26
              
              
              $
              (3,374,528
              )
              
              
              48,044,946
              
              
              $
              (0.07
              )
              
              $
              2,293,107
              
              
              
              47,662,446
              
              
              $
              0.05Effect
      of dilutive securities:Stock Options and
                Restricted Stock
              
              
              
              3,710,055
              
              
              
              
              
              
              
              
              
              
              
              -
              
              
              
              
              
              
              
              
              
              
              
              3,113,950Diluted
      EPS
              
              $
              12,741,856
              
              
              
              53,130,903
              
              
              $
              0.24
              
              
              $
              (3,374,528
              )
              
              
              48,044,946
              
              
              $
              (0.07
              )
              
              $
              2,293,107
              
              
              
              50,776,396
              
              
              $
              0.05











54
 Table of Contents





(o)
            Comprehensive
      Income (Loss)





Comprehensive
income (loss) includes: (i) the Company’s net income (loss), (ii) foreign
currency translation adjustments, (iii) unrealized (gains)/losses on marketable
securities, net of tax, and (iv) minimum pension liability adjustments, net of
tax. pursuant to SFAS No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements
No. 87, 88, 106, and 132(R) (see Note 11 Employee Benefit Plans for
further details.) As of December 31, 2007 and 2006, accumulated other
comprehensive income (loss) was comprised of: (i) foreign currency translation
adjustment losses of $362,006 and $363,163, respectively, (ii) unrealized
(gains) losses on marketable securities of $(43,493) and $23,482, net of tax,
respectively, and (iii) unrecognized pension adjustments of $203,407 and
$87,482, net of tax, respectively.





(p)
            Investments





As of
December 31, 2007 and 2006, the Company maintained certain cost-method
investments aggregating $1,116,457 and $317,406, respectively, which are
included in “Other assets” in the accompanying consolidated balance sheets.
During 2007, the Company recognized impairment charges related to certain of its
cost-method investments of $124,038 as a result of other-than-temporary declines
in market value related to certain of these investments. These charges are
included in “Interest and other income” in the accompanying consolidated
statements of operations.





During 2007, the Company
made approximately $924,000 of various cost-method investments. Such
investments included an $866,000 investment with the Institute of Computing
Technology of the Chinese Academy of Science and other independent third parties
to establish a newly formed company, Tianjin Zhongke Blue Whale Information
Technology Co., Ltd. (“Blue Whale”), that will research, produce and market
enterprise-class storage, archiving and compliance solutions domestically and
internationally.Additionally, during 2007, the Company
entered into a license agreement with Blue Whale, which resulted in
approximately $800,000 of revenue. The license agreement and the investment were
separate arms-length transactions and were not made in contemplation of each
other.  The Company evaluates its investments in accordance with the
APB No. 18, The
Equity Method of Accounting for Investments in Common Stock,(“APB 18”),
and since each of its investments represents less than 20% of the enitity, and
the Company does not have significant influence, the Company accounts for each
under the cost-method of accounting.





(q)
            New Accounting Pronouncements





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. The Company is currently evaluating the potential
impact, if any, of the adoption of SFAS No. 141(R) on its consolidated financial
statements.




In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. The Company is currently
evaluating the potential impact, if any, of the adoption of SFAS No. 160 on its
consolidated financial statements.




In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities – Including an amendment of FASB Statement No.
115.SFAS No. 159 permits entities to choose to measure
eligible items at fair value at specified election dates and to report
unrealized gains and losses on items for which the fair value option has been
elected in earnings at each subsequent reporting date. SFAS No. 159 is effective
for fiscal years beginning after November 15, 2007. The Company is currently
evaluating the potential impact, if any, of the provisions of SFAS No. 159 on
its consolidated financial statements.







55
 Table of Contents




In September 2006, the FASB
issued SFAS No. 157, Fair
Value Measurements, to clarify the definition of fair value, establish a
framework for measuring fair value and expand the disclosures on fair value
measurements. SFAS No. 157 defines fair value as the price that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date (an exit price).
SFAS No. 157 also stipulates that, as a market-based measurement, fair value
should be determined based on the assumptions that market participants would use
in pricing the asset or liability, and establishes a fair value hierarchy that
distinguishes between (a) market participant assumptions developed based on
market data obtained from sources independent of the reporting entity
(observable inputs) and (b) the reporting entity's own assumptions about market
participant assumptions developed based on the best information available in the
circumstances (unobservable inputs). Adoption was originally required as of the
beginning of the first fiscal year that begins after November 15, 2007. The FASB
subsequently deferred the adoption of SFAS No. 157 for nonfinancial assets and
liabilities to the fiscal year beginning after November 15, 2008. The Company is
currently evaluating the potential impact, if any, of the provisions of SFAS No.
157 on its consolidated financial statements.




(r)
            Reclassifications





Certain
reclassifications have been made to the Company’s 2007 consolidated financial
statements as discussed below:





The
disclosure of the Company’s gross deferred tax assets and related valuation
allowance as of December 31, 2006, decreased by approximately $47 million when
compared to amounts previously disclosed. The decrease was attributable to
updated assessments as to the Company’s ability to utilize or sustain such
assets and the corresponding need for a related valuation
allowance.





The
Company reclassified the December 31, 2006 presentation of approximately
$500,000 of amounts previously reported as marketable securities to cash and
cash equivalents to conform to December 31, 2007 classifications of similar
securities.




(2)  Property
and Equipment





Property
and equipment consist of the following:





December
      31,
            
            
            December
      31,2007
            
            
            2006Computer
      hardware and software
            
            $
            20,104,860
            
            
            $
            14,845,319Furniture
      and equipment
            
            
            530,530
            
            
            
            511,184Leasehold
      improvements
            
            
            1,158,173
            
            
            
            812,586Automobile
            
            
            13,008
            
            
            
            13,00821,806,571
            
            
            
            16,182,097Less
      accumulated depreciation
            
            
            (13,861,313
            )
            
            
            (10,221,780
            )$
            7,945,258
            
            
            $
            5,960,317





Depreciation
expense was $3,565,116, $3,071,018, and $2,452,737 in 2007, 2006, and 2005,
respectively.











56
 Table of Contents




(3) 
Marketable securities





The
Company’s marketable securities consist of available-for-sale securities, which
are carried at fair value, with unrealized gains and losses reported as a
separate component of stockholders’ equity.  Unrealized gains and
losses are computed on the specific identification method. Realized gains,
realized losses and declines in value judged to be other-than-temporary, are
included in interest and other income, net. The cost of available-for-sale
securities sold is based on the specific identification method and interest
earned is included in interest and other income.





The cost
and fair values of the Company’s available-for-sale marketable securities as of
December 31, 2007, are as follows:





Aggregate
                Fair Value
              
              
              Cost
                Basis
              
              
              Net
      Unrealized
                Gains / (loss)Auction
      rate securities
              
              $
              8,400,000
              
              
              $
              8,400,000
              
              
              $
              -Government
      securities
              
              
              16,336,408
              
              
              
              16,237,759
              
              
              
              98,649Corporate
      bonds
              
              
              4,948,671
              
              
              
              4,936,117
              
              
              
              12,554Certificate
      of deposit
              
              
              999,127
              
              
              
              997,857
              
              
              
              1,270$
              30,684,206
              
              
              $
              30,571,733
              
              
              $
              112,473







As of
December 31, 2007 there are two corporate bonds that are in an immaterial
unrealized loss position. Based on the credit ratings of these securities and
the Company’s intent and ability to hold these securities for a period of time
sufficient to recover the value of the investments, such unrealized losses have
not been determined to be other-than-temporary.





The cost
and fair values of the Company’s available-for-sale marketable securities as of
December 31, 2006, are as follows:




Aggregate
                Fair Value
              
              
              Cost
                Basis
              
              
              Net
      Unrealized
                Gain/ (losses)Auction
      rate securities
              
              $
              10,900,000
              
              
              $
              10,900,000
              
              
              $
              -Government
      securities
              
              
              12,457,124
              
              
              
              12,479,272
              
              
              
              (22,148
              )Corporate
      bonds
              
              
              997,455
              
              
              
              998,789
              
              
              
              (1,334
              )Certificate
      of deposit
              
              
              500,000
              
              
              
              500,000
              
              
              
              -$
              24,854,579
              
              
              $
              24,878,061
              
              
              $
              (23,482
              )




The cost basis and fair value of
available-for-sale securities by contractual maturity as of December 31, 2007,
were as follows:




FairCost
              
              
              ValueDue
      within one year
              
              $
              29,384,212
              
              
              $
              29,478,792Due
      between one and two years
              
              
              1,187,521
              
              
              
              1,205,414$
              30,571,733
              
              
              $
              30,684,206




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(4) Accrued Expenses




Accrued
expenses are comprised of the following:




December
      31,
            
            
            December
      31,2007
            
            
            2006Accrued
      compensation
            
            $
            3,398,783
            
            
            $
            2,267,222Accrued
      consulting and professional fees
            
            
            746,799
            
            
            
            606,702Accrued
      marketing and promotion
            
            
            127,852
            
            
            
            220,419Other
      accrued expenses
            
            
            1,189,557
            
            
            
            1,052,536Accrued
      income taxes
            
            
            371,251
            
            
            
            247,376Accrued
      other taxes
            
            
            360,565
            
            
            
            256,989Accrued
      litigation settlement fee
            
            
            -
            
            
            
            1,100,000Accrued
      hardware purchases
            
            
            93,159
            
            
            
            314,101Accrued
      and deferred rent
            
            
            423,265
            
            
            
            440,191$
            6,711,231
            
            
            $
            6,505,536




(5)  Income
Taxes
  Information
pertaining to the Company’s income before income taxes and the applicable
provision (benefit) for income taxes is as follows:




2007
              
              
              2006
              
              
              2005Income
      before income taxes:Domestic
      income (loss)
              
              $
              7,788,284
              
              
              $
              (1,599,446
              )
              
              $
              4,390,212Foreign
      income (loss)
              
              
              641,536
              
              
              
              (1,456,609
              )
              
              
              (1,978,355
              )Total
      income before income taxes:
              
              $
              8,429,820
              
              
              $
              (3,056,055
              )
              
              $
              2,411,857Provision
      (benefit) for income taxes:Current:Federal
              
              $
              4,421,578
              
              
              $
              239,411
              
              
              $
              55,887State
      and local
              
              
              802,074
              
              
              
              22,862
              
              
              
              1,113Foreign
              
              
              301,794
              
              
              
              56,200
              
              
              
              61,7505,525,446
              
              
              
              318,473
              
              
              
              118,750Deferred:Federal
              
              
              (8,843,575
              )
              
              
              -
              
              
              
              -State
      and local
              
              
              (696,490
              )
              
              
              -
              
              
              
              -Foreign
              
              
              (297,417
              )
              
              
              -
              
              
              
              -(9,837,482
              )
              
              
              -
              
              
              
              -Total
      provision (benefit) for income taxes:
              
              $
              (4,312,036
              )
              
              $
              318,473
              
              
              $
              118,750





58
 Table of Contents




Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
income tax purposes. Significant components of the Company’s deferred tax assets
and liabilities as of December 31, 2007 and 2006 are as follows:





12/31/2007
              
              
              12/31/2006Deferred
      Tax Assets and Liabilities:Allowance for receivables
              
              $
              3,359,922
              
              
              $
              2,258,062Deferred revenue
              
              
              1,499,332
              
              
              
              1,056,016Share-based compensation
              
              
              2,497,682
              
              
              
              1,529,144Accrued expenses and other liabilities
              
              
              397,283
              
              
              
              418,356Domestic net operating loss carryforwards
              
              
              1,896,537
              
              
              
              5,234,914Foreign net operating loss carryforwards
              
              
              1,123,200
              
              
              
              1,484,416Tax credit carryforwards
              
              
              1,312,266
              
              
              
              1,084,845AMT tax credit carryforwards
              
              
              287,922
              
              
              
              222,684Capital loss carryforwards
              
              
              650,137
              
              
              
              850,134Fixed assets
              
              
              100,522
              
              
              
              (37,943
              )Intangibles
              
              
              259,602
              
              
              
              189,889Sub-total
              
              
              13,384,405
              
              
              
              14,290,517Valuation Allowance
              
              
              (3,607,301
              )
              
              
              (14,290,517
              )Net Deferred Tax Asset
              
              $
              9,777,104
              
              
              $
              -




For the
year ended December 31, 2007, the Company’s deferred tax asset valuation
allowance decreased by $10.7 million in response to positive evidence which
developed during 2007 from the Company’s emergence from cumulative losses in
recent years, and updated assessments as to the Company’s ability to realize
benefits of its deferred tax assets, based primarily upon its expectations for
future taxable income. The portion of the valuation allowance reduction that
reduced the provision for income taxes for the year ended December 31, 2007 was
$8.9 million. The remaining portion of the valuation allowance reduction related
to the realization of excess share-based compensation deductions of $1.8 million
was allocated to additional-paid-in-capital.





As of
December 31, 2007, the deferred tax asset valuation allowance of $3.6 million
relates to: (i) capital loss carry forwards of $0.7 million, (ii) net operating
losses related to excess share-based compensation expense deductions of $1.9
million, (iii) foreign tax credits of $0.2 million, and (iv) certain foreign net
operating losses of $0.8 million. If the remaining valuation allowance were to
be reversed, approximately $1.9 million would be allocated to additional
paid-in-capital as such amounts are attributable to the tax effects of excess
compensation deductions from exercises of employee and consultant stock options.
The remainder of the valuation allowance of approximately $1.7 million would
reduce income tax expense.








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The
Company’s effective tax rate differs from the statutory federal income tax rate
as follows:





2007
              
              
              2006
              
              
              2005Tax
      at Federal statutory rate
              
              $
              2,950,437
              
              
              $
              (1,066,688
              )
              
              $
              820,031Increase (reduction) in income taxes resulting from:State and local taxes
              
              
              461,823
              
              
              
              62,711
              
              
              
              885,733Non-deductible expenses
              
              
              169,310
              
              
              
              355,144
              
              
              
              302,207Shared-based payment compensation
              
              
              811,659
              
              
              
              1,170,364
              
              
              
              -Net effect of foreign operations
              
              
              154,888
              
              
              
              36,279
              
              
              
              128,150Research and development credit
              
              
              (227,421
              )
              
              
              (568,520
              )
              
              
              (433,013
              )AMT tax
              
              
              -
              
              
              
              199,677
              
              
              
              23,007Change in tax rates
              
              
              283,585
              
              
              
              -
              
              
              
              -Increase (decrease) in valuation allowance
              
              
              (8,916,317
              )
              
              
              129,506
              
              
              
              (1,607,365
              )$
              (4,312,036
              )
              
              $
              318,473
              
              
              $
              118,750





At
December 31, 2007, the Company had approximately $5.1 million of federal net
operating loss carryforwards, which are available to offset future taxable
income. If not used, these carryforwards expire between 2023 through
2024.  The net operating loss carryforwards relate to excess
compensation deductions from exercises of employee and consultant share-based
payment deductions and as discussed above the resulting tax benefits of
approximately $1.9 million will be credited to additional-paid-in-capital when
realized.





The
Company adopted the provisions of FIN 48 on January 1, 2007.  A
reconciliation of the beginning and ending amount of unrecognized tax benefits
is as follows:




Balance
      at January 1, 2007
            
            $
            4,399,914Increases
      in tax positions for prior years
            
            
            —Decreases
      in tax positions for prior years
            
            
            —Increases
      in tax positions for current year
            
            
            —Settlements
            
            
            —Lapse
      in statute of limitations
            
            
            —Balance
      at December 31, 2007
            
            $
            4,399,914




The
entire amount of unrecognized tax benefits if recognized would reduce our annual
effective tax rate. As of January 1, 2007, the Company had approximately $22,193
of accrued interest and penalties and $39,898 as of December 31, 2007. The
Company does not expect its unrecognized tax benefits to change significantly
over the next 12 months.





The
Company files in the U.S., state and foreign income tax returns in jurisdictions
with varying statutes of limitations. The 2004 through 2007 tax years generally
remain subject to examination by federal and most state tax authorities. In
addition to the US, the Company’s major taxing jurisdictions include Taiwan,
France, Germany and Korea. There have not been any past examinations nor are
there any current tax examinations in progress.






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 Table of Contents





(6)  Stockholders’
Equity





In
September 2003, the Company entered into a worldwide OEM agreement with a major
Technology Company (the “Technology Company”), and granted to the Technology
Company warrants to purchase 750,000 shares of the Company’s common stock with
an exercise price of $6.18 per share. A portion of the warrants were to vest
annually subject to the Technology Company’s achievement of pre-defined and
mutually agreed upon sales objectives over a three-year period beginning June 1,
2004. As of June 1, 2007, none of the warrants had vested and the rights to
exercise the warrants have expired.




(7)  Stock
Repurchase Program





On
October 25, 2001, the Company announced that its Board of Directors authorized
the repurchase of up to two million shares of the Company’s outstanding common
stock. The repurchases may be made from time to time in open market transactions
in such amounts as determined at the discretion of the Company’s management. The
terms of the stock repurchases will be determined by management based on market
conditions. During the year ended December 31, 2007, the Company repurchased
318,900 shares of its common stock in open market purchases for a total cost of
$3,273,661. During the year ended December 31, 2006, the Company repurchased
315,600 shares of its common stock in open market purchases for a total cost of
$2,147,233.  As of December 31, 2007, the Company had repurchased a
total of 1,184,100 shares of its common stock at an aggregate purchase price of
$9,053,824, and had the ability to repurchase an additional 815,900 shares of
its common stock under the original October 2001 authorization.





On
February 6, 2008, the Company’s Board of Directors increased the authorization
from two million to five million shares of the Company’s outstanding common
stock. The repurchases may be made from time to time in open market transactions
in such amounts as determined at the discretion of the Company’s management. The
terms of the stock repurchases will be determined by management based on market
conditions.





(8)  Share-Based
Payment Arrangements





As of May
1, 2000, the Company adopted the FalconStor Software, Inc. 2000 Stock Option
Plan (the “2000 Plan”). The 2000 Plan is administered by the Board of Directors
and, as amended, provides for the grant of options to purchase up to 14,162,296
shares of Company common stock to employees, consultants and non-employee
directors. Options may be incentive (“ISO”) or non-qualified. ISOs granted must
have exercise prices at least equal to the fair value of the common stock on the
date of grant, and have terms not greater than ten years, except those to an
employee who owns stock with greater than 10% of the voting power of all classes
of stock of the Company, in which case they must have an option price at least
110% of the fair value of the stock, and expire no later than five years from
the date of grant. Non-qualified options granted must have exercise prices not
less than eighty percent of the fair value of the common stock on the date of
grant, and have terms not greater than ten years. All options granted under the
2000 Plan must be granted before May 1, 2010. As of December 31, 2007, 328,320
shares were available for grant under the 2000 Plan.




On May
14, 2004, the Company adopted the FalconStor Software, Inc. 2004 Outside
Directors Stock Option Plan (the “2004 Plan”). The 2004 Plan is administered by
the Board of Directors and provides for the granting of options to non-employee
directors of the Company to purchase up to 300,000 shares of Company common
stock. Exercise prices of the options must be equal to the fair market value of
the common stock on the date of grant. Options granted have terms of ten years.
All options granted under the 2004 Plan must be granted within three years of
the adoption of the 2004 Plan. No additional options are available for grant
under the 2004 Plan.




On May
17, 2006, the Company adopted the FalconStor Software, Inc. 2006 Incentive Stock
Plan (the “2006 Plan”).  The 2006 Plan was amended on May 8, 2007. The
2006 Plan is administered by the Board of Directors and provides for the grant
of incentive and nonqualified stock options, and restricted stock, to employees,
officers, consultants and advisors of the Company.  The number of
shares available for grant or issuance under the 2006 Plan, as amended, is
determined as follows:  If, on July 1st of any
calendar year in which the 2006 Plan is in effect, the number of shares of stock
to which options may be granted is less than five percent (5%) of the number of
outstanding shares of stock, then the number of shares of stock available for
issuance under the 2006 Plan is automatically increased so that the number
equals five percent (5%) of the shares of stock outstanding. In no event shall
the number of shares of stock subject to the 2006 Plan in the aggregate exceed
twenty million shares, subject to adjustment as provided in the 2006 Plan. On
July 1, 2007, the total number of outstanding shares of the Company’s common
stock totaled 49,615,610. Pursuant to the 2006 Plan, as amended, the total
shares available for issuance under the 2006 Plan thus increased by 2,170,731
shares to 2,480,781 shares available for issuance as of July 1, 2007. As of
December 31, 2007, 1,293,206 shares were available for grant under the 2006
Plan. Exercise prices of the options must be equal to the fair market value of
the common stock on the date of grant. Options granted have terms of not greater
than ten years. All options and shares of restricted stock granted under the
2006 Plan must be granted within ten years of the adoption of the 2006
Plan.






61
 Table of Contents




On May 8,
2007, the Company adopted the FalconStor Software, Inc. 2007 Outside Directors
Equity Compensation Plan (the “2007 Plan”). The 2007 Plan is administered by the
Board of Directors and provides for the issuance of up to 300,000 shares of
Company common stock upon the vesting of options or upon the grant of shares
with such restrictions as determined by the Board of Directors to the
non-employee directors of the Company. Exercise prices of the options must be
equal to the fair market value of the common stock on the date of grant. Options
granted have terms of ten years. Shares of restricted stock have the terms and
conditions set by the Board of Directors and are forfeitable until the terms of
the grant have been satisfied. As of December 31, 2007, 235,000 shares were
available for grant under the 2007 Plan.




A summary
of the Company’s stock option activity for 2007 is as follows:




WeightedWeighted
              
              
              AverageAverage
              
              
              Remaining
              
              
              AggregateNumber
      of
              
              
              Exercise
              
              
              Contractual
              
              
              IntrinsicOptions
              
              
              Price
              
              
              Life (Years)
              
              
              ValueOptions
      Outstanding at December 31, 2006
              
              
              10,835,975
              
              
              $
              5.62Granted
              
              
              1,523,500
              
              
              $
              12.42Exercised
              
              
              (2,179,379
              )
              
              $
              4.59Canceled
      / Forfeited
              
              
              (512,722
              )
              
              $
              8.44Options
      Outstanding at December 31, 2007
              
              
              9,667,374
              
              
              $
              6.79
              
              
              
              6.27
              
              
              $
              45,799,379Options
      Exercisable at December 31, 2007
              
              
              6,770,088
              
              
              $
              5.47
              
              
              
              5.19
              
              
              $
              39,209,239Options
      Expected to Vest at December 31, 2007
              
              
              2,271,730
              
              
              $
              9.81
              
              
              
              8.74
              
              
              $
              3,294,009




Stock
option exercises are fulfilled with new shares of common stock. The total cash
received from stock option exercises for the years ended December 31, 2007, 2006
and 2005 was $10,007,174, $2,501,156 and $1,942,540, respectively. The total
intrinsic value of stock options exercised during the years ended December 31,
2007, 2006 and 2005 was $15,166,216, $2,697,850 and $2,804,738,
respectively.





The
Company realized share-based compensation expense for awards issued under the
Company’s stock option plans in the following line items in the consolidated
statement of operations:




Year
      Ended December 31,
              
              
              Year
      Ended December 31,2007
              
              
              2006Cost
      of maintenance, software services and other revenue
              
              $
              1,034,424
              
              
              $
              1,342,970Software
      development costs
              
              
              3,279,065
              
              
              
              4,331,902Selling
      and marketing
              
              
              2,615,503
              
              
              
              2,803,585General
      and administrative
              
              
              1,008,531
              
              
              
              914,697$
              7,937,523
              
              
              $
              9,393,154
   62
 Table of Contents


The
Company recognized approximately $1,025,000 of tax benefits related to
share-based compensation expense during the year ended December 31, 2007. 
The Company did not recognize any tax benefits related to share-based
compensation expense in 2006.





In 2006,
pursuant to the 2006 Plan, the Company granted options to purchase 25,000 shares
of common stock to certain non-employee consultants in exchange for professional
services. The fair value of each option award is determined using the
Black-Scholes method as of each balance sheet date, and is being expensed over
its respective period of services to be provided. As of December 31, 2007, the
cumulative expense for these grants totaled $93,094, of which $75,180 and
$17,914 were recognized during the years ended December 31, 2007 and 2006,
respectively.




In 2007,
pursuant to the 2006 Plan, the Company granted options to purchase 6,000 shares
of common stock to certain non-employee consultants in exchange for professional
services and granted 11,000 shares of restricted stock to certain other
non-employee consultants in exchange for professional services. The fair value
of the option award is determined using the Black-Scholes method as of each
balance sheet date, and is being expensed over its respective period of service
to be provided. The fair value of the restricted stock award is being expensed
at the fair value per share as of each balance sheet date, or $11.26 per share
over its respective period of service to be provided. As of December 31, 2007,
the cumulative expense recognized for these grants totaled
$134,039.




A summary of the Company’s restricted
stock activity for 2007 is as follows:


Number
      of RestrcitedStock
      AwardsNon-Vested
      at December 31, 2006
              225,000Granted
              373,000Vested
              (75,350)Canceled
              (25,000)Non-Vested
      at December 31, 2007
              497,650


The Company began issuing restricted
stock in 2006. During 2006, the Company granted 225,000 shares of restricted
stock to certain officers and employees at an average fair value per share at
date of grant of $7.06 per share. During 2007, the Company granted a total of
373,000 shares of restricted stock at various times to certain outside
directors, officers, employees and non-employee consultants. The fair value of
the restricted stock awards are being expensed at the fair value per share at
date of grant as follows; (i) 26,500 shares of restricted stock at $11.10 per
share, (ii) 287,000 shares of restricted stock at $9.87, (iii) 10,000 shares of
restricted stock at $13.47 per share, and (iv) 49,500 shares of restricted stock
at $15.30 per share. As of December 31, 2007, an aggregate of 598,000 shares of
restricted stock have been issued, of which, 75,350 have vested and 25,000 have
been canceled. As of December 31, 2006, 225,000 shares of restricted stock had
been issued, of which none had vested or been forfeited.




For
periods prior to January 1, 2006, the Company recorded compensation expense for
employee stock options based upon their intrinsic value on the date of grant
pursuant to APB No. 25, Accounting for Stock Issued to
Employees. Since the exercise price for such options was equal to the
fair market value of the Company’s stock at the date of grant, the stock options
had no intrinsic value upon grant and, therefore, no expense was recorded in the
consolidated statements of operations.




Pursuant
to SFAS No. 123(R), had the compensation cost of the Company’s share-based
payments been determined in accordance with SFAS No. 123, the Company’s pro
forma net income and net income per share for the year ended December 31, 2005
would have been:






63
 Table of Contents




Year
      Ended December 31, 2005Net
      Income as reported
              
              $
              2,293,107Add
      share-based payment compensation expense included in reported net income
      (loss), net of tax
              
              $
              -Deduct
      total share-based payment compensation expense determined
      under  fair-value-based method, net of tax
              
              $
              (8,565,701
              )Net
      loss – pro forma
              
              $
              (6,272,594
              )Basic
      and diluted net income per common share-as reported
              
              $
              0.05Basic
      and diluted net loss per common share-pro forma
              
              $
              (0.13
              )




Under the
modified prospective method, SFAS No. 123(R) applies to new awards and to awards
outstanding on the effective date that are subsequently modified or cancelled.
Compensation expense for outstanding awards for which the requisite service had
not been rendered as of December 31, 2005 is recognized over the remaining
service period using the compensation cost calculated for pro forma disclosure
purposes under SFAS No. 123. Prior to the adoption of SFAS No. 123(R), the
Company valued graded vesting awards based on the entire award for purposes of
pro forma disclosure. The Company has elected to continue valuing awards with
graded vesting, based on the value of the entire award. The Company allocates
the fair value of all awards on a straight-line basis over the vesting period.
Cumulative compensation expense recognized at any date will at least equal the
grant date fair value of the vested portion of the award at that
time.





The
Company estimates the fair value of share-based payments using the Black-Scholes
option-pricing model. The Company believes that this valuation technique and the
approach utilized to develop the underlying assumptions are appropriate in
estimating the fair value of the Company’s share-based payments granted during
the years ended December 31, 2007 and 2006. Estimates of fair value are not
intended to predict actual future events or the value ultimately realized by the
employees who receive equity awards.





The per
share weighted average fair value of share-based payments granted during the
years ended December 31, 2007, 2006 and 2005 was $7.79, $4.32 and $4.52,
respectively. In addition to the exercise and grant date prices of the awards,
certain weighted average assumptions that were used to estimate the fair value
of share-based payment grants in the respective periods are listed in the table
below:





Years
      ended December 31,2007
              2006
              2005Expected
      dividend yield
              0%
              0%
              0%Expected
      volatility
              54
      - 57%
              57
      - 60%
              61
      – 65%Risk-free
      interest rate
              3.4
      -5.0%
              4.4
      – 5.1%
              3.7
      – 4.6%Expected
      term (years)
              6
              6
              6Discount
      for post-vesting restrictions
              N/A
              N/A
              N/A


Options
granted to officers, employees and directors during fiscal 2007 have exercise
prices equal to the fair market value of the stock on the date of grant, a
contractual term of ten years, and a vesting period of three years. The Company
adjusts share-based compensation expense on a quarterly basis for changes to its
estimate of expected forfeitures based on its review of recent forfeiture
activity and expected future employee turnover.  The Company’s
expected forfeiture rates were estimated for three groups; officers, employees
and directors. Based on each respective group’s historical vesting experience
and expected trends, the estimated forfeiture rate for officers, employees and
directors was 11%, 24% and 9%, respectively.






64
 Table of Contents




Options
granted to officers, employees and directors during fiscal 2006 have exercise
prices equal to the fair market value of the stock on the date of grant, a
contractual term of ten years, and a vesting period of three
years.  Based on each respective group’s historical vesting experience
and expected trends, the estimated forfeiture rate for officers, employees and
directors, as adjusted, was 11%, 24% and 9%, respectively. All options granted
through December 31, 2005 had exercise prices equal to the fair market value of
the stock on the date of grant, a contractual term of ten years, generally a
vesting period of three years and an estimated forfeiture rate of ranging from
5% - 15%.





Options
granted to non-employee consultants have exercise prices equal to the fair
market value of the stock on the date of grant and contractual term of ten
years. Restricted stock awards granted to non-employee consultants have a
contractual term equal to the lapse of restriction(s) of each specific award.
Vesting periods for both options granted and restricted stock awarded to
non-employee consultants range from one month to three years depending on the
respective service requirements.





The
Company estimates expected volatility based primarily on historical daily
volatility of the Company’s stock and other factors, if applicable. The
risk-free interest rate is based on the United States treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued after December 31, 2005 was determined
using the “simplified method” prescribed in SEC Staff Accounting Bulletin
(“SAB”) No. 107.





As of
December 31, 2007, there was approximately $15,234,191 of total unrecognized
compensation cost related to the Company’s unvested stock options and restricted
stock awards granted under the Company’s stock plans. The unrecognized
compensation cost is expected to be recognized over a weighted-average period of
1.85 years.




As of
December 31, 2007, the Company has 12,021,550 shares of common stock reserved
for issuance upon the exercise of options and restricted stock.




(9)
Litigation Settlement Charges





In
January 2007, we resolved claims brought against us by two former shareholders
of IP Metrics, Inc. (“IP Metrics”). When we purchased IP Metrics in July 2002,
part of the contractual consideration was payments to be made in 2003 and 2004
to the former IP Metrics shareholders based on sales of IP Metrics products,
and/or payments to be made if certain events occurred. We made payments to all
four former shareholders in 2003 and 2004. Two of the former shareholders
alleged that they were entitled to additional payments based on the alleged
occurrence of certain contingent events and they brought an action against us.
This action was resolved in January 2007 without any admission of liability, by
the payment of an additional $0.8 million to the two former shareholders. This
amount was recorded as an operating expense as of December 31, 2006. All claims
in the lawsuit have now been dismissed.





(10)
Commitments and Contingencies





The
Company has an operating lease covering its primary office facility that expires
in February 2012. The Company also has several operating leases related to
offices in foreign countries.  The expiration dates for these leases
range from 2007 through 2015. The following is a schedule of future minimum
lease payments for all operating leases as of December 31,
2007:




Year ending December
      31,2008
              
              $
              2,265,0492009
              
              
              2,093,7372010
              
              
              1,654,5982011
              
              
              1,394,3652012
              
              
              376,883Thereafter
              
              
              419,133$
              8,203,765
   65
 Table of Contents


These
leases require the Company to pay its proportionate share of real estate taxes
and other common charges.  Total rent expense for operating leases was
$2,177,927, $1,945,991, and $1,461,051 for the years ended December 31, 2007,
2006 and 2005, respectively.





The
Company typically provides its customers a warranty on its software products for
a period of no more than 90 days. Such warranties are accounted for in
accordance with SFAS No. 5, Accounting for Contingencies.
To date, the Company has not incurred any costs related to warranty
obligations.





Under the
terms of substantially all of its software license agreements, the Company has
agreed to indemnify its customers for all costs and damages arising from claims
against such customers based on, among other things, allegations that the
Company’s software infringes the intellectual property rights of a third party.
In most cases, in the event of an infringement claim, the Company retains the
right to (i) procure for the customer the right to continue using the software;
(ii) replace or modify the software to eliminate the infringement while
providing substantially equivalent functionality; or (iii) if neither (i) nor
(ii) can be reasonably achieved, the Company may terminate the license agreement
and refund to the customer a pro-rata portion of the license fee paid to the
Company.  Such indemnification provisions are accounted for in
accordance with SFAS No. 5. As of December 31, 2007, there are no claims
outstanding under such indemnification provisions.





The
Company is subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, the Company believes that
such matters will not have a material adverse effect on its financial condition
or liquidity. The Company expenses legal costs related to contingencies when
incurred.





In
November 2005, the Company entered into a second Amended and Restated Employment
Agreement (“Amended Employment Agreement”) with ReiJane Huai. Pursuant to the
Amended Employment Agreement, the Company agreed to employ Mr. Huai as President
and Chief Executive Officer of the Company until December 31, 2007, at an annual
salary of $275,000. The Amended Employment Agreement also provides for the
payment of annual bonuses to Mr. Huai based on the Company’s operating income
(as defined in the employment agreement) and for certain other contingent
benefits set forth in the Amended Employment Agreement.





On
December 31, 2007, the Company entered into an Employment Agreement (“Employment
Agreement”) with ReiJane Huai. Pursuant to the Employment Agreement, the Company
agreed to employ Mr. Huai as President and Chief Executive Officer of the
Company effective January 1, 2008 through December 31, 2010, at annual salaries
of $310,000, $341,000 and $375,100 for calendar years 2008, 2009 and 2010,
respectively. The Employment Agreement also provides for the payment of annual
bonuses to Mr. Huai, in the form of shares of the Company’s restricted stock,
based on the Company’s operating income (as defined in the Employment Agreement)
and for certain other contingent benefits set forth in the Employment
Agreement.





On
December 1, 2005, the Company adopted the 2005 FalconStor Software, Inc., Key
Executive Severance Protection Plan, as amended (“Severance Plan”). Pursuant to
the Severance Plan, the Company’s Chief Executive Officer, Chief Financial
Officer and certain other key executives are entitled to receive certain
contingent benefits, as set forth in the Severance Plan, including lump sum
payments and acceleration of stock option vesting, each in certain
circumstances.





(11)
Employee Benefit Plans





Defined
Contribution Plan





Effective
July 2002, the Company established a voluntary savings and defined contribution
plan (the “Plan”) under Section 401(k) of the Internal Revenue Code. This Plan
covers all U.S. employees meeting certain eligibility requirements and allows
participants to contribute a portion of their annual compensation. Employees are
100% vested in their own contributions. For the years ended December 31, 2007,
2006 and 2005, the Company did not make any contributions to the
Plan.





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Defined
Benefit Plan





The
Company has a defined benefit plan covering employees in Taiwan. On December 31,
2006, the Company adopted the provisions of SFAS No. 158, which required the
Company to recognize the funded status of its defined benefit plan in the
accompanying consolidated balance sheet at December 31, 2006, with the
corresponding adjustment to accumulated other comprehensive income, net of tax.
Therefore, as a result of adopting the provisions of SFAS No. 158, the Company
increased other non-current liabilities and accumulated other comprehensive
income by $87,482 as of December 31, 2006.





At
December 31, 2007 and 2006, $203,407 and $87,482, respectively, is included in
accumulated other comprehensive income for amounts that have not yet been
recognized in net periodic pension cost. These amounts include the following:
unrecognized transition obligation of $57,985 and $63,120 at December 31, 2007
and 2006, respectively, and unrecognized actuarial losses of $145,422 and
$24,362 at December 31, 2007 and 2006, respectively. During 2007, the total
amount recorded in other comprehensive income related to the pension plan was
$115,925 (net of tax), which consisted of an actuarial loss of $121,138 and the
recognition of $5,213 of transition obligations recognized during 2007 as a
component of net periodic pension cost.  The transition obligation and
actuarial loss included in accumulated other comprehensive loss and expected to
be recognized in net periodic pension cost for the year ended December 31, 2008,
is $5,213 and $8,897, respectively.




Pension
information for the years ended December 31, 2007 and 2006, is as
follows:




2007
              
              
              2006Accumulated
      benefit obligation
              
              $
              132,231
              
              
              $
              108,418Changes
      in projected benefit obligation:Projected
      benefit obligation at beginning of year
              
              
              157,122
              
              
              
              120,457Interest
      cost
              
              
              4,282
              
              
              
              4,216Actuarial
      (gain)/loss
              
              
              119,971
              
              
              
              31,320Benefits
      paid
              
              
              -
              
              
              
              -Service
      cost
              
              
              1,570
              
              
              
              1,129Currency
      translation and other
              
              
              1,741
              
              
              
              -Projected
      benefit obligation at end of year
              
              $
              284,686
              
              
              $
              157,122Changes
      in plan assets:Fair
      value of plan assets at beginning of year
              
              
              19,571
              
              
              
              5,780Actual
      return on plan assets
              
              
              329
              
              
              
              28Benefits
      paid
              
              
              -
              
              
              
              -Employer
      contributions
              
              
              13,495
              
              
              
              13,763Currency
      translation and other
              
              
              197
              
              
              
              -Fair
      value of plan assets at end of year
              
              $
              33,592
              
              
              $
              19,571Funded
      status
              
              $
              251,094
              
              
              $
              137,551Components
      of net periodic pension cost:Interest
      cost
              
              $
              4,282
              
              
              $
              4,253Expected
      return on plan assets
              
              
              (533
              )
              
              
              204Amortization
      of net loss
              
              
              5,947
              
              
              
              5,306Service
      cost
              
              
              1,570
              
              
              
              1,139Net
      periodic pension cost
              
              $
              11,266
              
              
              $
              10,902








67
 Table of Contents





The
company makes contributions to the plan so that minimum contribution
requirements, as determined by government regulations, are met. Company
contributions of approximately $14,000 are expected to be made during 2008.
Benefit payments of approximately $190,000 are expected to be paid in 2013
through 2017.





The
Company utilized the following assumptions in computing the benefit obligation
at December 31, 2007 and 2006 as follows:




December
      31, 2007
              December
      31, 2006Discount
      Rate
              2.75%
              2.75%Rate
      of increase in compensation levels
              4.37%
              2.00%Expected
      long-term rate of return on plan assets
              2.75%
              2.75%




(12)
Segment Reporting and Concentrations





The
Company is organized in a single operating segment for purposes of making
operating decisions and assessing performance. Revenues from the United States
to customers in the following geographical areas for the years ended December
31, 2007, 2006 and 2005, and the location of long-lived assets as of December
31, 2007, 2006 and 2005, are summarized as follows:





2007
            
            
            2006
            
            
            2005Revenues:United
      States
            
            $
            51,078,007
            
            
            $
            37,461,247
            
            
            $
            28,300,822Asia
            
            
            12,329,395
            
            
            
            8,352,382
            
            
            
            6,535,128Other
      international
            
            
            13,991,820
            
            
            
            9,252,399
            
            
            
            6,128,153Total
      revenues
            
            $
            77,399,222
            
            
            $
            55,066,028
            
            
            $
            40,964,103Long-lived
      assets (includes all non-current assets):United
      States
            
            $
            18,483,890
            
            
            $
            10,113,633
            
            
            $
            9,716,031Asia
            
            
            1,720,098
            
            
            
            1,498,534
            
            
            
            1,320,865Other
      international
            
            
            499,632
            
            
            
            279,695
            
            
            
            207,098Total
      long-lived assets
            
            $
            20,703,620
            
            
            $
            11,891,862
            
            
            $
            11,243,994





For the
year ended December 31, 2007, the Company had two customers that together
accounted for a total of 38% of revenues. For the year ended December 31, 2006,
the Company had one customer that accounted for a total of 27% of revenues. For
the year ended December 31, 2005, the Company had two customers that together
accounted for a total of 31% of revenues. As of December 31, 2007, the Company
had one customer with an accounts receivable balance greater than 10%, which
totaled 17% of the gross accounts receivable balance. As of December 31, 2006,
the Company had one customer with an accounts receivable balance greater than
10% of gross accounts receivable, which represented 21% of the gross accounts
receivable balance.







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(13)
Valuation and Qualifying Accounts – Allowance for Returns and Doubtful
Accounts




Period
      Ended
              
              Balance
      at
                  Beginning
      of
                  Period
              
              
              Additions
      charged
                  to
      Expense
              
              
              Deductions
              
              
              Balance
      at
                  End
      of
                  PeriodDecember
      31, 2007
              
              $
              6,016,298
              
              
              $
              5,041,216
              
              
              $
              2,276,634
              
              
              $
              8,780,880December
      31, 2006
              
              $
              3,846,882
              
              
              $
              4,765,148
              
              
              $
              2,595,732
              
              
              $
              6,016,298December
      31, 2005
              
              $
              2,551,616
              
              
              $
              4,340,102
              
              
              $
              3,044,836
              
              
              $
              3,846,882




(14)
Quarterly Financial Data (Unaudited)




The
following is a summary of selected quarterly financial data for the years ended
December 31, 2007 and 2006:




Fiscal
      QuarterFirst
              
              
              Second
              
              
              Third
              
              
              Fourth2007Revenue
              
              $
              16,340,678
              
              
              $
              17,750,544
              
              
              $
              18,527,537
              
              
              $
              24,780,463Net
      income (loss)
              
              $
              (554,575
              )
              
              $
              1,379,568
              
              
              $
              6,260,286
              
              
              $
              5,656,577Basic
      net income (loss) per share
              
              $
              (0.01
              )
              
              $
              0.03
              
              
              $
              0.13
              
              
              $
              0.11Diluted
      net income (loss) per share
              
              $
              (0.01
              )
              
              $
              0.03
              
              
              $
              0.12
              
              
              $
              0.10Basic
      weighted average common shares outstanding
              
              
              48,594,410
              
              
              
              49,378,812
              
              
              
              49,686,430
              
              
              
              50,005,315Diluted
      weighted average common shares outstanding
              
              
              48,594,410
              
              
              
              53,007,181
              
              
              
              53,482,577
              
              
              
              54,283,3862006Revenue
              
              $
              9,208,320
              
              
              $
              12,668,227
              
              
              $
              12,966,111
              
              
              $
              20,223,370Net
      income (loss)
              
              $
              (3,636,886
              )
              
              $
              (1,304,795
              )
              
              $
              (1,258,371
              )
              
              $
              2,825,524Basic
      net income (loss) per share
              
              $
              (0.08
              )
              
              $
              (0.03
              )
              
              $
              (0.03
              )
              
              $
              0.06Diluted
      net income (loss) per share
              
              $
              (0.08
              )
              
              $
              (0.03
              )
              
              $
              (0.03
              )
              
              $
              0.06Basic
      weighted average common shares outstanding
              
              
              48,006,309
              
              
              
              48,047,291
              
              
              
              47,990,558
              
              
              
              48,134,809Diluted
      weighted average common shares outstanding
              
              
              48,006,309
              
              
              
              48,047,291
              
              
              
              47,990,558
              
              
              
              50,370,514




The sum
of the quarterly net loss per share amounts do not necessarily equal the annual
amount reported, as per share amounts are computed independently for each
quarter and the annual period based on the weighted average common shares
outstanding in each period.






69
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Item9.        Changes in and
Disagreements with Accountants on Accounting and Financial
Disclosure




None.





Item9A.     Controls
and Procedures




Disclosure Controls and
Procedures


The
Company maintains “disclosure controls and procedures,” as such term is defined
in Rules 13a-15e and 15d-15e of the Securities and Exchange Act of 1934, as
amended (the “Exchange Act”), that are designed to ensure that information
required to be disclosed in its reports, pursuant to the Exchange Act, is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms, and that such information is accumulated and
communicated to its management, including its Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding the
required disclosures. In designing and evaluating the disclosure controls and
procedures, management has recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurances of
achieving the desired control objectives, and management necessarily is required
to apply its judgment in evaluating the cost benefit relationship of possible
controls and procedures.





The
Company’s Chief Executive Officer (its principal executive officer) and Chief
Financial Officer (its principal finance officer and principal accounting
officer) have evaluated the effectiveness of its “disclosure controls and
procedures” as of the end of the period covered by this Annual Report on Form
10-K. Based on their evaluation, the principal executive officer and principal
financial officer concluded that its disclosure controls and procedures are
effective.





Internal Control Over
Financial Reporting





Management’s Report on
Internal Control Over Financial Reporting





The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting for the Company; as such term is
defined in Rules 13a-15(f). To evaluate the effectiveness of the Company’s
internal control over financial reporting, the Company’s management uses the
Integrated Framework adopted by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”).





The
Company’s management has assessed the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2007, using the COSO
framework. The Company’s management has determined that the Company’s internal
control over financial reporting is effective as of that date.








Item9B.     Other
Information




Not applicable.








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PART
      III


Item10.
              Directors,
      Executive Officers and Corporate
  Governance


Information
      called for by Part III, Item 10, regarding the Registrant’s directors will
      be included in our Proxy Statement relating to our annual meeting of
      stockholders scheduled to be held in May 2008, and is incorporated herein
      by reference. The information appears in the Proxy Statement under the
      captions “Election of Directors”, “Management”, “Executive Compensation”,
      “Section 16 (a) Beneficial Ownership Reporting Compliance”, and
      “Committees of the Board of Directors.” The Proxy Statement will be filed
      within 120 days of December 31, 2007, our
  year-end.


Item11.
                Executive
      Compensation


Information
      called for by Part III, Item 11, will be included in our Proxy Statement
      relating to our annual meeting of stockholders scheduled to be held in May
      2008, and is incorporated herein by reference. The information appears in
      the Proxy Statement under the captions “Executive Compensation”, “Director
      Compensation”, “Compensation Committee Interlocks and Insider
      Participation”, Compensation Committee Report” and “Committees of the
      Board of Directors.” The Proxy Statement will be filed within 120 days of
      December 31, 2007, our year-end.
 Item12.
                  Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters


Information
      regarding Securities Authorized for Issuance Under Equity Compensation
      Plans is included in Item 5 and is incorporated herein by reference. All
      other information called for by Part III, Item 12, will be included in our
      Proxy Statement relating to our annual meeting of stockholders scheduled
      to be held in May 2008, and is incorporated herein by reference. The
      information appears in the Proxy Statement under the caption “Beneficial
      Ownership of Shares.” The Proxy Statement will be filed within 120 days of
      December 31, 2007, our year-end.


Item13.
              Certain
      Relationships and Related Transactions, and Director
      Independence


Information
      regarding our relationships and related transactions will be included in
      our Proxy Statement relating to our annual meeting of stockholders
      scheduled to be held in May 2008, and is incorporated by reference. The
      information appears in the Proxy Statement under the caption “Certain
      Relationships and Related Transactions.” The Proxy Statement will be filed
      within 120 days of December 31, 2007, our
  year-end.


Item14.
              Principal
      Accountant Fees and
Services


Information
      called for by Part III, Item 14, will be included in our Proxy Statement
      relating to our annual meeting of stockholders scheduled to be held in May
      2008, and is incorporated herein by reference. The information appears in
      the Proxy Statement under the caption “Principal Accountant Fees and
      Services.” The Proxy Statement will be filed within 120 days of December
      31, 2007, our year-end.











71
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PART
      IV







Item15.    Exhibits, Financial Statement
Schedules




The
information required by subsections (a)(1) and (a)(2) of this item are included
in the response to Item 8 of Part II of this annual report on Form
10-K.





(b)
            Exhibits





2.1
            Agreement
      and Plan of Merger and Reorganization, dated as of May 4, 2001, among
      FalconStor, Inc., Network Peripherals Inc., and Empire Acquisition Corp,
      incorporated herein by reference to Annex A to the Registrant’s joint
      proxy/prospectus on Form S-4, filed May 11,
  2001.





3.1
            Restated
      Certificate of Incorporation, incorporated herein by reference to Exhibit
      3.1 to the Registrant’s registration statement on Form S-1 (File no.
      33-79350), filed on April 28, 1994.





3.2
            Bylaws,
      incorporated herein by reference to Exhibit 3.2 to the Registrant’s
      quarterly report on form 10-Q for the period ended March 31, 2000, filed
      on May 10, 2000.





3.3
            Certificate
      of Amendment to the Certificate of Incorporation, incorporated herein by
      reference to Exhibit 3.3 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 1998, filed on March 22,
    1999.





3.4
            Certificate
      of Amendment to the Certificate of Incorporation, incorporated herein by
      reference to Exhibit 3.4 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 2001, filed on March 27,
    2002.







3.5
            Amendment
      to By-Laws of FalconStor Software, Inc., dated August 6, 2007,
      incorporated herein by reference to Exhibit 3.1 to the Registrant’s
      quarterly report on Form 10-Q for the period ended June 30, 2007, filed on
      August 8, 2007.





4.1
            2000
      Stock Option Plan, incorporated herein by reference to Exhibit 4.1 of the
      Registrant’s registration statement on Form S-8, filed on September
      21, 2001.





4.2
            2000
      Stock Option Plan, as amended May 15, 2003, incorporated herein by
      reference to Exhibit 99 to the Registrant’s quarterly report on Form 10-Q
      for the period ended June 30, 2003, filed on August 14,
    2003.





4.3
            2000
      Stock Option Plan, as amended May 14, 2004, incorporated herein by
      reference to Exhibit 4.3 to the Registrant’s Annual Report on Form 10-K
      for the year ended December 31, 2004, filed on March 16,
    2005.





4.4
            1994
      Outside Directors Stock Plan, as amended May 17, 2002 incorporated herein
      by reference to Exhibit 4.2 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 2002, filed on March 17,
    2003.




4.5
            2004
      Outside Directors Stock Option Plan, incorporated herein by reference to
      Exhibit 4.5 to the Registrant’s Annual Report on Form 10-K for the year
      ended December 31, 2004, filed on March 16,
  2005.




4.6
            Amended
      and Restated 2006 Incentive Stock Plan incorporated herein by reference to
      Exhibit 4.1 to the Registrant’s quarterly report on Form 10-Q for the
      quarter ended March 31, 2007 , filed on May 9,
  2007.






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4.7
            2007
      Outside Directors Equity Compensation Plan incorporated herein by
      reference to Exhibit 4.2 to the Registrant’s quarterly report on Form 10-Q
      for the quarter ended March 31, 2007, filed on May 9,
  2007.




10.1
              dated August 2003, incorporated herein by reference to
      Exhibit 99.1 to the Registrant’s quarterly report on Form 10-Q for the
      period ended September 30, 2003, filed on November 14,
  2003.


10.2
            Employment
      Agreement dated December 31, 2007 between Registrant and ReiJane Huai,
      incorporated herein by reference to Exhibit 10.1 to the Registrant’s
      Current Report on Form 8-K, dated December 31,
  2007.





10.3
            FalconStor
      Software, Inc., 2005 Key Executive Severance Protection Plan, as amended
      August 6, 2007, incorporated herein by reference to Exhibit 10.2 to
      Registrant’s quarterly report on Form 10-Q for the period ended June 30,
      2007, filed on August 8, 2007.





10.4
            Amended
      and Restated FalconStor Software, Inc., 2005 Key Executive Severance
      Protection Plan, incorporated herein by reference to Exhibit 10.3 to
      Registrant’s annual report on Form 10-K for the year ended December 31,
      2005, filed on March 15, 2006.





21.1
            Subsidiaries
      of Registrant – FalconStor, Inc., FalconStor AC, Inc., FalconStor Software
      (Korea), Inc.





23.1
            *Consent
      of KPMG LLP





31.1
            *Certification
      of the Chief Executive Officer





31.2
            *Certification
      of the Chief Financial Officer





32.1
            *Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 (18 U.S.C. § 1350)





32.2
            *Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 (18 U.S.C. § 1350)





*- filed herewith.





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 Table of Contents










SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized in Melville, State of New York on March 12, 2008.





FALCONSTOR
SOFTWARE, INC.





By:
              /s/
      ReiJane Huai
              
              Date:       March
      12, 2008ReiJane
      Huai, President, Chief  Executive
                Officer
      of FalconStor Software, Inc.





POWER
OF ATTORNEY




FalconStor Software, Inc. and each of
the undersigned do hereby appoint ReiJane Huai and James Weber, and each of them
severally, its or his true and lawful attorney to execute on behalf of
FalconStor Software, Inc. and the undersigned any and all amendments to this
Annual Report on Form 10-K and to file the same with all exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission; each of such attorneys shall have the power to act hereunder with or
without the other.





Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
date indicated.





By:
              /s/
      ReiJane Huai
              
              March
      12, 2008ReiJane
      Huai, President, Chief Executive Officer and Chairman of the Board
      (Principal Executive Officer)
              
              DateBy:
              /s/
      James Weber
              
              March
      12, 2008James
      Weber, Chief Financial Officer, Vice President and Treasurer (Principal
      Financial Officer and Principal Accounting Officer)
              
              DateBy:
              /s/
      Steven L. Bock
              
              March
      12, 2008Steven
      L. Bock, Director
              
              DateBy:
              /s/
      Patrick B. Carney
              
              March
      12, 2008Patrick
      B. Carney, Director
              
              DateBy:
              /s/
      Lawrence S. Dolin
              
              March
      12, 2008Lawrence
      S. Dolin, Director
              
              DateBy:
              /s/
      Steven R. Fischer
              
              March
      12, 2008Steven
      R. Fischer, Director
              
              DateBy:
              /s/
      Alan W. Kaufman
              
              March
      12, 2008Alan
      W. Kaufman, Director
              
              Date





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