SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 FORM
10-K
 
 ý
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 For the
fiscal year ended December 31, 2008.
 
 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
                incorporation
      or organization)
              
              (I.R.S.
      Employer
                Identification
      No.)2
      Huntington Quadrangle, Suite 2S01
                Melville,
      New York
              
              11747(Address
      of principal executive offices)
              
              (Zip
      code)
 
 Registrant's
telephone number, including area code:  631-777-5188
 
 Securities registered pursuant to
Section 12(b) of the Act:Common Stock, $.001 par
value
 
 Securities registered pursuant to
Section 12(g) of the Act:None
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes  ̈   No
ý
 
 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  ̈   No
ý
 
 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 ý   No
 ̈
 
 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. ý
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition
of  “large accelerated filer”, “accelerated filer”, and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 
 Large
Accelerated Filer  ̈                                                               Accelerated
Filer ý
 Non-Accelerated
Filer  ̈                                                               Smaller
Reporting Company  ̈
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).     Yes  ̈   No
ý
  
  The
aggregate market value of Common Stock held by non-affiliates of the Registrant
as of June 30, 2008 was $270,018,477 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 25, 2009 was 51,975,442 and
44,963,392, 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
  FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
 
 2008
ANNUAL REPORT ON FORM 10-K
 
 TABLE
OF CONTENTS
 Page
 PART I.Item 1.
              Business
              4Item 1A.
              Risk Factors
              12Item 1B.
              Unresolved Staff Comments
              24Item 2.
              Properties
              24Item 3.
              Legal Proceedings
              24Item 4.
              Submission of Matters to a Vote of Security
      Holders
              24PART II.Item 5.
              Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
              24Item 6.
              Selected Financial Data
              27Item 7.
              Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
              29Item 7A.
              Qualitative and Quantitative Disclosures About Market
      Risk
              46Item 8.
              Financial Statements and Supplementary
    Data
              46Item 9.
              Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure78Item 9A.
              Controls and Procedures
              78Item 9B.
              Other Information
              78PART III.Item 10.
              Directors, Executive Officers and Corporate
      Governance
              79Item 11.
              Executive Compensation
              79Item 12.
              Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
              79Item 13.
              Certain Relationships and Related Transactions, and
      Director Independence
              79Item 14.
              Principal Accountant Fees and Services
              79PART IV.Item 15.
              Exhibits and Financial Statement
    Schedules
              80SIGNATURES
              
              82




3


PART I




Item 1.
              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 data protection solutions, built upon the award-winning
IPStor®virtualization platform, include the industry leading Virtual Tape
Library (VTL) with data deduplication for backup optimization, Continuous Data
Protector (CDP) for fast data recovery, Network Storage Server
(NSS)  for storage virtualization and provisioning, and the File
Interface Deduplication System (FDS) for capacity optimized storage solutions.
All of our solutions are enabled with WAN-optimized replication options for
cost-effective 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 with optimal
return on investment (ROI).
 
 The FalconStor storage virtualization
and data protection solutions are 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.
FalconStor solutions are engineered to integrate and to work seamlessly with
database, email and file systems, and with business applications. The
application level integration allows for maintaining space-efficient redundant
sets of active data that are generated with complete transactional and
point-in-time integrity.  FalconStor solutions enhance business
productivity by eliminating the need for the time-consuming consistency checks
and data rebuilds that traditionally create long periods of downtime during a
recovery process.
 
 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 data
migration. Companies benefit from lower administrative overheard, elimination of
storage over-provisioning, massive 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 Fibre Channel over Ethernet) 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 propositions of
FalconStor’s proven, cutting-edge technology multiple partners utilize
FalconStor’s innovative software products – including CDP, VTL and NSS to power
their storage appliances and their bundled solutions.  FalconStor’s
products have been certified by such industry leaders as 3Par, Acer, Adaptec,
Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Citrix,
Compellent, COPAN Systems, Dell, H3C, Hitachi Data Systems, Huawei, IBM,
Intel,  Lanchao, LSI Logic, Microsoft, NEC, Nexsan, Novell, NS
Solutions Corporation, Oracle, Pillar Data Systems, QLogic, Spectra Logic, Sun
Microsystems, Symantec, Virtual Iron, Voltaire, VMware, and
Xiotech.
 
 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
released new solutions powered by FalconStor products and have pursued 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 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
  PRODUCTS
AND TECHNOLOGY
 
 FalconStor’s products and solutions are
built on IPStor, common 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 deduplication, CDP, NSS and FDS. A WAN-optimized
replication option enables all FalconStor products for cost-effective disaster
recovery and remote/branch office protection. FalconStor solutions share several
key technologies that foster seamless integration and offer a competitive
edge.
 
 One independent, TOTALLY Open data
protection platform - FalconStor solutions provide complete independence
to choose any storage or connectivity, delivering comprehensive data protection
across the enterprise, and scaling from the data center to the remote office or
single user desktop.
 
 Integrated - FalconStor
solutions are built on a common platform, eliminating the compatibility and
integration issues typically found with “bolted together” solutions created from
disparate products with different development histories.  In addition,
FalconStor solutions are built to seamlessly integrate within customers’
environments to provide a high level of data services and protection to business
applications.
 
 Optimized - FalconStor
solutions are designed to optimize performance and capacity utilization, making
use of the latest advances in storage networking speed and technologies such as
thin provisioning and deduplication. Application-specific tools optimize
protection of key enterprise applications. Protection is enhanced even as costs
are reduced.
 
 Available - FalconStor
solutions are built to provide the best in data protection, recovery, and
persistent data accessibility.  FalconStor delivers data protection
with complete transactional integrity for fast and reliable
recovery.  FalconStor solutions are deployed in high availability
models, with built-in failover capabilities.
 
 FalconStor’s
data protection solutions address the full spectrum of data protection business
challenges, 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% per 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 or FalconStor FDS, depending on customers’
environments. 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 that arise from the explosive storage growth,
customers use the FalconStor NSS to virtualize, to provision, and to protect
their data.  And for protecting remote office data from disasters,
FalconStor has built a highly efficient replication solution that integrates
with VTL, CDP, NSS, and FDS. Because all of these solutions are built from a
single technology platform, deployment is simplified and businesses benefit from
the peace of mind knowing that FalconStor solutions work together in an easily
managed and a highly efficient fashion, with high data availability and rapid
recovery always paramount.
 
 Deployment
options
 
 FalconStor
sells its solutions as standalone software or as software pre-installed on
FalconStor-supplied hardware appliances, or as virtual appliances.
 
 Software
Products
 
 FalconStor
offers a wide range of data protection and storage virtualization
solutions:
 
 ·
              Tape
      Backup Optimization – FalconStor
VTL
 
 ·
              Local
      and Remote Data Recovery – FalconStor
CDP
 
 ·
              Storage
      Virtualization, Provisioning, and Management – FalconStor
    NSS
 
 ·
              Data
      Deduplication for Capacity Optimized Storage – FalconStor
    FDS
  5
  FalconStor
provides data protection services at all levels from operating systems and
application software, to files, databases, and messaging data, across the entire
organization.  Our products are extremely scalable, allowing
FalconStor solutions to address the needs of small/medium businesses, large
organizations, and global enterprises. Our solutions offer high availability
(HA) through RAID, synchronous and asynchronous mirroring, HA failover, and
clustering technologies.
 
 Network
Storage Server (NSS)
 
 FalconStor
Network Storage Server (NSS) integrates storage virtualization and provisioning
across multiple disk arrays and connection protocols for an easy-to-use,
scalable SAN solution. From a small iSCSI virtual server lab to an
enterprise-class Fibre Channel SAN running Tier-1 database applications,
FalconStor NSS is designed to meet all of the storage needs of any
organization.
 
 By
virtualizing storage on any disk arrays, FalconStor NSS provides the ability to
pool and tier disk assets, simplifying provisioning, reducing allocation errors,
and maximizing resource utilization. This allows IT organizations to avoid
over-provisioning of disk resources and to bring new servers and projects online
quickly and efficiently. FalconStor NSS incorporates a full set of
application-aware data protection services, including real-time synchronous
mirroring, volume snapshots and site-to-site WAN-optimized data replication, for
disaster recovery.
 
 Virtual
server environments are well served by virtualized
storage.  FalconStor NSS is designed to make it easy to create a new
disk resource to house virtual machine files, and disk resources are
re-allocated to different servers or shared among servers to facilitate virtual
machine high-availability operations that require shared disk. Specific
integration tools allow NSS to service virtual server environments in an optimal
manner providing rapid and effective recovery processes of a virtual machine or
entire virtual server farms.
 
 In
addition, FalconStor NSS enables and automates serverless backup
processes.  FalconStor backup server integration tools offload backup
processes from the server to the NSS repository, freeing up the application host
server and completely eliminating the backup window.
 
 The NSS
Virtual Appliance enables cost-effective server virtualization by converting
internal or external server storage resources into shared storage resources to
enable high availability options across virtual servers. The solution reduces
infrastructure cost and complexity while maximizing customers’ return on
investment. The FalconStor NSS Virtual Appliance brings all the benefits and
features of server and storage virtualization to the remote and branch offices
to reduce costs and to enable effective data protection and recovery solutions
across the enterprise.
 
 Virtual
Tape Library (VTL)
 
 FalconStor
Virtual Tape Library (VTL) is the industry’s leading virtual tape solution, and
we believe it is unmatched in terms of performance and
scalability.  With virtual tape, backups complete faster and more
reliably, with little or no change needed to the backup environment. It enhances
backup operations seamlessly without changing any backup processes or policies.
Sophisticated physical tape integration and data security complete the
solution.  Designed from the start as an enterprise-class application,
FalconStor VTL can achieve high backup speeds allowing users to solve the single
biggest issue in backup: meeting the backup window.
 
 Built-in
data deduplication significantly reduces the amount of data needed to be stored
on disk. By eliminating redundant backup data, the storage footprint can be
reduced by 95% or more, allowing organizations to keep weeks or even months
worth of data on disk, for fast, dependable restore, without any of the
reliability concerns of a tape-based restore.
 
 While
deduplication can eliminate or greatly reduce the need for physical tapes, many
organizations still require tape for long-term, off-site, or archival storage.
FalconStor VTL has the industry’s most sophisticated and the broadest
integration with physical tape libraries, allowing companies to export data
directly to physical tape, leveraging the speed of the VTL without impacting the
backup network.
 
 FalconStor
VTL also supports small and remote office environments through VTL storage
appliances and small footprint virtual appliances.
  6
  Continuous
Data Protector (CDP)
 
 FalconStor
Continuous Data Protector (CDP) technology reinvents the way data backup and
recovery are implemented and performed. Moving far beyond failure-prone
once-a-day tape backup models, FalconStor CDP combines local and remote
protection into a cost-effective, unified, disk-based solution that allows
organizations to recover data back to the most recent transaction. Combining
application-aware snapshots and continuous journaling functions, CDP enables
customers to recover data to any point in time.  The Recovery Point
Objective (RPO) shrinks to mere seconds.
 
 In
addition, FalconStor CDP software delivers fast, reliable recovery, bringing
business applications back online in a matter of minutes. Using a wealth of
sophisticated technologies — including application integration,
physical-to-virtual recovery, and WAN-optimized replication — entire systems can
be restored in under ten minutes. Lost files can be recovered in two minutes.
Data is protected in its native format, and is instantly accessible. With
FalconStor CDP, the Recovery Time Objective (RTO) changes from hours to minutes,
minimizing system downtime and economic impact.
 
 In
addition, FalconStor CDP enables and automates serverless backup
processes.  FalconStor backup server integration tools offload backup
processes from the server to the CDP repository, freeing up the application host
server and completely eliminating the backup window.
 
 The CDP Virtual Appliance is a
pre-configured, ready-to-run software application packaged 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
to the remote and branch office to enable comprehensive and effective data
protection and recovery solutions across the enterprise.
 
 File
Interface Deduplication System (FDS)
 
 In December 2008, FalconStor announced
the future availability of its new File Interface Deduplication System
(FDS).  This solution will allow FalconStor to extend its
deduplication technology to service a broader set of applications that goes
beyond tape backup applications.  FalconStor FDS allows companies to
optimize storage capacity services for disk-to-disk backup and archiving
applications.
 
 FalconStor FDS presents file interface
accessibility to a block level deduplication repository through common LAN-based
file access protocols such as CIFS and NFS.  Its deployment simplicity
easily extends FalconStor data deduplication technology across multiple
applications.  FalconStor FDS delivers global deduplication and is
enabled with a WAN-optimized replication option for cost effective DR
implementations.
 
 FalconStor FDS is also offered as a
Virtual Appliance, providing remote and branch offices as well as small
enterprises with an economical data deduplication solution.  The
Virtual Appliance deployment model can eliminate tape-based backup processes at
the remote office and the costs and risks associated with physical tape
shipments.
 
 Application-Aware
Snapshot Agents
 
 FalconStor Snapshot Agents automate and
minimize quiescence time during data replication, backup, and other
snapshot-based operations to ensure transactional integrity and point-in-time
consistency of Windows, Unix, Linux, and VMware systems, databases applications
and messaging stores for fast time-to-recovery.  Snapshot Agents are
available for IBM® DB2® UDB,
Informix®,
Microsoft® SQL
Server, Oracle®,  Prevasive.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 recover individual mailboxes quickly 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 recover a database quickly from point-in-time
snapshot images of their SQL database.
  7
  BUSINESS
STRATEGY
 
 FalconStor intends to maintain its
position as the only premier provider of 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-independent, unified architecture, and robust TOTALLY Open
data protection technology of its solution to maintain a leadership position in
the enterprise and SMB disk-based data protection software markets. The
disk-based data protection market is rapidly growing. Gartner forecasts the
total storage management software market will reach $13.1B by 2011, a 7.9%
CAGR.  In addition, Gartner forecasts that data replication software
for Disaster Recovery will reach $3.9B by 2011, an 11.8% CAGR. In a
user survey analysis by Gartner in North America in 2008, over 50% of the
respondents said they are committed to storage consolidation, and to optimizing
their backup processes, and half of those users are implementing disk to disk
backup and VTL.  In another user survey by Gartner, 54% of the U.S.
respondents expect to increase their storage budgets in 2009. But Gartner also
recommends that in order for storage vendors to be competitive, they need to
ramp up their efforts to provide excellent customer care by demonstrating their
products’ affordability and lower total cost of ownership (TCO). In 2009, as IT
directors of small and large enterprises alike move to reduce capital
expenditures and operating costs, to conserve energy, and to maximize return on
assets, they will investigate how to extend the use of their existing IT
infrastructure by deriving value from it in innovative ways. FalconStor is
poised to capitalize on this trend. FalconStor plans to continue its leadership
in this market through its deep commitment to research and development and
through continued rapid technology innovation. For information on our research
and development expenditures, please see “Management’s Discussion and Analysis
of Financial Condition and Results of Operations” and our audited consolidated
financial statements.
 
 Expand
Product Offerings
 
 In 2008, FalconStor continued
aggressively to develop its product portfolio. In May 2008, FalconStor announced
the general availability of FalconStor Storage Replication Adapter for VMware
Site Recovery Manager. This integration provides DR automation and heterogeneous
data replication for VMware infrastructure to VMware and FalconStor customers.
Also in May, FalconStor announced the availability of the FalconStor Virtual
Tape Library (VTL) OpenStorage Option for integration with the Veritas NetBackup
OpenStorage API from Symantec.  The FalconStor VTL OpenStorage Option, the
first qualified Fibre Channel OST option by Symantec, ensures business
continuity by speeding up and simplifying backup and recovery through
integration of intelligent disk devices to NetBackup using high-speed Fibre
Channel connections.
 
 In
September 2008, FalconStor announced the availability of the FalconStor NSS
Virtual Appliance and its qualification under the VMware Ready program. This
product enables cost-effective server virtualization by converting internal or
external server storage resources into shared storage resources to enable
high-availability options across virtual servers.  The introduction of
NSS as a virtual appliance complements the FalconStor offering for small
businesses and the remote and branch offices.  With this latest
addition to its Virtual Appliance portfolio, FalconStor now offers all its
products with a virtual appliance model.
 
 In addition, FalconStor has announced
the introduction of File Interface Deduplication System (FDS), a new product
offering that extends the FalconStor data deduplication technology to more
applications such as disk-to-disk backup and archiving
applications.  The product is scheduled to be available in the first
quarter of 2009 and should allow FalconStor to expand its position in the
Capacity Optimized Storage (COS) market.
 
 FalconStor also announced its expansion
in the Software as a Service (SaaS) market, collaborating with HiNet - the
Internet Service Provider (ISP) arm of Chunghwa Telecom (NYSE: CHT), Taiwan's
largest information and telecom service provider - to make online backup
services available to customers and small-and-medium-size businesses in
Taiwan.
 
 In an
effort to respond to market demand for easy to deploy storage solutions
FalconStor expanded its collaboration with China-based H3C Technologies to
distribute a high-performance line of storage appliances based on H3C hardware
and FalconStor software.  The offering was introduced to the European
market in October and is aimed at the mid-size enterprise market.
  8
  Expand
Corporate Visibility
 
 Throughout 2008, FalconStor took
significant steps to increase its market presence and awareness. First, we
expanded on a successful advertising campaign featuring customer testimonials
for each of our product lines, as well as taking additional steps to increase
our online presence in the form of banner ads on key media and industry
community sites.  In addition, we added an updated look and feel, a
more user-friendly navigation, and additional resources to our website to make
information more readily available to our customers and partners.
 
 Second, through the release of new
products, strategic relationships, and customer wins, we continued to increase
our engagement with the press, analyst and blogging communities to create
awareness of and credibility for our TOTALLY Open data protection message. We
have stepped up our participation in online conversations both with our own
FalconStor expert bloggers and by monitoring and commenting on other
blogs.  This broad effort has led to several awards and
accolades:
 
 ·
              Business
      Solutions Magazine names FalconStor among the Best Channel Vendors for
      storage in 2009
 ·
              FalconStor
      NSS was named a finalist in Storage Magazine’s 2008 Products of the Year
      Award
 ·
              FalconStor
      Software's VP of Sales Wendy Petty was named one of the most powerful
      women in the channel by VARBusiness
 ·
              FalconStor
      was a Leader in the Forrester WaveTM: Enterprise Open Systems Virtual Tape
      Libraries, Q1 2008 report
 ·
              FalconStor
      VTL was named number one VTL in TheInfoPro Wave 10 Research and “Exciting
      Vendor” in TheInfoPro Wave 11
Research
 ·
              FalconStor
      was certified by CMP’s VARBusiness as a Gold 5-Star Overall Winner in its
      2008 Partner Program Guide
 ·
              FalconStor
      CDP Virtual Appliance was named New Product of the Year finalist by
      Network Computing magazine
 ·
              FalconStor
      NSS was named number one virtualization product by
  CRN
 ·
              FalconStor
      CDP Virtual Appliance for VMware Virtual Infrastructure was awarded an
      “Excellent” rating by ZDNet
 
 We
anticipate that this positive recognition will continue throughout 2009, as we
continue to innovate in our products and to refine our message to address new
market conditions while delivering targeted marketing campaigns.
 
 In
addition we increased our investment in our partners, both OEM and channel, for
joint marketing and field engagement. We have also expanded our channel by
partnering with new distributors and Direct Market Resellers (DMR) to further
penetrate the mid-range market and extend our channel and customer
reach.
 
 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
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 a 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 services. 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 2009.
  9
  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 acquisition 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, customers and technological synergies;
  and/or
 ·
              Key
      personnel.
 
 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 2009. 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. Our 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.   We
have also expanded our presence in Japan and extended our collaboration with
Softbank BB Corp. to solutions for both the Enterprise and the SMB
markets.
 
 Current
economic conditions suggest that there will be more limited IT spending budgets
in 2009. We anticipate that companies will be looking for innovative solutions
to reduce their IT costs and take full advantage of their current
investments.  FalconStor has been helping companies to reduce Capital
Expenditures (CapEx), and to minimize Operating Expenditures (OpEx) through the
deployment of cost-effective solutions that maximize the utilization rates for
IT resources, consolidate management operations, and reduce storage capacity and
networking bandwidth requirements.
 
 Industry
analysts predict that technologies such as data deduplication, storage
virtualization, and network bandwidth optimization are on the top of almost
every IT project list for 2009.  We believe that FalconStor will see a
growing demand for its products and solutions, as a market leader of disk-based
data protection solutions, and as a leading developer of technologies such as
data deduplication, storage virtualization, and WAN-optimized
replication.
 
 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 2008, we
strengthened our relationships with vendors like VMware, Citrix, and Microsoft
and we have developed more integration tools and solutions to support and
enhance these environments. We expect that in 2009 these relationships and joint
technology solutions will continue to grow and will put FalconStor in a strong
position to service customers that are looking at deploying these
solutions.
  10
  SALES,
MARKETING AND CUSTOMER SERVICE
 
 FalconStor plans to continue to sell its
products primarily through original equipment manufacturers (OEMs), value-added
resellers (VARs) or solution providers, large system integrators, Direct Market
Resellers (DMRs), 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 products in various geographic
areas.  FalconStor has increased its sales and marketing
infrastructure to further support and expand our network of VARs worldwide.
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’s Professional Services
personnel are also available to assist customers and partners throughout the
lifecycle 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 test phases of the
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
delivering comprehensive data protection across the data center. FalconStor
holds multiple patents on key technologies that enable and optimize our data
protection and data reduction platform. We believe that our integrated services
and products -- NSS, VTL, CDP, FDS, and WAN-optimized replication for remote
offices and data centers are 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 service running on a standard Linux-, Windows-, or
Solaris-based appliance. FalconStor believes that the principal competitive
factors enhancing 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 products. Increased competition could result in price
reductions and reduced gross margins, which could impact 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.
  11
  INTELLECTUAL
PROPERTY
 
 FalconStor’s success is dependent in
part upon it proprietary technology. 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 Software” and “IPStor” – and 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, patents, trademark and trade secret protection, as
well as through contractual protections such as proprietary information
agreements and nondisclosure agreements.  The technological and
creating skills of its personal, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leader position.
  FalconStor
generally enters into confidentiality or license agreements with employees,
consultants, and corporate partners, and generally controls access to and
distribution or 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
my not protect its proprietary rights as fully as do the laws of the United
States.
  MAJOR
CUSTOMERS
  For the
year ended December 31, 2008, we had two customers, EMC Corporation and Sun
Microsystems, which accounted for 20% and 13%, respectively, of our total
revenues. For the year ended December 31, 2007, Corporation and Sun Microsystems
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. As of December 31, 2008, EMC Corporation and H3C Technologies Co.,
Ltd.’s accounts receivable balance were each 11% of our gross accounts
receivable balance. As of December 31, 2007, EMC Corporation’s accounts
receivable balance was 17% of our gross accounts receivable
balance.
  EMPLOYEES
 
 As of
December 31, 2008, we had 505 full-time and part-time employees, consisting of
206 in research and development, 167 in sales and marketing, 103 in service, and
29 in general administration.  We are not subject to any collective
bargaining agreements and believe our employee relations are
good.
 
 INTERNET
ADDRESS AND AVAILABILTY 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, 2008.
 
 Item 1A.
              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.
  12
  We face a number
of risks related to the recent financial crisis and severe tightening in the
global credit markets.
 
 The
ongoing global financial crisis affecting the banking system and financial
markets has resulted in a severe tightening in the credit markets, a low level
of liquidity in many financial markets, and extreme volatility in credit and
equity markets. This financial crisis has impacted us and could continue to
impact our business in a number of ways, including:
  Potential Deferment
of Purchases and Orders by Customers: Uncertainty about current and future
global economic conditions may cause end users, including businesses and
governments, to defer purchases in response to tighter credit, decreased cash
availability and declining consumer confidence. Accordingly, future demand for
our products could differ materially from our current expectations.
 
 Customers’
Inability to Obtain Financing to Make Purchases from Us and/or Maintain Their
Business:Some
of our customers require financing in order to fund their operations and make
purchases from us. The inability of these customers to obtain sufficient credit
to finance purchases of our products and meet their payment obligations to us
could adversely impact our financial results. In addition, if the financial
crisis results in insolvencies for our customers, it could adversely impact our
financial results.
 
 Negative Impact from Increased
Financial Pressures on Third-Party OEMs and Resellers: Most of our
software licenses are sold through third-party OEMs, solution providers and
distributors. Although many of these third parties have significant operations
and maintain access to available credit, others are smaller and more likely to
be impacted by the significant decrease in available credit that has resulted
from the current financial crisis. If credit pressures or other financial
difficulties result in insolvency for these third parties and we are unable to
successfully transition end users to purchase our products from other third
parties, or from us directly, it could adversely impact our financial
results.
  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 and
disaster recovery 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 we may not be able 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.
  13
  If
we are unable to develop and manufacture new products that achieve acceptance in
the data protection and the network storage software markets, our operating
results may suffer.
  The data
protection and the network storage software markets continue 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 data protection or
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 data protection or network storage
software products with our customers by meeting customer performance and quality
specifications. 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.
  Our
products may have errors or defects that could result in reduced demand for our
products or costly litigation.
  Our
IPStor platform, the basic building block of all of our solutions, 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 VTL, CDP, NSS or FDS 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.
  Issues
with the hardware on which our software products are installed could increase
our support costs and result in lower sales of our products.
  We deliver some of our products, both
through our resellers and directly to end-users, installed on third party
hardware. If the hardware does not function properly, our support costs will go
up. We will have to arrange or pay for the repair or replacement of the broken
hardware and we may have to increase the size of our support operations.
Hardware reliability issues could also cause resellers and end-users to refuse
to make purchases from us, even if our software products function
properly.
  14
  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.
 The failure of
our resellers to sell our software applications effectively 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 and fiscal year. For the year ended December 31, 2008, we
had two customers, EMC Corporation and Sun Microsystems, which accounted for 20%
and 13%, respectively of our total revenues. 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. While we believe that we will continue to receive revenue from these
customers, our agreements do not have any minimum sales requirements and we
cannot guarantee continued revenue. If our contract with any of these customers
terminates, or if the volume of sales from any of these customers significantly
declines, it would have a material adverse effect on our operating
results.
  15
  In
addition, as of December 31, 2008, EMC Corporation’s and H3C Technologies Co.,
Ltd.’s accounts receivable balance were each 11% of our gross accounts
receivable. As of December 31, 2007, EMC Corporation’s accounts receivable
balance was 17% of our gross accounts receivable balance.  While we
currently have no reason to question the collectability 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.
  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 the right 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.
  16
  Consolidation
in the data protection or the network storage industries 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.
  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.
  17
  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 data
protection and network storage software. Because the market for our software is
primarily major corporate customers, any softness in demand for data protection
or 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 2008, and we anticipate that our quarterly results for 2009 will show the
effects of seasonality as well.
  Our
future performance will depend on many factors, including:
  ·
              fluctuations
      in the economy
  ·
              the
      timing of securing software license contracts and the delivery of software
      and related revenue recognition;
  ·
              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, 2008, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $2.09 and $10.74 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;
  18
  ·
              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.
  Our
marketable securities portfolio could experience a decline in market value which
could materially and adversely affect our financial results.
 
 As of December 31, 2008, we held
short-term and long-term marketable securities aggregating $20.4 million.
We invest in a mixture of corporate bonds, government securities and marketable
debt securities, the majority of which are high investment grade, and we limit
the amount of credit exposure through diversification and investment in highly
rated securities. However, investing in highly rated securities does not
entirely mitigate the risk of potential declines in market value. A further
deterioration in the economy, including further tightening of credit markets or
significant volatility in interest rates, could cause our marketable securities
to decline in value or could impact the liquidity of the portfolio. If market
conditions deteriorate significantly, our results of operations or financial
condition could be materially and adversely affected.
  The
amount of income taxes we have to pay may increase.
  During 2008, we received the remaining
benefits of net operating loss carryforwards, which reduced the amount of income
taxes that we would have been required to pay. As of December 31, 2008, we did
not have remaining U.S. Federal net-operating loss carryforwards available for
use to offset future taxable income. If we have taxable income in 2009, we will
have a material tax liability.
  The
ability to predict our future effective tax rates correctly 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.
  19
  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, 2008, we had options to purchase 9,675,145 shares of our common
stock outstanding, and we had an aggregate of 488,840 outstanding restricted
shares and restricted stock units. If all of these outstanding options were
exercised, and all of the outstanding restricted stock and restricted stock
units vested, the proceeds to the Company would average $6.10 per share. We also
had 3,593,038 shares of our common stock reserved for issuance under our stock
plans with respect to options (or restricted stock or restricted stock units)
that have not been granted. In addition, if, on July 1st of any calendar year in
which our 2006 Incentive Stock Plan, as amended (the “2006 Plan”), is in effect,
the number of shares of stock to which options, restricted shares and restricted
stock units 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. 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 restricted stock units and/or the grant and exercise of
additional options and/or the grant and vesting of restricted stock and
restricted stock units 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.
  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.
  20
  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.
  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.
  Foreign
currency fluctuations may impact our revenues.
  Our licenses and services in Japan are
sold in Yen. Our licenses and services in the Republic of Korea are sold in Won.
Many of the sales of our licenses and services in Europe, the Middle East and
Africa, are made in European Monetary Units (“Euros”).
  Changes in economic or political
conditions globally and in any of the countries in which we operate could result
in exchange rate movements, new currency or exchange controls or other
restrictions being imposed on our operations.
  Fluctuations
in the value of the U.S. dollar may adversely affect our results of operations.
Because our consolidated financial results are reported in U.S. dollars,
translation of sales or earnings generated in other currencies into U.S. dollars
can result in a significant increase or decrease in the reported amount of those
sales or earnings.  Significant changes in the value of these foreign
currencies relative to the U.S. dollar could have a material adverse effect on
our financial condition or results of operations.
  Fluctuations
in currencies relative to currencies in which our earnings are generated make it
more difficult to perform period-to-period comparisons of our reported results
of operations. For purposes of accounting, the assets and liabilities of our
foreign operations, where the local currency is the functional currency, are
translated using period-end exchange rates, and the revenues, expenses and cash
flows of our foreign operations are translated using average exchange rates
during each period.
  In
addition to currency translation risks, we incur currency transaction risk
whenever we enter into either a purchase or a sales transaction using a currency
other than the local currency of the transacting entity. Given the volatility of
exchange rates, we cannot be assured we will be able to effectively manage our
currency transaction and/or translation risks. Volatility in currency exchange
rates may have a material effect on our financial condition or results of
operations. Currency exchange rate fluctuations have not, in the past, resulted
in a material impact on earnings. However, we may experience at times in the
future an impact on earnings as a result of foreign currency exchange rate
fluctuations.
  We currently do not engage in any
hedging of these foreign currency risks. We may, in the future, attempt to hedge
currency risks.
  21
  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 57 people as of December 31, 2008.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:
 
 •
              
              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;
  •
              
              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 twelve 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:
  22
  ·
              cease
      selling our products that use the challenged intellectual
      property;
 
 ·
              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.
  23
  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.
 
 Item 1B.
              Unresolved
      Staff Comments
  None
  Item 2.
              Properties
  The
Company’s headquarters are located in an approximately 45,000 square foot
facility in Melville, New York.  Offices are also leased for
development, sales and marketing personnel, which total an aggregate of
approximately 62,000 square feet in Le Chesnay and Toulouse, France; Taipei and
Taichung, Taiwan; Tokyo, Japan; Beijing, Shenzhen and Shanghai, China; Munich,
Germany; Seoul, Korea; Kuala Lumpur, Malaysia; North Sydney, Australia; London,
UK; Fremont, 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.
 
 Item 4.
              Submission
      of Matters to a Vote of Security
Holders
  None
 
 PART II
  Item 5.
              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:
  2008
                                        
                                        
                                        2007High
                                        
                                        
                                        Low
                                        
                                        
                                        High
                                        
                                        
                                        LowFourth
      Quarter
                                        
                                        $
                                        5.09
                                        
                                        
                                        $
                                        2.09
                                        
                                        
                                        $
                                        15.30
                                        
                                        
                                        $
                                        9.94Third
      Quarter
                                        
                                        $
                                        7.80
                                        
                                        
                                        $
                                        5.05
                                        
                                        
                                        $
                                        12.50
                                        
                                        
                                        $
                                        9.87Second
      Quarter
                                        
                                        $
                                        9.13
                                        
                                        
                                        $
                                        6.99
                                        
                                        
                                        $
                                        12.10
                                        
                                        
                                        $
                                        10.33First
      Quarter
                                        
                                        $
                                        10.74
                                        
                                        
                                        $
                                        6.85
                                        
                                        
                                        $
                                        11.23
                                        
                                        
                                        $
                                        8.13
  24
  Holders
of Common Stock
  We had
approximately 142 holders of record of Common Stock as of February 25, 2009.
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.
  Number
      of Securities to be Issued upon Exercise of Outstanding Options, Warrants
      and Rights (1)
                            Weighted
      - Average exercise Price of Outstanding Options, Warrants and Rights
      (1)
                            Number
      of Securities Remaining Available for Future Issuance Under Equity
      Compensation Plans (Excluding Securities Reflected in Column
      (a)(1)Plan Category
                            
                            (a)
                            
                            (b)
                            
                            (c)Equity
      compensation plans approved by security holders
                            10,163,985
                            
                            $6.10
                            
                            3,593,038
  (1) As of
December 31, 2008 we had 3,593,038 shares of our common stock reserved for
issuance under our stock plans with respect to options (or restricted stock or
restricted stock units) 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. See Note (8) Share-Based Payment
Arrangements to our consolidated financial statements for further
information.
 
 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.
  25
  
  ASSUMES
$100 INVESTED ON DEC. 31, 2003
 ASSUMES
DIVIDEND REINVESTED
 FISCAL
YEAR ENDING DECEMBER 31, 2008
 
 Fiscal Year Ending2003
                      
                      
                      2004
                      
                      
                      2005
                      
                      
                      2006
                      
                      
                      2007
                      
                      
                      2008FALCONSTOR
      SOFTWARE, INC.
                      
                      $
                      100.00
                      
                      
                      $
                      109.50
                      
                      
                      $
                      84.55
                      
                      
                      $
                      98.97
                      
                      
                      $
                      91.53
                      
                      
                      $
                      31.81HEMSCOTT
      GROUP INDEX
                      
                      $
                      100.00
                      
                      
                      $
                      109.83
                      
                      
                      $
                      110.10
                      
                      
                      $
                      127.84
                      
                      
                      $
                      143.75
                      
                      
                      $
                      86.96RUSSELL
      3000 INDEX
                      
                      $
                      100.00
                      
                      
                      $
                      110.08
                      
                      
                      $
                      114.79
                      
                      
                      $
                      130.62
                      
                      
                      $
                      139.50
                      
                      
                      $
                      85.52
 
 There can
be no assurance that the Common Stock’s performance will continue with the same
or similar trends depicted in the graph above.
  Issuer
Purchase of Equity Securities
  Shares of
common stock repurchased during the quarter ended December 31,
2008:
  Total
      Number of
                                      Shares
      Purchased
                                    
                                    
                                    Average
      Price
                                      Paid
      per Share
                                    
                                    
                                    Total
      Number of
                                      Shares
      Purchased
                                      as
      Part of Publicly
                                      Announced
      Plan
                                    
                                    
                                    Maximum
      Number
                                      of
      Shares that May
                                      Yet
      Be Purchased
                                      Under
      the
                                      Plan
      at Month EndOctober
      2008
                                    
                                    
                                    5,000
                                    
                                    
                                    $
                                    2.98
                                    
                                    
                                    
                                    5,000
                                    
                                    
                                    
                                    3,250,900November
      2008
                                    
                                    
                                    1,445,200
                                    
                                    
                                    $
                                    2.34
                                    
                                    
                                    
                                    1,445,200
                                    
                                    
                                    
                                    1,805,700December  2008
                                    
                                    
                                    629,750
                                    
                                    
                                    $
                                    2.79
                                    
                                    
                                    
                                    629,750
                                    
                                    
                                    
                                    1,175,950Total
                                    
                                    
                                    2,079,950
                                    
                                    
                                    $
                                    2.48
                                    
                                    
                                    
                                    2,079,950
                                    
                                    
                                    
                                    1,175,950
  26
  On
February 4, 2009, the Company’s Board of Directors increased its authorization
to repurchase the Company’s outstanding common stock from eight million shares
to fourteen million shares in the aggregate. As of December 31, 2008, the
Company had repurchased 6,824,050 shares. The program has no expiration date.
See Note (7) Stockholders’
Equity to our consolidated financial statements for further
information.
  Item 6.
              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,
                                  
                                  Year
      Ended December 31,
                                  
                                  Year
      Ended December 31,
                                  
                                  
                                  Year
      Ended December 31,
                                  
                                  
                                  Year
      Ended December 31,2008
      (a)
                                  
                                  
                                  
                                  2007
      (a), (b)
                                  
                                  
                                  2006
      (a)
                                  
                                  
                                  2005
                                  
                                  
                                  2004(In
      thousands, except per share data)Revenues:Software
      license revenue
                                  
                                  $
                                  58,590
                                  
                                  
                                  $
                                  53,154
                                  
                                  
                                  $
                                  38,317
                                  
                                  
                                  $
                                  29,544
                                  
                                  
                                  $
                                  21,488Maintenance
      revenue
                                  
                                  
                                  23,283
                                  
                                  
                                  
                                  18,607
                                  
                                  
                                  
                                  12,475
                                  
                                  
                                  
                                  7,594
                                  
                                  
                                  
                                  4,443Software
      services and other revenue
                                  
                                  
                                  5,152
                                  
                                  
                                  
                                  5,639
                                  
                                  
                                  
                                  4,274
                                  
                                  
                                  
                                  3,826
                                  
                                  
                                  
                                  2,77887,025
                                  
                                  
                                  
                                  77,399
                                  
                                  
                                  
                                  55,066
                                  
                                  
                                  
                                  40,964
                                  
                                  
                                  
                                  28,709Operating
      expenses:Amortization
      of purchased and capitalized software
                                  
                                  
                                  143
                                  
                                  
                                  
                                  122
                                  
                                  
                                  
                                  362
                                  
                                  
                                  
                                  782
                                  
                                  
                                  
                                  1,394Cost
      of maintenance, software services and other revenue
                                  
                                  
                                  13,731
                                  
                                  
                                  
                                  11,091
                                  
                                  
                                  
                                  9,048
                                  
                                  
                                  
                                  6,114
                                  
                                  
                                  
                                  4,150Software
      development costs
                                  
                                  
                                  25,296
                                  
                                  
                                  
                                  22,405
                                  
                                  
                                  
                                  20,022
                                  
                                  
                                  
                                  12,039
                                  
                                  
                                  
                                  9,050Selling
      and marketing
                                  
                                  
                                  38,097
                                  
                                  
                                  
                                  29,656
                                  
                                  
                                  
                                  23,713
                                  
                                  
                                  
                                  16,109
                                  
                                  
                                  
                                  14,277General
      and administrative
                                  
                                  
                                  8,746
                                  
                                  
                                  
                                  8,024
                                  
                                  
                                  
                                  5,828
                                  
                                  
                                  
                                  4,213
                                  
                                  
                                  
                                  5,109Litigation
      settlement
                                  
                                  
                                  --
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  799
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  1,30086,013
                                  
                                  
                                  
                                  71,298
                                  
                                  
                                  
                                  59,772
                                  
                                  
                                  
                                  39,257
                                  
                                  
                                  
                                  35,280Operating
      income (loss)
                                  
                                  
                                  1,012
                                  
                                  
                                  
                                  6,101
                                  
                                  
                                  
                                  (4,706
                                  )
                                  
                                  
                                  1,707
                                  
                                  
                                  
                                  (6,571
                                  )Interest
      and other income
                                  
                                  
                                  1,689
                                  
                                  
                                  
                                  2,329
                                  
                                  
                                  
                                  1,650
                                  
                                  
                                  
                                  705
                                  
                                  
                                  
                                  714Income
      (loss) before income taxes
                                  
                                  
                                  2,700
                                  
                                  
                                  
                                  8,430
                                  
                                  
                                  
                                  (3,056
                                  )
                                  
                                  
                                  2,412
                                  
                                  
                                  
                                  (5,857
                                  )Provision
      (benefit)  for income taxes
                                  
                                  
                                  1,498
                                  
                                  
                                  
                                  (4,312
                                  )
                                  
                                  
                                  319
                                  
                                  
                                  
                                  119
                                  
                                  
                                  
                                  32Net
      income (loss)
                                  
                                  $
                                  1,203
                                  
                                  
                                  $
                                  12,742
                                  
                                  
                                  $
                                  (3,375
                                  )
                                  
                                  $
                                  2,293
                                  
                                  
                                  $
                                  (5,889
                                  )Basic
      net income (loss) per share
                                  
                                  $
                                  0.03
                                  
                                  
                                  $
                                  0.26
                                  
                                  
                                  $
                                  (0.07
                                  )
                                  
                                  $
                                  0.05
                                  
                                  
                                  $
                                  (0.13
                                  )Diluted
      net income (loss) per share
                                  
                                  $
                                  0.02
                                  
                                  
                                  $
                                  0.24
                                  
                                  
                                  $
                                  (0.07
                                  )
                                  
                                  $
                                  0.05
                                  
                                  
                                  $
                                  (0.13
                                  )Basic
      weighted average common shares outstanding
                                  
                                  
                                  47,859
                                  
                                  
                                  
                                  49,421
                                  
                                  
                                  
                                  48,045
                                  
                                  
                                  
                                  47,662
                                  
                                  
                                  
                                  46,967Diluted
      weighted average common shares outstanding
                                  
                                  
                                  49,497
                                  
                                  
                                  
                                  53,131
                                  
                                  
                                  
                                  48,045
                                  
                                  
                                  
                                  50,776
                                  
                                  
                                  
                                  46,967
  (a)
              We
      adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R),
      Share-Based Payments,on January 1, 2006, and recorded $9.1 million, $7.9 million and
      $9.4 million of compensation expenses in our consolidated statements of
      operations for the years ended December 31, 2008, 2007 and 2006,
      respectively. See Note (8) Share-Based Payment
      Arrangements to our consolidated financial statements for further
      information.
  27
  (b)
              During
      2007, we recorded 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. See Note (6)
      Income Taxes to
      our consolidated financial statements for further
    information.
  CONSOLIDATED
BALANCE SHEET DATA:
  
   December
      31,2008
                                  
                                  December
      31,2007
                                  
                                  
                                  December 31,2006
                                  
                                  
                                  December
      31,2005
                                  
                                  
                                  December
      31,2004(In
      thousands)Cash
      and cash equivalents andmarketable
      securities
                                  
                                  $
                                  42,810
                                  
                                  
                                  $
                                  62,904
                                  
                                  
                                  $
                                  40,960
                                  
                                  
                                  $
                                  36,631
                                  
                                  
                                  $
                                  33,973Working
      capital
                                  
                                  
                                  48,329
                                  
                                  
                                  
                                  71,845
                                  
                                  
                                  
                                  46,934
                                  
                                  
                                  
                                  39,730
                                  
                                  
                                  
                                  36,452Total
      assets
                                  
                                  
                                  96,364
                                  
                                  
                                  
                                  115,182
                                  
                                  
                                  
                                  78,231
                                  
                                  
                                  
                                  63,974
                                  
                                  
                                  
                                  56,074Long-term
      obligations
                                  
                                  
                                  6,192
                                  
                                  
                                  
                                  5,070
                                  
                                  
                                  
                                  3,783
                                  
                                  
                                  
                                  2,316
                                  
                                  
                                  
                                  1,290Stockholders’
      equity
                                  
                                  
                                  65,076
                                  
                                  
                                  
                                  87,478
                                  
                                  
                                  
                                  55,043
                                  
                                  
                                  
                                  48,658
                                  
                                  
                                  
                                  46,364
  28
  ITEM 7.
              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
  Our
results did not meet our expectations in 2008. While our revenues increased,
they did not reach our initial projection for the year.  In addition,
our earnings and our gross margins fell.
  We
attribute the shortfall in revenues, and the resulting decline in earnings and
gross margin, to the general economic slowdown that has affected both the U.S.
and the global economies. Our revenues for the first two quarters of the year
were on target with the annual projection we announced in February,
2008.  As late as the first week in September, 2008, our revenues
continued to be on track towards meeting our targets. Then the crisis in the
financial markets – including the Lehman Brothers’ bankruptcy filing and the
weakened banking industry, which lead to a tightening of credit – seemed to
significantly curtail the spending by our current and prospective end users.
Orders we had expected did not materialize.  Our results for the third
quarter ended up falling well short of our expectations.
  Given our
results for the third quarter, and the continuing economic downturn, we revised
our projections for the fourth quarter. Although the revised target was lower
than our original projections, we are pleased that we exceeded both our revised
revenue and our revised earnings target for the fourth quarter.
  In
furtherance of our continuing strategy to grow the Company for the long term, we
continued to invest in both personnel and other assets throughout the first
eight months of 2008 to grow and to support the then-current level of business
and the level of business we were projecting for the remainder of 2008 and
beyond. When the expected revenue did not come in, our increased expenses,
combined with the revenue shortfall, reduced our earnings and our gross
margin.
  While our
2008 results fell short of our goals, we believe that our results indicate that
we are still on the right track.
  Our
revenues for the full year increased to $87 million from $77.4 million in 2007.
This is a twelve percent year over year increase in revenues. Just over half of
our revenues in 2008 came from our VTL product, both the basic version and a
version that was enhanced with deduplication capability in 2008. We anticipate
further revenue growth in 2009, although growth could be constrained or
undermined by the global economic slowdown.
  Net
income for the year was $1.2 million, compared with net income of $12.7 million
in 2007. Approximately one third of the 2007 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 that 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 $9.1 million in 2008
and $7.9 million in 2007, 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 2008 was $1 million, compared with $6.1 million in
2007. These numbers again include stock-based compensation expense. We attribute
the decline in operating income from 2007 to 2008 primarily to the increase in
expenses that outpaced our revenue growth.
  Another
important measure of our business is gross margin. Among other things, gross
margin measures our ability to scale our business. 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
2008 was 84% compared with 86% for 2007. The impact of the equity-based
compensation expense on gross margin in 2008 and 2007 was equivalent to 2% and
1%, respectively.  The decline in gross margin is a result of the
investments we made in our business, particularly in the sales and marketing and
the technical support area, outpacing our revenue growth.
  29
  Operating
margin is a measure of operating efficiency. Our operating margin decreased. In
2008, our operating margin was 1%, compared with 8% in 2007. The impact of the
equity-based compensation expense on operating margin in 2008 and 2007 was
equivalent to 10% each year.
  As it has
been in the past, our focus for 2009 will continue to be on managing our
business with a view towards long-term success and growth.  It is
certainly our goal to keep making the Company more profitable, but we do not
manage the business to meet quarterly or annual earnings targets.  Our
continued ability to generate cash from operations allows us to put money back
into the business to continue its growth.
  In
2008, we continued to invest in research and development and in sales and
marketing, along with other areas, to build on our momentum, to design new
products, and to enhance our existing products to position the Company for
future growth. Even as the economy weakened, we continued to invest in areas
that we believe will provide a long-term benefit. While we will be mindful of
economic conditions, and we will seek to make only prudent investments in our
business, we will continue to invest in the Company in 2009. In particular, we
anticipate continued investment in our sales and our marketing
functions.  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 2009.
  To
continue to create industry-leading, cutting-edge network storage solutions, we
hired additional software development engineers and quality assurance engineers
in 2008. 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 for us
to remain competitive and to continue our growth.
  We also
increased our sales force and our marketing team.  These increases are
intended to help us to promote our products to potential customers by
highlighting the capabilities of the products.
  We also
continued to increase our technical support team.  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 are:
  ·
              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;
  ·
              the
      development and sales of our new
products;
  ·
              re-orders
      from existing customers; and
  ·
              the
      growth of the overall market for data protection and storage
      solutions.
  30
  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 five percent of our revenues in 2008, down
slightly from forty eight percent in 2007.  On an absolute basis,
revenues from OEMs grew four percent from 2007 to $39.1 million in 2008.
Revenues from EMC, our largest OEM, decreased compared with 2008 due to product
transition that had a negative impact on sales in the second and third quarters.
Our revenues from Sun grew 21% to $11.1 million in 2008.  We regard
the simultaneous year over year increase in revenues from OEMs and year over
year decline in the percentage of our revenues attributable to OEMs to be an
indicator of the health of our business. It shows that even as our OEM customers
continue 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 2009. We expect that at least two OEMs will account for at least ten percent
of our revenues in 2009. 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.
  In 2008,
both Sun and EMC launched new ranges of products that incorporate our VTL
technology. Sun incorporated our data deduplication technology into their
products. We signed OEM agreements with additional companies in 2008, both in
the United States and China. 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.
  We
continue to enhance our reseller program and 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 increased twenty percent in 2008 to $47.9 million. Increasing
sales from resellers remains an area of focus for us and in 2008 we made
significant investments in our sales force and in our marketing team to help
grow these sales. We also have instituted, and we will be instituting further,
support, training and incentive programs intended to increase sales by our
resellers.
  In 2008,
we signed agreements with new resellers worldwide. The type of resellers with
whom we are signing agreements has continued to evolve.  While we
still sign agreements with strong local and regional resellers, we have also
entered into reseller agreements with national and multi-national resellers who
have their own distribution networks.  The enhanced distribution and
marketing networks offered by these larger resellers should help us to continue
to grow our sales.
  31
  We also
terminated relationships with resellers who we believed were not properly
selling our products in 2008. 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 16% to $22.1 million as of December 31, 2008,
compared with $19.0 million as of December 31, 2007.  We expect
deferred revenue to continue to grow in 2009.
  Consolidation
in the network storage market continued in 2008. The consolidation did not have
a significant impact on our revenue.
  The data
protection and the storage solutions markets continued to grow in 2008. The
amount of data generated each day continues to grow. All of that data has to be
stored, and prudent organizations need ways to backup the data efficiently and
to restore the data quickly and effectively in the event of a failure. While we
expect these markets to continue to grow, we cannot predict the impact that the
global economic crisis will have on these markets in 2009.
  Sales from outside the United States,
including China, remain an area of growth. Our revenues from non-OEM
international sales, while still lower than our domestic non-OEM revenues, grew
thirty percent compared with 2007.   We will continue to invest
in our international operations in 2009.
  Our
expenses increased 21% in 2008 from $71.3 million in 2007 to $86 million in
2008.  This is in line with the increase from 2006 to 2007, which was
19%. The increase in expenses outpaced our increase in revenues.  Most
of the increase in expenses had been incurred or planned before the global
economic situation deteriorated in the second half of 2008.  Although
the increase in expenses hurt our profitability for 2008, we believe that the
investments we have made in our business will provide a pay off in the long run
through increased sales and market share. Included in our operating expenses for
the years ended December 31, 2008 and 2007 was $9.1 million and $7.9 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.
  We 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.  While
our results were skewed by the impact of the collapse in the financial sector in
third quarter, our quarterly results reflected this seasonality in 2008, and we
anticipate that our quarterly results for 2009 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 2008. 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.
  32
  RESULTS
OF OPERATIONS – FOR THE YEAR ENDED DECEMBER 31, 2008 COMPARED WITH THE YEAR
ENDED DECEMBER 31, 2007
  Revenues for the year ended December 31,
2008 increased 12% to $87.0 million compared with $77.4 million for the year
ended December 31, 2007. Our operating expenses increased 21% from $71.3 million
in 2007 to $86.0 million in 2008. Included in our operating expenses for the
years ended December 31, 2008 and 2007 were $9.1 million and $7.9 million,
respectively, of share-based compensation expense in accordance with SFAS No.
123(R). Net income for the years ended December 31, 2008 and 2007 was $1.2
million and $12.7 million, respectively. Included in our net income for the year
ended December 31, 2008 was a tax provision of $1.5 million compared with the
year ended December 31, 2007 which included 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. Our 12% revenue growth for the year ended December
31, 2008 as compared with the same period in 2007 was due to growth in both our
software license revenue and maintenance revenues. This growth in revenues was
primarily driven by increases in (i) demand for our data protection and network
storage solution software, (ii) maintenance revenue from new and existing
customers and (iii) sales to our resellers, direct end-users and OEM partners.
However, during the second half of 2008, our revenue growth slowed, particularly
software license revenues, as a result of the difficult economic conditions
encountered as a result of the disruptions in the global financial markets,
specifically in North America, when compared with the same period in 2007.
Because of our well-established installed customer base and growing number of
software licenses sold, our revenue from maintenance agreements were not
significantly impacted as compared with our software license revenues as a
result of the downturn in information technology spending experienced during the
second half of 2008. Revenue contribution from our OEM partners increased in
absolute dollars for the year ended December 31, 2008 as compared with the same
period in 2007. Revenue from resellers, distributors and direct end-users
increased in both absolute dollars and as a percentage of total revenue for the
year ended December 31, 2008 as compared with the same period in 2007. 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 505 employees as of
December 31, 2008, as compared with 414 employees as of December 31, 2007.
Finally, we continue to invest in our infrastructure with our continued capital
expenditures, particularly with purchases of equipment for support of our
existing and future product offerings.
 
 Revenues
 
 Year
      Ended December 31,2008
                        
                        
                        2007Revenues:Software
      license revenue
                        
                        $
                        58,590,246
                        
                        
                        $
                        53,153,980Maintenance
      revenue
                        
                        
                        23,283,094
                        
                        
                        
                        18,606,591Software
      services and other revenue
                        
                        
                        5,151,520
                        
                        
                        
                        5,638,651Total
      Revenues
                        
                        $
                        87,024,860
                        
                        
                        $
                        77,399,222Year-over-year
      Percentage GrowthSoftware
      license revenue
                        
                        
                        10
                        %
                        
                        
                        39
                        %Maintenance
      revenue
                        
                        
                        25
                        %
                        
                        
                        49
                        %Software
      services and other revenue
                        
                        
                        -9
                        %
                        
                        
                        32
                        %Total
      percentage growth
                        
                        
                        12
                        %
                        
                        
                        41
                        %
   33
  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 10% from $53.2 million for the year ended December 31,
2007 to $58.6 million for the year ended December 31, 2008. Software license
revenue represented 67% and 69% of our total revenues for the years ended
December 31, 2008 and 2007, respectively. As a result of broader market
acceptance of our software applications, new product offerings and increased
demand for our products from our expanding base of customers, we continued to
experience increased software license revenues. However, during the second half
of 2008, as a result of the difficult economic conditions encountered as a
result of the disruptions in the global financial markets, specifically in North
America, our software license revenue growth slowed when compared with the same
period in 2007. Overall, during the year ended December 31, 2008, gross software
license revenue from our OEM partners decreased 7%, while gross software license
revenues from our direct end-users and resellers increased 22% when compared to
the same period in 2007. We expect our software license revenue to continue to
grow in future periods.
  Maintenance
revenue
 
 Maintenance
revenue is comprised of software maintenance and technical support services.
Revenues derived from maintenance and technical support contracts are deferred
and recognized ratably over the contractual maintenance term. Maintenance
revenues increased 25% from $18.6 million for the year ended December 31, 2007
to $23.3 million for the year ended December 31, 2008.
  The major
factor behind the increase in maintenance revenue was an increase in the number
of maintenance and technical support contracts we sold. As we are in business
longer, and as we license more software to new customers and grow our installed
customer base, we expect the amount of maintenance and technical support
contracts we have to grow as well. We expect our maintenance revenue to continue
to increase 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.
 
 Software
services and other revenue
  Software
services and other revenues are comprised of professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. 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 the years ended December 31, 2008 and 2007,
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 is delivered
to the customer based on its relative fair value. Software services and other
revenue decreased 9% from $5.6 million for the year ended December 31, 2007 to
$5.2 million for the year ended December 31, 2008.
  The
decrease in software services and other revenue was primarily due to a decrease
in computer hardware sales, which declined from $3.4 million for the year ended
December 31, 2007 to $3.0 million for the year ended December 31, 2008. Our
professional services revenue decreased $0.1 million to $2.2 million for the
year ended December 31, 2008 from $2.3 million in the same period in 2007. The
professional services revenue will vary from year to year based upon (i) the
number of software license contracts sold during the year, (ii) the number of
our software license customers who elected to purchase professional services,
and/or (iii) the number of professional services contracts that were completed
during the year. We expect professional services revenues to vary from year to
year based upon the number of customers who elect to utilize our professional
services upon purchasing our software licenses. The hardware revenue will vary
from year to year based upon the number of customers who wish to have us bundle
hardware with our software for one complete solution but is expected to grow in
2009 when new storage and data protection appliances are offered for
sale.
  34
  Cost
of Revenues
  Year
      ended December 31,2008
                      
                      
                      2007Total
      Revenues:
                      
                      $
                      87,024,860
                      
                      
                      $
                      77,399,222Cost
      of maintenance, software servicesand
      other revenue
                      
                      $
                      13,874,238
                      
                      
                      $
                      11,213,935Gross
      Profit
                      
                      $
                      73,150,622
                      
                      
                      $
                      66,185,287Gross
      Margin
                      
                      
                      84
                      %
                      
                      
                      86
                      %
   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, amortization of
purchased and capitalized software 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 increased $2.7 million
or 24% to $13.9 million for the year ended December 31, 2008, from $11.2 million
for the same period in 2007. The increase in cost of maintenance, software
services and other revenue was primarily due to the increase in personnel and
related costs. As a result of our increased sales from maintenance and support
contracts, we continued to hire additional employees to provide technical
support services. Our cost of maintenance, software services and other revenue
will continue to grow in absolute dollars as our revenues from these services
also increase.
 
 Gross
profit increased $7.0 million or 11% to $73.2 million for the year ended
December 31, 2008, from $66.2 million for the same period in
2007.  Gross margins decreased from 86% for the year ended December
31, 2007, to 84% for the year ended December 31, 2008. Even though we had an
increase in our gross profit, our gross margins decreased. Generally, our gross
margins may fluctuate based on several factors, including (i) revenue growth
levels, (ii) timing of changes in personnel headcount and related costs, (iii)
our mix of product offerings and services, and (iv) costs related to the
procurement of hardware for our bundled solutions.
 
 Share-based
compensation expense included in the cost of maintenance, software services and
other revenue increased in absolute dollars to $1.4 million from $1.0 million
for the years ended December 31, 2008 and 2007, respectively. Share-based
compensation expense was equal to 2% and 1% of revenue for the years ended
December 31, 2008 and 2007, 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 13% to $25.3 million
for the year ended December 31, 2008, from $22.4 million in the same period in
2007. 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 the
development of new innovative features and options. Share-based compensation
expense included in software development costs decreased in absolute dollars to
$3.2 million from $3.3 million for the years ended December 31, 2008 and 2007,
respectively. Share-based compensation expense included in software development
costs was equal to 4% of revenue for each of the years ended December 31, 2008
and 2007, respectively. We intend to continue recruiting and hiring product
development personnel to support our software development process.
  35
  Selling
and Marketing
  Selling
and marketing expenses consist primarily of salary and personnel costs for 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 28% to $38.1 million for the year ended December 31, 2008, from $29.7
million for the same period in 2007. The increase in selling and marketing
expenses was primarily due to (i) higher salary and personnel related costs as a
result of increased sales and marketing headcount, and (ii) higher advertising
and marketing related expenses as a result of trade and industry shows, new
product offerings/enhancements, new product branding and related advertising and
marketing of such initiatives. Share-based compensation expense included in
selling and marketing increased in absolute dollars to $3.5 million from $2.6
million for the years ended December 31, 2008 and 2007, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 4% and 3% for the years ended December 31, 2008 and 2007, 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 9% to $8.7
million for the year ended December 31, 2008 from $8.0 million for the same
period in 2007. Increased compensation and personnel related costs as a result
of increased headcount to support our general and administrative needs was
offset by decreases in professional fees and various administrative expenses
during the year ended December 31, 2008, as compared with the same period in
2007. Share-based compensation expense included in general and administrative
expenses decreased in absolute dollars to $0.9 million from $1.0 million for the
years ended December 31, 2008 and 2007, respectively. Share-based compensation
expense included in general and administrative expenses was equal to 1% of
revenue for each of the years ended December 31, 2008 and 2007,
respectively.  Additionally, as our revenue and number of employees
increase, our overall general corporate overhead costs have generally increased
and are likely to continue to increase.
  Interest
and Other Income
  We invest
our cash primarily in money market funds, commercial paper, government
securities, and corporate bonds. As of December 31, 2008, our cash, cash
equivalents, and marketable securities totaled $42.8 million, compared with
$62.9 million as of December 31, 2007. Interest and other income decreased to
$1.7 million for the year ended December 31, 2008, compared with $2.3 million
for the same period in 2007. The decrease in interest income was primarily
related to (i) a decrease in our cash, cash equivalents and marketable
securities balances as a result of our repurchase of 5.6 million shares of our
common stock at a total cost of $33.9 million during 2008, and (ii) lower
interest rates on average cash balance invested during the year ended December
31, 2008, particularly during the second half of 2008, as a result of the U.S.
banking liquidity crisis, as compared with the same period in 2007. The interest
income in both 2008 and 2007 was impacted partially by other non-operating
income and expenses, particularly, foreign currency gains of $0.2 million and
$22,000, respectively.
  Income
Taxes
  For the
year ended December 31, 2008, our provision for income taxes was $1.5 million
and consisted primarily of U.S., state, local and foreign taxes.  For
the year ended December 31, 2007, our benefit from income taxes
was  $4.3 million, which primarily related to a substantial reversal
of our deferred income tax valuation allowance. During the year ended December
31, 2007, we determined that based upon a number of factors, including our then
cumulative taxable income over the prior three years and expected profitability
in future years, certain of our deferred tax assets were “more likely than not”
realizable through future earnings. 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.
  36
   As
of January 1, 2008, we had approximately $5.1 million of federal net operating
loss carryforwards available to offset future taxable income.  These
net operating loss carryforwards related to excess compensation deductions from
previous year’s exercises of stock options. During 2008, we utilized all of our
net loss carryforwards, the benefits of which were credited to
additional-paid-in-capital. As of December 31, 2008 and December 31, 2007, our
deferred tax assets, net of a deferred tax liabilities and valuation allowance,
were $10 million and $9.8 million, respectively.
  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, which 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.
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 primarily as a result of our increased worldwide headcount to 414
employees as of December 31, 2007, as compared with 340 employees as of December
31, 2006.
  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 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.  Increased market acceptance
and increased demand for our products from our expanding base of customers
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.
  37
 
 Maintenance
revenues
 
 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.  The major
factor behind the increase in maintenance revenue was an increase in the number
of maintenance and technical support contracts we sold. As we are in business
longer, and as we license more software to new customers and grow our installed
customer base, we expect the amount of maintenance and technical support
contracts we have to grow as well.
 
 Software
services and other revenue
 
 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
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.
  
 Cost
of Revenues
  Year
      ended December 31,2007
                      
                      
                      2006Total
      Revenues:
                      
                      $
                      77,399,222
                      
                      
                      $
                      55,066,028Cost
      of maintenance, software servicesand
      other revenue
                      
                      $
                      11,213,935
                      
                      
                      $
                      9,410,513Gross
      Profit
                      
                      $
                      66,185,287
                      
                      
                      $
                      45,655,515Gross
      Margin
                      
                      
                      86
                      %
                      
                      
                      83
                      %
 
 
 Cost
of maintenance, software services and other revenue
 
 Cost of
maintenance, software services and other revenues for the year ended December
31, 2007, increased by 19% to $11.2 million compared with $9.4 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 number of
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.
 
 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. 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.
  38
  Software
Development Costs
  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.
  Selling
and Marketing
  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.
  General
and Administrative
  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.
  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
invested 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 impacted partially by other
non-operating income and expenses.
  39
  Income
Taxes
  For the
year ended December 31, 2007, our benefit from income taxes was $4.3 million,
which primarily related to a substantial reversal of our deferred income tax
valuation allowance. Also included in our benefit 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, 2007, we determined that based upon a number
of factors, including our then cumulative taxable income over the prior three
years and expected profitability in future years, that certain of our deferred
tax assets were “more likely than not” realizable through future earnings.
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 assets,
net of a valuation allowance were $9.8 million. We had approximately $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.  Additionally, 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.
  LIQUIDITY
AND CAPITAL RESOURCES
  Cash flow
information is as follows:
  Years
      Ended December 31,2008
                      
                      
                      2007
                      
                      
                      2006Cash
      provided by (used in):Operating
      activities
                      
                      $
                      18,231,609
                      
                      
                      $
                      16,588,539
                      
                      
                      $
                      8,162,783Investing
      activities
                      
                      
                      3,335,856
                      
                      
                      
                      (12,357,286
                      )
                      
                      
                      (11,329,412
                      )Financing
      activities
                      
                      
                      (30,998,308
                      )
                      
                      
                      11,803,544
                      
                      
                      
                      399,818Effect
      of exchange rate changes
                      
                      
                      (424,271
                      )
                      
                      
                      79,543
                      
                      
                      
                      74,847Net
      (decrease) increase in cash and cash equivalents
                      
                      $
                      (9,855,114
                      )
                      
                      $
                      16,114,340
                      
                      
                      $
                      (2,691,964
                      )
  Our
principal sources of liquidity are cash flows generated from operations and our
cash, cash equivalents, and marketable securities balances. Our cash and cash
equivalents and marketable securities balances as of December 31, 2008, totaled
$42.8 million, as compared with $62.9 million as of December 31, 2007. Cash and
cash equivalents totaled $22.4 million and marketable securities totaled $20.4
million at December 31, 2008. As of December 31, 2007, we had $32.2 million in
cash and cash equivalents and $30.7 million in marketable
securities.
  In 2008,
we continued making investments in our infrastructure to support our current and
long-term growth. We increased our total number of employees in 2008 as well as
our continued investments in property and equipment. 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.
During the third quarter of 2008, we purchased certain assets of World Venture
Limited for an aggregate purchase price of $1.7 million including transaction
and closing costs (see Note (9) Acquisitions to our
consolidated financial statements). As of the date of this filing, we have no
other agreements, commitments or understandings with respect to any such
acquisitions.
 
 40
  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 2 million shares of our outstanding common
stock.  On February 6, 2008 and July 22, 2008, our Board of Directors
increased the authorization to repurchase our outstanding common stock by 3
million shares and 3 million shares, respectively, to 8 million shares in the
aggregate. On February 4, 2009, our Board of Directors again increased the
authorization to repurchase our outstanding common stock from 8 million shares
to 14 million shares in the aggregate with the result being that as of such
date, we may repurchase up to 7.2 million shares of our outstanding common
stock. During 2008, we repurchased 5,639,950 shares of our common stock in open
market purchases for a total cost of $33,874,504. During 2007, we repurchased
318,900 shares of our common stock in open market purchases for a total cost of
$3,273,661. Since October 2001, we had repurchased a total of 6,824,050 shares
of our common stock at an aggregate purchase price of $42,928,328. As of
December 31, 2008, we had the ability to repurchase an additional 1,175,950
shares of our common stock based upon our judgment and market conditions, before
the February 4, 2009, increased authorization. See Note (7) Stockholders’ Equity to our
consolidated financial statements for further information.
  Net cash
provided by operating activities totaled $18.2 million for the year ended
December 31, 2008, compared with net cash provided by operating activities of
$16.6 million and $8.2 million for the years ended December 31, 2007 and 2006,
respectively. Although our net income in 2008 decreased when compared with 2007,
and increased when compared with 2006, the increase in net cash provided by
operating activities during 2008, when compared with 2007 and 2006, was
primarily related to the following adjustments: (i) the impact of non-cash
charges, particularly relating to deferred income taxes, stock-based
compensation and depreciation and amortization; and (ii) adjustments for net
changes in operating assets and liabilities, particularly changes in our
accounts receivable, accounts payable, accrued expenses,  and our
deferred revenues. In addition, net cash provided by operating activities was
impacted by the tax benefits recognized as a result of excess stock-based
compensation deductions and exercises of stock options, particularly in 2008 and
2007. 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 $2.1 million and $5.1 million for the years ended December 31,
2008 and 2007, respectively. There were insignificant adjustments for the impact
of non-cash income tax benefits for the year ended December 31,
2006.
  Net cash
provided in investing activities was $3.3 million for the year ended December
31, 2008, compared with net cash used in investing activities of $12.4 million
and $11.3 million for the years ended December 31, 2007 and 2006, respectively.
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 provided by investing activities from
the net sales (purchases) of securities was $9.9 million, ($5.7) million and
($7.0) million for the years ended December 31, 2008, 2007 and 2006,
respectively. 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 $4.5 million, $5.5 million and $3.7 million for the years
ended December 31, 2008, 2007 and 2006, respectively. In addition, as discussed
above, and further in Note (9) Acquisitions to our
consolidated financial statements, during 2008 we used $1.7 million for the
acquisition of assets, while we did not use any cash for acquisitions of assets
in the same period of 2007 and 2006. We continually evaluate opportunities to
acquire 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
used in financing activities was $31.0 million for the year ended December 31,
2008, compared with net cash provided by financing activities of $11.8 million
and $0.4 million for the years ended December 31, 2007 and 2006, respectively.
Cash outflows from financing activities result from the repurchase of our
outstanding common stock. During 2008, we repurchased 5.6 million shares of our
common stock at an aggregate purchase price of $33.9 million. During 2007, we
repurchased 0.3 million shares of our common stock at an aggregate purchase
price of $3.3 million. During 2006, we repurchased 0.3 million shares of our
common stock at an aggregate purchase price of $2.1 million. Cash inflows from
financing activities primarily results from proceeds received from the exercise
of stock options. We received proceeds from the exercise of stock options of
$0.8 million, $10.0 million and $2.5 million in 2008, 2007, and 2006,
respectively. During 2008 and 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 $2.1 million and $5.1 million for the
years ended December 31, 2008 and 2007, respectively. There were insignificant
adjustments for the impact of non-cash income tax benefits for the year ended
December 31, 2006.
  41
  As
discussed in Note (4) Fair Value Measurements to
our consolidated financial statements, we adopted the provisions of SFAS No. 157
effective January 1, 2008. We utilize unobservable
(Level 3) inputs in determining the fair value of auction rate
securities we hold, totaling $1.5 million (at par value) at December 31,
2008.
  As of
December 31, 2008, $1.5 million (at par value) of our investments was
comprised of auction rate securities. Liquidity for these auction rate
securities is typically provided by an auction process, which allows holders to
sell their notes, and resets the applicable interest rate at pre-determined
intervals. During the first quarter of 2008, we began experiencing failed
auctions on auction rate securities. An auction failure means that the parties
wishing to sell their securities could not be matched with an adequate volume of
buyers. In the event that there is a failed auction, the indenture governing the
security requires the issuer to pay interest at a contractually defined rate
that is generally above market rates for other types of similar short-term
instruments. The securities for which auctions have failed will continue to
accrue interest at the contractual rate and continue to reset the next auction
date every 28 or 35 days until the auction succeeds, the issuer calls the
securities, or they mature. Because there is no assurance that auctions for
these securities will be successful in the near term and due to our ability and
intent to hold these securities to maturity, the auction rate securities were
classified as long-term investments in our consolidated balance sheet at
December 31, 2008.
  Our
auction rate securities are classified as available-for-sale securities and are
reflected at fair value. In prior periods during the auction process, which took
place every 28-35 days for most securities, quoted market prices were
readily available, which would qualify as Level 1 under SFAS No. 157.
However, due to events in credit markets throughout 2008, the auction events for
most of these instruments failed, and, therefore, we have determined the
estimated fair values of these securities utilizing a discounted cash flow
analysis or other type of valuation model as of December 31, 2008. These
analyses consider, among other items, the collateral underlying the security,
the creditworthiness of the issuer, the timing of the expected future cash
flows, including the final maturity, associated with the securities, and an
assumption of when the next time the security is expected to have a successful
auction. These securities were also compared, when possible, to other observable
and relevant market data, which is limited at this time. Due to these events, we
reclassified these instruments as Level 3 in 2008 and recorded a temporary
unrealized decline in fair value in the aggregate of approximately $333,000,
with an offsetting entry to accumulated other comprehensive loss, net of tax. We
currently believe that this temporary decline in fair value is due primarily to
liquidity concerns and not the creditworthiness of the underlying assets,
because the majority of securities are almost entirely backed by the
U.S. Government.
  In
addition, our holdings of auction rate securities represented approximately 4%
of our cash equivalents, and marketable securities balance at December 31, 2008,
which we believe allows us sufficient time for the securities to return to full
value or to be refinanced by the issuer. Because we believe that the current
decline in fair value is temporary and based primarily on liquidity issues in
the credit markets, any difference between our estimate and an estimate that
would be arrived at by another party would have no impact on our earnings, since
such difference would also be recorded to accumulated other comprehensive loss.
We will re-evaluate each of these factors as market conditions change in
subsequent periods.
  As of
December 31, 2007, we had $8.4 million of auction rate securities included
within our portfolio of marketable securities. During 2008 we sold $6.9 million
of the auction rate securities at par value. Accordingly, as of December 31,
2008, we had $1.5 million of auction rate securities remaining.
  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.
  We
currently do not have any debt and our only material cash commitments are
related to our office leases. We have an operating lease covering our corporate
office facility that expires in February 2012. We also have several operating
leases related to offices in the United States and foreign countries. The
expiration dates for these leases range from 2009 through 2012. The following is
a schedule of future minimum lease payments for all operating leases as of
December 31, 2008:
  42
  Year ending December 312009
                                
                                $
                                2,319,6902010
                                
                                
                                1,696,5222011
                                
                                
                                1,304,0702012
                                
                                
                                234,430$
                                5,554,712
 We
believe that our current balance of cash, cash equivalents and marketable
securities, and our 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, 2008 and 2007, 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, accounting for share-based compensation
expense, acquisitions and goodwill and other intangible assets.
  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 consider (i) 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 tax assets, and report such deferred tax assets at
the amount that is determined to be more-likely-than-not recoverable. We also
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 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. As of December 31, 2008 and 2007,
our deferred tax assets, net of deferred tax liabilities and valuation
allowance, were $10.0 million and $9.8 million, respectively. 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 assets valuation allowance of approximately $8.9
million.
  43
 
 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. The expected
option term is the number of years that we estimate that the stock options will
be outstanding prior to exercise. The estimated expected term of the stock
awards issued after December 31, 2007 was determined pursuant to SEC Staff
Accounting Bulletin (“SAB”) No. 110. The expected term of the awards issued
prior to January 1, 2008, was determined using the “simplified method”
prescribed in SAB No. 107. 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, 2008, 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.
  Acquisitions. We account for
acquisitions using the purchase method of accounting as required by SFAS No.
141, Business
Combination. Under SFAS No. 141, the acquiring company allocates the
purchase price of the assets acquired and liabilities assumed based on their
estimated fair values at the date of acquisition, including intangible assets
that can be identified. The purchase price in excess of the fair value of the
net assets and liabilities is recorded as goodwill. Among other sources of
relevant information, we use independent appraisals or other valuations to
assist in determining the estimated and final recorded fair value of assets and
liabilities acquired. As discussed further in Note (9) Acquisitions in our
consolidated financial statements, during the third quarter of 2008, we
purchased certain assets of World Venture Limited for an aggregate purchase
price of $1.7 million including transaction and closing costs, and recorded
approximately $0.6 million of goodwill as a result of the related fair value
appraisals performed.
  Goodwill and Other Intangible
Assets. SFAS No. 142, Goodwill and Other Intangible
Assets,requires an
impairment-only approach to accounting for goodwill and other intangibles with
an indefinite life. Absent any prior indicators of impairment, we perform an
annual impairment analysis during the fourth quarter of our fiscal
year.
  As of December 31, 2008, we had $4.2
million of goodwill and $1.4 million (net of amortization) of other identifiable
intangible assets. We do not amortize goodwill, but we assess for impairment at
least annually and more often if a trigger event occurs. We amortize
identifiable intangible assets over their estimated useful lives, which
typically is three-years. We evaluate the recoverability of goodwill using a
two-step process based on an evaluation of the reporting unit. The first step
involves a comparison of a reporting unit’s fair value to its carrying value. In
the second step, if the reporting unit’s carrying value exceeds its fair value,
we compare the goodwill’s implied fair value and its carrying value. If the
goodwill’s carrying value exceeds its implied fair value, we recognize an
impairment loss in an amount equal to such excess. We evaluate the
recoverability of other identifiable intangible assets whenever events or
changes in circumstances indicate that its carrying value may not be
recoverable. Such events include significant adverse changes in business
climate, several periods of operating or cash flow losses, forecasted continuing
losses or a current expectation that an asset or asset a group will be disposed
of before the end of its useful life. As discussed further in Note (9) Acquisitions in our
consolidated financial statements, during the third quarter of 2008, we
purchased certain assets of World Venture Limited for an aggregate purchase
price of $1.7 million including transaction and closing costs, and recorded
approximately $0.6 million of goodwill as a result of the related fair value
appraisals performed. As of December 31, 2008, we did not record any impairment
charges on either our goodwill or other identifiable intangible
assets.
  44
  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. The adoption of the provisions of SFAS
No. 141(R) will only have an effect on our consolidated financial
statements in the event we enter into any business combinations subsequent to
January 1, 2009.
  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 adoption of the provisions of
SFAS No. 160 is not anticipated to have any impact on our consolidated
financial statements.
  In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
Effective Date of FASB
Statement No. 157 (“FSP 157-2”), to partially defer SFAS
No. 157, Fair Value
Measurements. FSP 157-2 defers the effective date of SFAS No. 157
for nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually), to fiscal years, and interim periods within those
fiscal years, beginning after November 15, 2008. The adoption of the
provisions of SFAS No. 157 on nonfinancial assets and liabilities is not
anticipated to materially impact our consolidated financial
statements.
 
 In April
2008, the FASB issued SFAS No. 142-3, Determination of the Useful Life of
Intangible Assets. SFAS No.  142-3 amends the factors that
should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under SFAS
No. 142, Goodwill and
Other Intangible Assets. The intent is to improve the consistency between
the useful life of a recognized intangible asset under SFAS No. 142 and the
period of expected cash flows used to measure the fair value of the asset under
SFAS No. 141(R), and other GAAP. SFAS No. 142-3 will be effective for
intangible assets acquired beginning January 1, 2009. Accordingly, the
impact on us would be limited to the extent of any future
acquisitions.
 
 In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (the GAAP
hierarchy). SFAS No. 162 will become effective sixty days following the
Securities and Exchange Commission’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. The adoption of
the provisions of SFAS No. 162 is not anticipated to materially impact our
consolidated financial statements.
 
 In
October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active.
FSP 157-3 clarified the application of SFAS No. 157. FSP 157-3
demonstrated how the fair value of a financial asset is determined when the
market for that financial asset is inactive. FSP 157-3 was effective upon
issuance, including prior periods for which financial statements had not been
issued. The guidance provided by FSP 157-3 is consistent with our approach to
valuing financial assets, for which there are no active markets, including its
investment in auction rate securities. See Note (4) Fair Value Measurements to
our consolidated financial statements for additional information.
  45
  In
January 2009, the FASB issued FSP No. Emerging Issues Task Force
(EITF) 99-20-1, Amendments to
the Impairment Guidance of EITF Issue No. 99-20, (FSP No. EITF
99-20-1). This FSP provided additional guidance with respect to how entities
determine whether an “other-than-temporary impairment” (OTTI) exists for certain
beneficial interests in a securitized transaction, such as asset-backed
securities and mortgage-backed securities, that (i) do not have a high
quality rating or (ii) can be contractually prepaid or otherwise settled
such that the holder would not recover substantially all of its investment. FSP
No. EITF 99-20-1 amended EITF Issue No. 99-20 to more closely align
its OTTI guidance with that of SFAS No. 115, Accounting for Certain Investment in
Debt and Equity Securities. This FSP was effective for us prospectively
beginning October 1, 2008. We have considered this FSP’s additional
interpretation of EITF Issue No. 99-20 when classifying respective
additional impairments as “temporary” or “other-than-temporary” commencing in
the fourth quarter of 2008. This FSP had no material impact on such
classifications. See Note (4) Fair Value Measurements to
our consolidated financial statements for additional information.
 
 Item 7A.
              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 $42.8 million as of December 31, 2008, 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, 2008, 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, 2008, the effect on our other comprehensive income would
be insignificant. We do not use derivative financial instruments to limit our
foreign currency risk exposure.
 
  Item 8.
              Financial
      Statements and Supplementary Data
  Index
      to Consolidated Financial Statements
                  PageReports
      of Independent Registered Public Accounting Firm
                  47Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                  49Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007 and
      2006.
                  50Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the
      years Ended December 31, 2008, 2007 and 2006
                  51Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007 and
      2006
                  52Notes
      to Consolidated Financial Statements
                  54
 
  46
  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, 2008 and 2007, 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, 2008.  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, 2008 and 2007, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2008, in conformity with U.S. generally accepted accounting
principles.
 
 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,
2008, 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 11, 2009, expressed an
unqualified opinion on the effective operation of internal control over
financial reporting.
 
  /s/
KPMG LLP
  Melville,
New York,
 March 11,
2009
  47
   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, 2008, 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,
2008, 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, 2008 and 2007, 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, 2008, and our report dated March 11, 2009,
expressed an unqualified opinion on those consolidated financial
statements.
 
 /s/  KPMG
LLP
 
 Melville,
New York
 March 11,
2009
  48
 
 FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
  December
      31,2008
                  
                  
                  2007AssetsCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  22,364,235
                  
                  
                  $
                  32,219,349Marketable
      securities
                  
                  
                  19,279,010
                  
                  
                  
                  30,684,206Accounts
      receivable, net of allowances of $8,474,428 and$8,780,880,
      respectively
                  
                  
                  25,015,848
                  
                  
                  
                  26,141,636Prepaid
      expenses and other current assets
                  
                  
                  2,468,632
                  
                  
                  
                  1,625,417Deferred
      tax assets, net
                  
                  
                  4,296,297
                  
                  
                  
                  3,807,325Total
      current assets
                  
                  
                  73,424,022
                  
                  
                  
                  94,477,933Property
      and equipment, net of accumulated depreciation of
                    $18,342,081
      and $13,861,313, respectively
                  
                  
                  7,963,019
                  
                  
                  
                  7,945,258Long-term
      marketable securities
                  
                  
                  1,166,945
                  
                  
                  
                  -Deferred
      tax assets, net
                  
                  
                  5,739,195
                  
                  
                  
                  5,969,778Other
      assets, net
                  
                  
                  2,544,545
                  
                  
                  
                  2,831,878Goodwill
                  
                  
                  4,150,339
                  
                  
                  
                  3,512,796Other
      intangible assets, net
                  
                  
                  1,375,695
                  
                  
                  
                  443,909Total
      assets
                  
                  $
                  96,363,760
                  
                  
                  $
                  115,181,552Liabilities
      and Stockholders' EquityCurrent
      liabilities:Accounts
      payable
                  
                  $
                  738,140
                  
                  
                  $
                  1,779,720Accrued
      expenses
                  
                  
                  8,288,732
                  
                  
                  
                  6,711,231Deferred
      revenue, net
                  
                  
                  16,068,370
                  
                  
                  
                  14,142,145Total
      current liabilities
                  
                  
                  25,095,242
                  
                  
                  
                  22,633,096Other
      long-term liabilities
                  
                  
                  199,323
                  
                  
                  
                  251,094Deferred
      revenue, net
                  
                  
                  5,992,843
                  
                  
                  
                  4,818,985Total
      liabilities
                  
                  
                  31,287,408
                  
                  
                  
                  27,703,175Commitments
      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,
                    51,970,442
      and 51,340,268 shares issued, respectively and 45,146,392
                    and
      50,156,168 shares outstanding, respectively
                  
                  
                  51,970
                  
                  
                  
                  51,340Additional
      paid-in capital
                  
                  
                  132,998,230
                  
                  
                  
                  122,294,782Accumulated
      deficit
                  
                  
                  (24,089,189
                  )
                  
                  
                  (25,292,001
                  )Common
      stock held in treasury, at cost (6,824,050 and 1,184,100 shares,
      respectively)
                  
                  
                  (42,928,328
                  )
                  
                  
                  (9,053,824
                  )Accumulated
      other comprehensive loss, net
                  
                  
                  (956,331
                  )
                  
                  
                  (521,920
                  )Total
      stockholders' equity
                  
                  
                  65,076,352
                  
                  
                  
                  87,478,377Total
      liabilities and stockholders' equity
                  
                  $
                  96,363,760
                  
                  
                  $
                  115,181,552
 
 See
accompanying notes to consolidated financial statements.
 49
  FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
  CONSOLIDATED
STATEMENTS OF OPERATIONS
  Years
      Ended December 31,2008
                
                
                2007
                
                
                2006Revenues:Software
      license revenue
                
                $
                58,590,246
                
                
                $
                53,153,980
                
                
                $
                38,317,352Maintenance
      revenue
                
                
                23,283,094
                
                
                
                18,606,591
                
                
                
                12,475,342Software
      services and other revenue
                
                
                5,151,520
                
                
                
                5,638,651
                
                
                
                4,273,33487,024,860
                
                
                
                77,399,222
                
                
                
                55,066,028Operating
      expenses:Cost
      of maintenance, software services and other revenue
                
                
                13,874,238
                
                
                
                11,213,935
                
                
                
                9,410,513Software
      development costs
                
                
                25,296,404
                
                
                
                22,405,058
                
                
                
                20,021,899Selling
      and marketing
                
                
                38,096,693
                
                
                
                29,656,034
                
                
                
                23,712,488General
      and administrative
                
                
                8,745,777
                
                
                
                8,023,562
                
                
                
                5,828,150Litigation
      settlement
                
                
                -
                
                
                
                -
                
                
                
                799,31786,013,112
                
                
                
                71,298,589
                
                
                
                59,772,367Operating
      income (loss)
                
                
                1,011,748
                
                
                
                6,100,633
                
                
                
                (4,706,339
                )Interest
      and other income, net
                
                
                1,688,699
                
                
                
                2,329,187
                
                
                
                1,650,284Income
      (loss) before income taxes
                
                
                2,700,447
                
                
                
                8,429,820
                
                
                
                (3,056,055
                )Provision
      (benefit) for income taxes
                
                
                1,497,635
                
                
                
                (4,312,036
                )
                
                
                318,473Net
      income (loss)
                
                $
                1,202,812
                
                
                $
                12,741,856
                
                
                $
                (3,374,528
                )Basic
      net income (loss) per share
                
                $
                0.03
                
                
                $
                0.26
                
                
                $
                (0.07
                )Diluted
      net income (loss) per share
                
                $
                0.02
                
                
                $
                0.24
                
                
                $
                (0.07
                )Basic
      weighted average common shares outstanding
                
                
                47,858,679
                
                
                
                49,420,848
                
                
                
                48,044,946Diluted
      weighted average common shares outstanding
                
                
                49,496,736
                
                
                
                53,130,903
                
                
                
                48,044,946
 
 See
accompanying notes to consolidated financial statements.
 50
 
 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, 2005
                                    
                                    $
                                    48,442
                                    
                                    
                                    $
                                    87,342,747
                                    
                                    
                                    $
                                    (34,659,329
                                    )
                                    
                                    $
                                    (3,632,930
                                    )
                                    
                                    $
                                    (440,823
                                    )
                                    
                                    $
                                    48,658,107Exercise
      of stock awards
                                    
                                    
                                    644
                                    
                                    
                                    
                                    2,500,512
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    2,501,156
                                    
                                    
                                    
                                    –Net
      effects of tax benefits from  tock-based award
      activity
                                    
                                    
                                    –
                                    
                                    
                                    
                                    45,895
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    45,895
                                    
                                    
                                    
                                    –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 awards
                                    
                                    
                                    2,254
                                    
                                    
                                    
                                    10,004,920
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    10,007,174
                                    
                                    
                                    
                                    –Net
      effects of tax benefits from  stock-based award
      activity
                                    
                                    
                                    –
                                    
                                    
                                    
                                    5,070,031
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    5,070,031
                                    
                                    
                                    
                                    –Issuance
      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
                                    
                                    
                                    $
                                    12,694,063Exercise
      of stock awards
                                    
                                    
                                    630
                                    
                                    
                                    
                                    820,652
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    821,282
                                    
                                    
                                    
                                    –Net
      effects of tax benefits from  stock-based award
      activity
                                    
                                    
                                    –
                                    
                                    
                                    
                                    798,280
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    798,280
                                    
                                    
                                    
                                    –Issuance
      of stock options to non-employees
                                    
                                    
                                    –
                                    
                                    
                                    
                                    140,975
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    140,975
                                    
                                    
                                    
                                    –Share-based
      compensation
                                    
                                    
                                    –
                                    
                                    
                                    
                                    8,943,541
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    8,943,541Net
      Income
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    1,202,812
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    1,202,812
                                    
                                    
                                    
                                    1,202,812Acquisition
      of treasury stock
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    (33,874,504
                                    )
                                    
                                    
                                    –
                                    
                                    
                                    
                                    (33,874,504
                                    )
                                    
                                    
                                    –Minimum
      pension liability adjustment, net (Note 11)
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    61,454
                                    
                                    
                                    
                                    61,454
                                    
                                    
                                    
                                    61,454Change
      in unrealized gains / losses on marketable securities, net
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    (224,299
                                    )
                                    
                                    
                                    (224,299
                                    )
                                    
                                    
                                    (224,299
                                    )Foreign
      currency translation adjustment
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    (271,566
                                    )
                                    
                                    
                                    (271,566
                                    )
                                    
                                    
                                    (271,566
                                    )Balance,
      December 31, 2008
                                    
                                    $
                                    51,970
                                    
                                    
                                    $
                                    132,998,230
                                    
                                    
                                    $
                                    (24,089,189
                                    )
                                    
                                    $
                                    (42,928,328
                                    )
                                    
                                    $
                                    (956,331
                                    )
                                    
                                    $
                                    65,076,352
                                    
                                    
                                    $
                                    768,401
  See
accompanying notes to consolidated financial statements.
 51
  FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
  Years
      Ended December 31,2008
                
                
                2007
                
                
                2006Cash
      flows from operating activities:Net
      income (loss)
                
                $
                1,202,812
                
                
                $
                12,741,856
                
                
                $
                (3,374,528
                )Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Depreciation
      and amortization
                
                
                5,075,090
                
                
                
                3,917,484
                
                
                
                3,581,451Share-based
      payment employee compensation
                
                
                8,943,541
                
                
                
                7,728,305
                
                
                
                9,375,240Non-cash
      professional services expenses
                
                
                140,975
                
                
                
                209,218
                
                
                
                17,914Realized
      (gain) loss on marketable securities
                
                
                (7,403
                )
                
                
                (24,928
                )
                
                
                28,854Impairment
      (gain on sale) of cost method investments
                
                
                65,424
                
                
                
                124,038
                
                
                
                (3,112
                )Realized
      gain on sale of warrants
                
                
                --
                
                
                
                --
                
                
                
                (38,378
                )Excess
      tax benefits from stock-based award activity
                
                
                (2,054,914
                )
                
                
                (5,070,031
                )
                
                
                (45,895
                )Provision
      for returns and doubtful accounts
                
                
                4,088,575
                
                
                
                5,041,216
                
                
                
                4,765,148Deferred
      income taxes
                
                
                (1,125,867
                )
                
                
                (9,837,482
                )
                
                
                --Changes
      in operating assets and liabilities:Accounts
      receivable
                
                
                (2,968,069
                )
                
                
                (7,033,855
                )
                
                
                (13,704,152
                )Prepaid
      expenses and other current assets
                
                
                (848,588
                )
                
                
                (367,972
                )
                
                
                (326,695
                )Other
      assets
                
                
                139,253
                
                
                
                (129,459
                )
                
                
                122,098Accounts
      payable
                
                
                (1,020,454
                )
                
                
                300,766
                
                
                
                254,211Accrued
      expenses and other liabilities
                
                
                3,503,772
                
                
                
                5,139,110
                
                
                
                2,018,002Deferred
      revenue
                
                
                3,097,462
                
                
                
                3,850,273
                
                
                
                5,492,625Net
      cash provided by operating activities
                
                
                18,231,609
                
                
                
                16,588,539
                
                
                
                8,162,783Cash
      flows from investing activities:Purchase
      of marketable securities
                
                
                (99,690,769
                )
                
                
                (110,825,016
                )
                
                
                (78,776,443
                )Sale
      of marketable securities
                
                
                109,569,524
                
                
                
                105,156,272
                
                
                
                71,752,493Sale
      of cost method investment
                
                
                --
                
                
                
                --
                
                
                
                96,755Purchase
      of cost method investments
                
                
                --
                
                
                
                (923,636
                )
                
                
                (198,117
                )Acquisition
      of assets
                
                
                (1,696,000
                )
                
                
                --
                
                
                
                --Purchase
      of warrants
                
                
                --
                
                
                
                --
                
                
                
                (635,000
                )Sale
      of warrants
                
                
                --
                
                
                
                --
                
                
                
                673,378Purchase
      of property and equipment
                
                
                (4,502,417
                )
                
                
                (5,510,953
                )
                
                
                (3,693,756
                )Purchase
      of software licenses
                
                
                --
                
                
                
                (185,000
                )
                
                
                (173,431
                )Purchase
      of intangible assets
                
                
                (340,482
                )
                
                
                (266,401
                )
                
                
                (373,229
                )Refund
      of security deposits
                
                
                (4,000
                )
                
                
                197,448
                
                
                
                (2,062
                )Net cash provided by (used in) investing activities
                
                
                3,335,856
                
                
                
                (12,357,286
                )
                
                
                (11,329,412
                )  52
  Cash
      flows from financing activities:Proceeds
      from exercise of stock options
                
                
                821,282
                
                
                
                10,007,174
                
                
                
                2,501,156Payments
      to acquire treasury stock
                
                
                (33,874,504
                )
                
                
                (3,273,661
                )
                
                
                (2,147,233
                )Excess
      tax benefits from stock-based award activity
                
                
                2,054,914
                
                
                
                5,070,031
                
                
                
                45,895Net cash (used in) provided by financing activities
                
                
                (30,998,308
                )
                
                
                11,803,544
                
                
                
                399,818Effect
      of exchange rate changes
                
                
                (424,271
                )
                
                
                79,543
                
                
                
                74,847Net
      (decrease) increase in cash and cash equivalents
                
                
                (9,855,114
                )
                
                
                16,114,340
                
                
                
                (2,691,964
                )Cash
      and cash equivalents, beginning of year
                
                
                32,219,349
                
                
                
                16,105,009
                
                
                
                18,796,973Cash
      and cash equivalents, end of year
                
                $
                22,364,235
                
                
                $
                32,219,349
                
                
                $
                16,105,009Cash
      paid for income taxes
                
                $
                1,125,415
                
                
                $
                273,631
                
                
                $
                79,501
  The
Company did not pay any interest for the three years ended December 31,
2008.
 
 See accompanying notes to consolidated
financial statements.
 53
  FALCONSTOR SOFTWARE, INC. AND
SUBSIDIARIES
  Notes
to Consolidated Financial Statements
  December
31, 2008
 (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, cost-based investments, marketable securities and deferred
income taxes. Actual results could differ from those estimates.
  The
financial market volatility and poor economic conditions beginning in the third
quarter of 2008 and continuing into 2009, both in the U.S. and in many other
countries where the Company operates, have impacted and may continue to impact
the Company’s business. Such
conditions could have a material impact to the Company’s significant accounting
estimates discussed above, in particular those around accounts receivable
allowances, cost-based investments and marketable securities.
  (d)           CashEquivalents and Marketable
Securities
  The
Company considers all highly liquid investments with maturities of three months
or less when purchased to be cash equivalents. As of December 31, 2008 and
December 31, 2007, the Company’s cash equivalents consisted of money market
funds and commercial paper, and are recorded at fair value. At December 31,
2008, the fair value of the Company’s cash equivalents, as defined under
Financial Accounting Standards Board “FASB” Statement of Financial Accounting
Standards “SFAS” No. 157, Fair
Value Measurements, amounted to approximately $15.9 million. As of
December 31, 2008 and December 31, 2007, the Company’s marketable securities
consisted of corporate bonds, certificate of deposits, auction rate securities,
and government securities, and are recorded at fair value. As of December 31,
2008, the fair value of the Company’s current marketable securities as defined
under SFAS No. 157 was approximately $19.3 million. In addition, at December 31,
2008, the Company had an additional $1.2 million of long-term marketable
securities that required a higher level of judgment to determine the fair value,
as defined under SFAS No. 157. As of December 31, 2007, the Company’s cash
equivalents amounted to approximately $21.3 million, and marketable securities
amounted to approximately $30.7 million. All of the Company’s marketable
securities are classified as available-for-sale, and accordingly, unrealized
gains and losses on marketable securities, net of tax, are reflected as a
component of accumulated other comprehensive loss in stockholders’
equity.
 
 54
  As of
December 31, 2008, the Company had $1.5 million (at par value) of auction rate
securities included within its portfolio of marketable securities. During the
year ended December 31, 2008, the Company recorded approximately $0.3 million of
unrealized losses on these auction rate notes. The Company determined the
decline in market value below cost to be temporary based upon the Company’s
ability to retain the investment over a period of time, which would be
sufficient to allow for any recovery in market value. Accordingly, based upon
the Company’s intent and ability to retain these investments over a period of
time believed to be sufficient to recover the value, it has classified the
auction rate securities as long-term marketable securities on its consolidated
balance sheet as of December 31, 2008. See Note (4) Fair Value Measurements for
additional information.
  (e)           Fair
Value of Financial Instruments
  Effective
January1, 2008, the Company
adopted SFAS No. 157, except as it applies to the nonfinancial
assets and nonfinancial liabilities subject to FASB Staff Position
(“FSP”)
No. SFAS 157-2,Effective
Date of FASB Statement No. 157.SFAS No. 157
clarifies the definition of fair value, prescribes methods for measuring fair
value, establishes a fair value hierarchy based on the inputs used to
measure fair value, and expands disclosures about fair value measurements. The
three-tier fair value hierarchy, which prioritizes the inputs used in the
valuation methodologies, is as follows:
  
 Level 1—Valuations based
on quoted prices for identical assets and liabilities in active
markets.
 
 Level 2—Valuations based
on observable inputs other than quoted prices included in Level 1, such as
quoted prices for similar assets and liabilities in active markets, quoted
prices for identical or similar assets and liabilities in markets that are not
active, or other inputs that are observable or can be corroborated by observable
market data.
 
 Level 3—Valuations based
on unobservable inputs reflecting our own assumptions, consistent with
reasonably available assumptions made by other market participants. These
valuations require significant judgment.
  As of
December 31, 2008 and 2007, 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. See
Note (4) Fair Value
Measurementsfor additional information.
  (f)           Revenue
Recognition
  The
Company recognizes revenue from software licenses in accordance with Statement
of Position (“SOP”) 97-2, Software RevenueRecognition, 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.
  Revenues
associated with software implementation and software engineering services are
recognized when 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 to 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 hardware is delivered based on its
relative fair value.
  55
  (g)           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
terms of the respective leases or over their estimated useful lives, whichever
is shorter.
  (h)           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 SFAS No. 142, Goodwill and Other Intangible
Assets, the Company has not amortized goodwill related to its
acquisitions, but instead tests the balance for impairment. The Company’s annual
impairment assessment is performed during the fourth quarter of each year, and
an assessment is made at other times if events or changes in circumstances
indicate that it is more likely than not that the asset is impaired.
Identifiable intangible assets, which include (i) assets acquired through
business combinations, which include customer contracts and intellectual
property, and (ii) patents are amortized over three years using the
straight-line method. See Note (9) Acquisitions for additional
information.
  Amortization
expense was $464,495, $229,808 and $182,777 for the years ended December 31,
2008, 2007 and 2006, respectively. The gross carrying amount and accumulated
amortization of other intangible assets as of December 31, 2008 and December 31,
2007 are as follows:
 December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007Goodwill:
                        
                        $
                        4,150,339
                        
                        
                        $
                        3,512,796Other
      intangible assets:Gross
      carrying amount
                        
                        $
                        2,685,775
                        
                        
                        $
                        1,289,494Accumulated
      amortization
                        
                        
                        (1,310,080
                        )
                        
                        
                        (845,585
                        )Net
      carrying amount
                        
                        $
                        1,375,695
                        
                        
                        $
                        443,909
  As of
December 31, 2008, amortization expense for existing identifiable intangible
assets is expected to be $625,826, $516,718, and $233,151 for the years ended
December 31, 2009, 2010 and 2011, respectively.  Such assets will be
fully amortized at December 31, 2011.
  (i)           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.
  The
purchased software technology net carrying value of $102,540 and $246,017, after
accumulated amortization of $5,274,891 and $5,131,414, is included in “other
assets” in the balance sheets as of December 31, 2008 and December 31, 2007,
respectively. Amortization expense was $143,477, $122,560 and $362,159 for the
years ended December 31, 2008, 2007 and 2006, 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.
  56
  As of
December 31, 2008, amortization expense for software development costs and
purchased software technology is expected to be $67,540 and $35,000 for the
years ended December 31, 2009 and 2010, respectively.  Such assets
will be fully amortized at December 31, 2010.
  (j)           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 FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, (“FIN 48”). FIN 48 is an interpretation of SFAS 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 on January 1, 2007 did not result in any adjustment to the
recognized benefits from the Company’s uncertain tax positions. The Company
includes interest and penalties related to its tax contingencies in income tax
expense. See Note (6) Income
Taxes for additional information.
  (k)           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.
  (l)           Share-BasedPayments
  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.
  57
  The
Company accounts for stock option grants and grants ofrestricted shares of
common stock to non-employees in accordance with SFAS No. 123,Accounting for Stock-Based
Compensation, and Emerging Issues Task Force (“EITF”) Issue No. 96-18,Accountingfor Equity Instruments That Are
Issued to Other Than Employeesfor Acquiring, or in Conjunction
with Selling, Goods or Services, which requires 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.
  (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 consolidated statements
of operations within interest and other income, net.  During the years
ended December 31, 2008, 2007, and 2006, foreign currency realized gains
/(losses) totaled approximately $199,000, $22,000 and ($51,000),
respectively.
  (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 of 11,810,975 were excluded from diluted net loss per
share. As of December 31, 2008, 2007 and 2006, potentially dilutive common stock
equivalents included 8,525,928, 6,454,969, and 11,810,975 stock options and
shares of restricted stock outstanding, respectively. As of December 31, 2006,
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, 2008
                            
                            
                            Year
      Ended December 31, 2007
                            
                            
                            Year
      Ended December 31, 2006Net
      Income
                            
                            
                            Shares
                            
                            
                            Per
      Share
                            
                            
                            Net
      Income
                            
                            
                            Shares
                            
                            
                            Per
      Share
                            
                            
                            Net
      Income
                            
                            
                            Shares
                            
                            
                            Per
      Share(Numerator)
                            
                            
                            (Denominator)
                            
                            
                            Amount
                            
                            
                            (Numerator)
                            
                            
                            (Denominator)
                            
                            
                            Amount
                            
                            
                            (Numerator)
                            
                            
                            (Denominator)
                            
                            
                            AmountBasic
      EPS
                            
                            $
                            1,202,812
                            
                            
                            
                            47,858,679
                            
                            
                            $
                            0.03
                            
                            
                            $
                            12,741,856
                            
                            
                            
                            49,420,848
                            
                            
                            $
                            0.26
                            
                            
                            $
                            (3,374,528
                            )
                            
                            
                            48,044,946
                            
                            
                            $
                            (0.07
                            )Effect
      of dilutive securities:Stock
      Options and Restricted Stock
                            
                            
                            
                            
                            
                            
                            1,638,057
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            3,710,055
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            -Diluted
      EPS
                            
                            $
                            1,202,812
                            
                            
                            
                            49,496,736
                            
                            
                            $
                            0.02
                            
                            
                            $
                            12,741,856
                            
                            
                            
                            53,130,903
                            
                            
                            $
                            0.24
                            
                            
                            $
                            (3,374,528
                            )
                            
                            
                            48,044,946
                            
                            
                            $
                            (0.07
                            )
  58
 (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 additional information.
  For the
years ended December 31, 2008, 2007 and 2006 other comprehensive income is as
follows:
  2008
                        
                        
                        2007
                        
                        
                        2006Net
      income (loss)
                        
                        $
                        1,202,812
                        
                        
                        $
                        12,741,856
                        
                        
                        $
                        (3,374,528
                        )Other
      comprehensive (loss) income:Foreign
      currency translation (loss) gain adjustments
                        
                        
                        (271,566
                        )
                        
                        
                        1,157
                        
                        
                        
                        28,378Unrealized
      (loss) gain on  marketable securities, net of
tax
                        
                        
                        (224,299
                        )
                        
                        
                        66,975
                        
                        
                        
                        25,800Minimum
      pension adjustments
                        
                        
                        61,454
                        
                        
                        
                        (115,925
                        )
                        
                        
                        (87,482
                        )Other
      comprehensive (loss)
                        
                        
                        (434,411
                        )
                        
                        
                        (47,793
                        )
                        
                        
                        (33,304
                        )Comprehensive
      income / (loss)
                        
                        $
                        768,401
                        
                        
                        $
                        12,694,063
                        
                        
                        $
                        (3,407,832
                        )
 As of
December 31, 2008 and 2007, accumulated other comprehensive (loss) was comprised
of: (i) foreign currency translation adjustment losses; (ii) unrealized (gains)
losses on marketable securities, net of tax, and (iii) unrecognized pension
adjustments, net of tax. As of December 31, 2008 and 2007, accumulated other
comprehensive income is as follows:
 2008
                        
                        
                        2007Accumulated
      other comprehensive loss:Foreign
      currency translation  loss adjustments
                        
                        $
                        (633,572
                        )
                        
                        $
                        (362,006
                        )Unrealized
      (loss) gain on marketable securities, net of tax
                        
                        
                        (180,807
                        )
                        
                        
                        43,493Unrecognized
      pension adjustments, net of tax
                        
                        
                        (141,952
                        )
                        
                        
                        (203,407
                        )Accumulated
      other comprehensive loss
                        
                        $
                        (956,331
                        )
                        
                        $
                        (521,920
                        )
 (p)           Investments
  As of
December 31, 2008 and 2007, the Company maintained certain cost-method
investments aggregating $1,031,033 and $1,116,457, respectively, which are
included in “Other assets” in the accompanying consolidated balance sheets.
During 2008 and 2007, the Company recognized impairment charges of $65,424 and
$124,038, respectively, related to certain of its cost-method investments 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
forInvestments in
Common Stock,(“APB 18”), and since each of its investments represents
less than 20% of the entity, and the Company does not have significant
influence, the Company accounts for each under the cost-method of
accounting.
  59
  (q)           Treasury
Stock
  The
Company accounts for treasury stock under the cost method and includes treasury
stock as a component of stockholders’ equity.
  (r)           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. Theadoption of the
provisions of SFAS
No. 141(R) will only have an effect on the Company’s consolidated
financial statements in the event it enters into any business combinations
subsequent to January 1, 2009.
  In
December 2007, the FASBissued 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 effectivefor fiscal years
beginning after December 15, 2008. The adoption of the provisions of
SFASNo. 160 is not anticipated to have any impact on the Company’s
consolidated financial statements.
  In February 2008, the FASBissued
FSP No. FAS 157-2, to partially defer SFAS No. 157.
FSP 157-2 defers the effective date of SFAS No. 157 for nonfinancial assets
and nonfinancial liabilities, except those that are recognized or disclosed at
fair value in the financial statements on a recurring basis (at least annually),
to fiscal years, and interim periods within those fiscal years, beginning after
November 15, 2008. The adoption of the provisions of SFAS No. 157 on
nonfinancial assets and liabilities is not anticipated to materially impact the
Company’s consolidated financial
statements.
  In April
2008, the FASB issued SFAS No. 142-3, Determination of the Useful Life of
Intangible Assets. SFAS No.  142-3 amends the factors that
should be
considered in developing renewal or extension assumptions used to determine the
useful life of a recognized intangible asset under SFAS No. 142. The intent
is to improve the consistency between the useful life of a recognized intangible
asset under SFAS No. 142 and the period of expected cash flows used to measure
the fair value of the asset under SFAS No. 141(R), and other GAAP. SFAS No.
142-3 will be effective for intangible assets acquired beginning January 1,
2009. Accordingly, the impact on the Company would be limited to the extent of
any future acquisitions.
  In May 2008, the FASB
issued SFAS No. 162,The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162
identifies the sources of accounting principles and the framework for selecting
the principles used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles (the GAAP hierarchy). SFASNo. 162 will become
effective sixty days following the Securities and Exchange
Commission’s
approval of the Public Company Accounting Oversight Board amendments to AU
Section 411,The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles.
The adoption of the provisions of SFAS No. 162 is not anticipated to
materially impact the Company’s consolidated financial
statements.
  In
October 2008, the FASB issued FSP 157-3, Determiningthe Fair Value of a
Financial Asset When
the Market for That Asset Is Not Active.FSP 157-3 clarified
the application of SFAS No. 157. FSP 157-3 demonstrated how the fair
value of a financial asset is determined when the market for that financial
asset is inactive. FSP 157-3 waseffective upon issuance, including
prior periods for which financial statements had not been issued. The guidance
provided by FSP 157-3 is consistent with the Company’s approach to valuing
financial assets, for which there are no active markets, including its
investment in auction rate securities. See  Note (4) Fair Value Measurementsfor
additional information.
  60
  In
January 2009, the FASB issued FSP No. Emerging Issues Task Force
(EITF) 99-20-1, Amendments to
the Impairment Guidance of EITF Issue No. 99-20,
(FSP No. EITF 99-20-1). This FSP provided additional guidance with respect
to how entities determine whether an “other-than-temporary
impairment”(OTTI) exists for certain
beneficial interests in a securitized transaction, such as asset-backedsecurities and
mortgage-backed securities, that (i) do not have a high quality rating or
(ii) can be contractually prepaid or otherwise settled such that the holder
would not recover substantially all of its investment. FSP No. EITF 99-20-1
amended EITF Issue No. 99-20 to more closely align its OTTI guidance with
that of SFAS No. 115, Accounting
for Certain Investment in Debt and Equity Securities. This FSP was
effective for the Company prospectively beginning October 1, 2008. The
Company has considered this FSP’s additional
interpretation of EITF Issue No. 99-20 when classifying respective
additional impairments as “temporary”or“other-than-temporary”beginning with the fourth
quarter of 2008. This FSP had no material impact on such classifications. See
Note (4)Fair
ValueMeasurementsfor additional
information.
  (s)           Reclassifications
  Certain
reclassifications have been made to the prior periods consolidated financial
statements to conform to the current period’s presentation.
 (2)           Property
and Equipment
 Property
and equipment consist of the following:
 
 December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007Computer
      hardware and software
                        
                        $
                        24,110,190
                        
                        
                        $
                        20,104,860Furniture
      and equipment
                        
                        
                        566,598
                        
                        
                        
                        530,530Leasehold
      improvements
                        
                        
                        1,615,304
                        
                        
                        
                        1,158,173Automobile
                        
                        
                        13,008
                        
                        
                        
                        13,00826,305,100
                        
                        
                        
                        21,806,571Less
      accumulated depreciation
                        
                        
                        (18,342,081
                        )
                        
                        
                        (13,861,313
                        )$
                        7,963,019
                        
                        
                        $
                        7,945,258
 
 Depreciation
expense was $4,467,118, $3,565,116, and $3,071,018 in 2008, 2007, and 2006,
respectively.
 (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.
 61
  The cost
and fair values of the
Company’s available-for-sale marketable securities as of December 31, 2008, are
as follows:
  Aggregate
                                  Fair
      Value
                                
                                
                                Cost
                                  Basis
                                
                                
                                Net
      Unrealized
                                  Gains
      / (loss)Auction
      rate securities (a)
                                
                                $
                                1,166,945
                                
                                
                                $
                                1,500,000
                                
                                
                                $
                                (333,055
                                )Government
      securities
                                
                                
                                13,760,507
                                
                                
                                
                                13,600,725
                                
                                
                                
                                159,782Corporate
      debt securities (b)
                                
                                
                                5,518,503
                                
                                
                                
                                5,592,253
                                
                                
                                
                                (73,750
                                )$
                                20,445,955
                                
                                
                                $
                                20,692,978
                                
                                
                                $
                                (247,023
                                )
 (a)
                    As
      of December 31, 2008, the fair value and cost basis of auction rate
      securities was $1.2 million and $1.5 million, respectively. As of
      December 31, 2007, the fair value and cost basis of auction rate
      securities was $8.4 million and $8.4 million, respectively. See Note (4)
      Fair Value
      Measurements for additional
information.
 (b)
                    As
      of December 31, 2008, there are three corporate debt securities that are
      in an immaterial unrealized loss position. The Company evaluated the
      nature of these investments, the credit worthiness of the issuer and the
      duration of these impairments to determine if other-than-temporary decline
      in fair value has occurred and concluded that these losses were
      temporary.
  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
                              UnrealizedGainsAuction
      rate securities
                            
                            $
                            8,400,000
                            
                            
                            $
                            8,400,000
                            
                            
                            $
                            -Government
      securities
                            
                            
                            16,336,408
                            
                            
                            
                            16,237,759
                            
                            
                            
                            98,649Corporate
      debt securities
                            
                            
                            4,948,671
                            
                            
                            
                            4,936,117
                            
                            
                            
                            12,554Certificate
      of deposit
                            
                            
                            999,127
                            
                            
                            
                            997,857
                            
                            
                            
                            1,270$
                            30,684,206
                            
                            
                            $
                            30,571,733
                            
                            
                            $
                            112,473
 The cost
basis and fair value of available-for-sale securities by contractual maturity as
of December 31, 2008, were as follows:
 
 Fair Value
                                
                                
                                CostDue
      within one year
                                
                                $
                                11,146,534
                                
                                
                                $
                                11,083,804Due
      after one year
                                
                                
                                9,299,421
                                
                                
                                
                                9,609,174$
                                20,445,955
                                
                                
                                $
                                20,692,978
 (4)           Fair
Value Measurements
  The Company adopted the
provisions of SFAS No. 157 as of January 1, 2008, and effective October 10,
2008, adoptedthe provision s of FSP 157-3. Additionally, pursuant to
the provisions of
FSP 157-2, the Company will not apply the provisions of SFAS No. 157 for
nonfinancial assets and liabilities until January 1, 2009.SFAS No. 157
clarifies that fair value is an exit price, representing the amount that would
be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants. As a basis for considering such
assumptions, SFAS No. 157 establishes a three-tier value hierarchy, which
prioritizes the inputs used in the valuation methodologies in measuring fair
value:
  62
  Fair Value
Hierarchy
  SFAS
No. 157 specifies a hierarchy of valuation techniques based upon whether
the inputs to those valuation techniques reflect assumptions other market
participants would use based upon market data obtained from independent
sources (observable inputs) or reflect the Company’s own assumptions
of market participant valuation (unobservable inputs). In accordance with SFAS
No. 157, these two types of inputs have created the following fair value
hierarchy:
  ·
                  Level 1 – Quoted prices
      in active markets that are unadjusted and accessible at the measurement
      date for identical, unrestricted assets or liabilities. The Level 1
      category includes money market funds totaling $15.1 million, which are
      included within cash and cash equivalents and marketable securities in the
      consolidated balance sheets.
  ·
                  Level 2 –Quoted prices
      for identical assets and liabilities in markets that are not active,
      quoted prices for similar assets and liabilities in active markets or
      financial instruments for which significant inputs are observable, either
      directly or indirectly. The Level 2 category includes commercial paper
      totaling $0.8 million, and government securities and corporate debt
      securities totaling $19.3 million, which are included within cash and cash
      equivalents and marketable securities in the consolidated balance
      sheets.
  ·
                  Level
      3 – Prices or valuations that require inputs that are both significant to
      the fair value measurement and unobservable. The Level 3 category includes
      $1.2 million of auction rate securities, which are included within
      long-term marketable securities in the consolidated balance
      sheets.
  SFAS
No. 157 requires the use of observable market data if such data is
available without undue cost and effort.
 
 Measurement
of Fair Value
  The
Company measures fair value as an exit price using the procedures described
below for all assets and liabilities measured at fair value. When available, the
Company uses unadjusted quoted market prices to measure fair value and
classifies such items within Level 1. If quoted market prices are not available,
fair value is based upon financial models that
use, where possible, current market-based or independently-sourced market
parameters such as interest rates and currency rates. Items valued using
financial generated models are classified according to the lowest level input or
value
driver that is significant to the valuation. Thus, an item may be classified in
Level 3 even though there may be inputs that are readily observable. If quoted
market prices are not available, the valuation model used generally depends on
the specific asset or liability being valued. The determination of fair value
considers various factors including interest rate yield curves and time value
underlying the financial instruments.
  As of
December 31, 2008, the Company held certain assets that are required to be
measured at fair value on a recurring basis. Included within the Company’s
marketable securities portfolio are investments in auction rate securities,
which are classified as available-for-sale securities and are reflected at fair
value. However, during 2008, due to events in the U.S. credit markets, the
auction events for these securities held by the Company failed commencing in the
first quarter of 2008, and continued to fail throughout 2008. Therefore, the
fair values of these securities are estimated utilizing a discounted cash flow
analysis and other type of valuation model as of December 31, 2008. These
analyses consider, among other items, the collateral underlying the security,
the creditworthiness of the issuer, the timing of the expected future cash
flows, including the final maturity, and an assumption of when the next time the
security is expected to have a successful auction. These securities were also
compared, when possible, to other observable and relevant market data, which is
limited at this time.
  As of
December 31, 2008, the Company recorded an unrealized loss of $333,055 to
accumulated other comprehensive loss as a result of the declines in the fair
value of auction rate securities. The auction rate securities at December 31,
2008, totaled $1,500,000 (par value), and are collateralized by student loan
portfolios, which are almost fully guaranteed by the United States Government.
Because there is no assurance that auctions for these securities will be
successful in the near term, the Company classified the fair value of the
auction rate securities as Level 3 long-term investments. Any future fluctuation
in the fair value related to these securities that the Company deems to be
temporary, including any recoveries of previous write-downs, would be recorded
to accumulated other comprehensive loss, net of tax. Finally, the Company
believes that this temporary decline in fair value is primarily due to liquidity
concerns and not the creditworthiness of the underlying assets, because the
majorityof the
underlying securities are almost entirely backed by the U.S. Government.
However, if at any time in the future the Company determines that a valuation
adjustment is other-than-temporary, it will record a charge to earnings in the
period of determination.
  63
  Items
Measured at Fair Value on a Recurring Basis
  The
following table presents the
Company’s assets that are measured at fair value on a recurring basis at
December 31, 2008, consistent with the fair value hierarchy provisions of SFAS
No. 157:
  Fair Value Measurements at Reporting Date
      UsingQuoted
      Prices in
                            
                            
                            
                            
                            
                            SignificantActive
      Markets for
                            
                            
                            Significant
      other
                            
                            
                            UnobservableIdentical
      Assets
                            
                            
                            Inputs
                            
                            
                            InputsTotal
                            
                            
                            (Level 1)
                            
                            
                            (Level 2)
                            
                            
                            (Level 3)Cash
      equivalents:Money
      market funds
                            
                            $
                            15,088,465
                            
                            
                            $
                            15,088,465
                            
                            
                            $
                            -
                            
                            
                            $
                            -Commercial
      paper
                            
                            
                            799,920
                            
                            
                            
                            -
                            
                            
                            
                            799,920
                            
                            
                            
                            -Marketable
      securities:Corporate
      debt and government securities
                            
                            
                            19,279,010
                            
                            
                            
                            -
                            
                            
                            
                            19,279,010
                            
                            
                            
                            -Auction
      rate securities
                            
                            
                            1,166,945
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            1,166,945Total
      assets measured at fair value
                            
                            $
                            36,334,340
                            
                            
                            $
                            15,088,465
                            
                            
                            $
                            20,078,930
                            
                            
                            $
                            1,166,945
  Based on
market
conditions, the Company changed its valuation methodology for auction rate
securities to a discounted cash flow analysis and other type of valuation model
during the first quarter of 2008. Accordingly, these securities changed from
Level 1 to Level 3 within SFAS No. 157’s hierarchy since the Company’s
initial adoption of SFAS No. 157 on January 1, 2008. The following table
presents the Company’s assets measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) as defined in SFAS No. 157
at December 31, 2008:
  Fair
      Value Measurements Using Significant Unobservable
Inputs(Level 3)Auction Rate SecuritiesBalance
      at December 31, 2007
                                
                                $
                                -Transfers
      to Level 3
                                
                                
                                1,500,000Total
      unrealized losses in accumulated othercomprehensive
      loss
                                
                                
                                (333,055
                                )Balance
      at December 31, 2008
                                
                                $
                                1,166,945
  The
Company also uses fair value measurements for business acquisitions and
impairment testing of tangible and intangible assets.  However, the
application of SFAS No. 157 to fair value measurements of tangible and
intangible assets has been postponed in accordance with FSP 157-2.
  64
  (5)           Accrued
Expenses
  Accrued
expenses are comprised of the
following:
  December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007Accrued
      compensation
                        
                        $
                        3,708,523
                        
                        
                        $
                        3,398,783Accrued
      consulting and professional fees
                        
                        
                        957,527
                        
                        
                        
                        746,799Accrued
      marketing and promotion
                        
                        
                        107,393
                        
                        
                        
                        127,852Other
      accrued expenses
                        
                        
                        1,684,077
                        
                        
                        
                        1,189,557Accrued
      income taxes
                        
                        
                        441,380
                        
                        
                        
                        371,251Accrued
      other taxes
                        
                        
                        522,562
                        
                        
                        
                        360,565Accrued
      hardware purchases
                        
                        
                        502,864
                        
                        
                        
                        93,159Accrued
      and deferred rent
                        
                        
                        364,406
                        
                        
                        
                        423,265$
                        8,288,732
                        
                        
                        $
                        6,711,231
  (6)           Income
Taxes
  Information
pertaining to the Company’s income before income taxes and the applicable
provision (benefit) for income taxes is as follows:
  2008
                              
                              
                              2007
                              
                              
                              2006Income
      before income taxes:Domestic
      income (loss)
                              
                              $
                              1,238,431
                              
                              
                              $
                              7,788,284
                              
                              
                              $
                              (1,599,446
                              )Foreign
      income (loss)
                              
                              
                              1,462,016
                              
                              
                              
                              641,536
                              
                              
                              
                              (1,456,609
                              )Total
      income before income taxes:
                              
                              $
                              2,700,447
                              
                              
                              $
                              8,429,820
                              
                              
                              $
                              (3,056,055
                              )Provision
      (benefit) for income taxes:Current:Federal
                              
                              $
                              1,905,083
                              
                              
                              $
                              4,421,578
                              
                              
                              $
                              239,411State
      and local
                              
                              
                              336,363
                              
                              
                              
                              802,074
                              
                              
                              
                              22,862Foreign
                              
                              
                              382,056
                              
                              
                              
                              301,794
                              
                              
                              
                              56,2002,623,502
                              
                              
                              
                              5,525,446
                              
                              
                              
                              318,473Deferred:Federal
                              
                              $
                              (1,466,080
                              )
                              
                              $
                              (8,843,575
                              )
                              
                              $
                              -State
      and local
                              
                              
                              77,941
                              
                              
                              
                              (696,490
                              )
                              
                              
                              -Foreign
                              
                              
                              262,272
                              
                              
                              
                              (297,417
                              )
                              
                              
                              -(1,125,867
                              )
                              
                              
                              (9,837,482
                              )
                              
                              
                              -Total
      provision (benefit) for income taxes:
                              
                              $
                              1,497,635
                              
                              
                              $
                              (4,312,036
                              )
                              
                              $
                              318,473
  65
  During
2008, the Company recorded a tax provision of $1,497,635 related to federal,
state and local and foreign taxes. In addition, the Company recorded a deferred
tax benefit of $135,198 as a component of other comprehensive income relating to
unrealized losses on available for sale securities.
  During
2007, the Company recorded a tax benefit of $4,312,036, related
to  state, local and foreign taxes, offset by net benefits for the
reversal of a portion of the valuation allowance for certain deferred tax
assets. In addition, the Company recorded a deferred provision of $43,037 as a
component of other comprehensive income relating to unrealized gains on
available for sale securities.
  During
2006, the Company recorded a tax provision attributable to federal alternative
minimum tax, state and local taxes and foreign taxes.
  Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
for income tax purposes. Significant components of the Company’s deferred tax
assets and liabilities are as follows:
  December
      31,2008
                                  
                                  
                                  2007Deferred
      Tax Assets and Liabilities:Allowance
      for receivables
                                  
                                  $
                                  3,161,447
                                  
                                  
                                  $
                                  3,359,922Deferred
      revenue
                                  
                                  
                                  1,914,460
                                  
                                  
                                  
                                  1,499,332Share-based
      compensation
                                  
                                  
                                  3,277,771
                                  
                                  
                                  
                                  2,497,682Accrued
      expenses and other liabilities
                                  
                                  
                                  459,349
                                  
                                  
                                  
                                  397,283Domestic
      net operating loss carryforwards
                                  
                                  
                                  94,494
                                  
                                  
                                  
                                  1,896,537Foreign
      net operating loss carryforwards
                                  
                                  
                                  787,124
                                  
                                  
                                  
                                  1,123,200Tax
      credit carryforwards
                                  
                                  
                                  866,320
                                  
                                  
                                  
                                  1,312,266AMT
      tax credit carryforwards
                                  
                                  
                                  482,648
                                  
                                  
                                  
                                  287,922Capital
      loss carryforwards
                                  
                                  
                                  663,454
                                  
                                  
                                  
                                  650,137Fixed
      Assets
                                  
                                  
                                  (234,588
                                  )
                                  
                                  
                                  100,522Intangibles
                                  
                                  
                                  333,535
                                  
                                  
                                  
                                  259,602Sub-total
                                  
                                  
                                  11,806,014
                                  
                                  
                                  
                                  13,384,405Valuation
      Allowance
                                  
                                  
                                  (1,770,522
                                  )
                                  
                                  
                                  (3,607,301
                                  )Net
      Deferred Tax Asset
                                  
                                  $
                                  10,035,492
                                  
                                  
                                  $
                                  9,777,104
  During
the year ended December 31, 2008, the Company’s deferred tax asset valuation
allowance decreased by $1.8 million. The decrease in the valuation allowance was
attributable to realization of the tax effects for excess share-based
compensation deductions from the exercises of share-based awards, and such
amounts were recorded as benefits to additional-paid-in-capital.
  As of
December 31, 2008, the deferred tax asset valuation allowance of $1.8 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 $0.1
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 $0.1 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.
  During
the year ended December 31, 2007, the Company’s deferred tax asset valuation
allowance decreased by $10.7 million as a result of the Company’s then emergence
from cumulative losses in recent years, and its updated assessments as to its
ability to realize benefits from its deferred tax assets, based primarily upon
its expectations for its then 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, which was recorded as a benefit to
additional-paid-in-capital.
  66
  As of
December 31, 2007, the deferred tax asset valuation allowance of $3.6 million
related 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.
  As of
December 31, 2007, the Company had approximately $5.1 million of federal net
operating loss carryforwards available to offset future taxable income. These
net operating loss carryforwards related to excess share-based compensation
deductions from previous year’s exercises of stock options. During the year
ended December 31, 2008, the Company utilized all of its federal net loss
carryforwards which were benefits credited to
additional-paid-in-capital.
  The
Company has not provided for the United States income or the foreign withholding
taxes on the undistributed earnings of its subsidiaries operating outside of the
United States, with the exception of China.  It is the Company’s
intention to reinvest those earnings permanently, and accordingly, it is not
practicable to estimate the amount of tax that might be payable.
  The
effective tax rate before income taxes varies from the current statutory federal
income tax rate as follows:
  2008
                          
                          
                          2007
                          
                          
                          2006Tax
      at Federal statutory rate
                          
                          $
                          945,156
                          
                          
                          $
                          2,950,437
                          
                          
                          $
                          (1,066,688
                          )Increase
      (reduction) in income taxes resulting from:State
      and local taxes
                          
                          
                          119,963
                          
                          
                          
                          461,823
                          
                          
                          
                          62,711Non-deductible
      expenses
                          
                          
                          (25,076
                          )
                          
                          
                          169,310
                          
                          
                          
                          355,144Shared-based
      payment compensation
                          
                          
                          728,760
                          
                          
                          
                          811,659
                          
                          
                          
                          1,170,364Net
      effect of foreign operations
                          
                          
                          (52,755
                          )
                          
                          
                          154,888
                          
                          
                          
                          36,279Research
      and development credit
                          
                          
                          (446,033
                          )
                          
                          
                          (227,421
                          )
                          
                          
                          (568,520
                          )AMT
      Tax
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          199,677Change
      in tax rates
                          
                          
                          203,717
                          
                          
                          
                          283,585
                          
                          
                          
                          -Change
      in valuation allowance
                          
                          
                          23,903
                          
                          
                          
                          (8,916,317
                          )
                          
                          
                          129,506$
                          1,497,635
                          
                          
                          $
                          (4,312,036
                          )
                          
                          $
                          318,473
  The
Company adopted the provisions of FIN 48 on January 1, 2007.  A
reconciliation of the beginning and ending amount of unrecognized tax benefits,
excluding interest and penalties, is as follows:
  67
    2008
                          
                          
                          2007Balance
      at January 1
                          
                          $
                          4,399,914
                          
                          
                          $
                          4,399,914Increases
      in tax positions for prior years
                          
                          
                          452,365
                          
                          
                          
                          -Decreases
      in tax positions for prior years
                          
                          
                          -
                          
                          
                          
                          -Increases
      in tax positions for current year
                          
                          
                          133,166
                          
                          
                          
                          -Settlements
                          
                          
                          -
                          
                          
                          
                          -Lapse
      in statute of limitations
                          
                          
                          -
                          
                          
                          
                          -Balance
      at December 31
                          
                          
                          4,985,445
                          
                          
                          
                          4,399,914
  Of the
amounts reflected in the table above at December 31, 2008, the entire amount if
recognized would reduce the Company’s annual effective tax rate.  As
of December 31, 2008, the Company had approximately $68,445 of accrued interest
and penalties.   The Company does not expect its unrecognized tax
benefits to change significantly over the next 12 months.
  The
Company files federal, state, and foreign income tax returns in jurisdictions
with varying statutes of limitations. The 2005 through 2008 tax years generally
remain subject to examination by federal and most state tax authorities. In
addition to the U.S., the Company’s major taxing jurisdictions include China,
Taiwan, France, Germany and Korea.
  (7)           Stockholders’
Equity
  Stock
Repurchase Activity
  On
October 25, 2001, the Company’s Board of Directors authorized the repurchase of
up to 2 million shares of the Company’s outstanding common stock. On February 6,
2008, and on July 22, 2008, the Company’s Board of Directors increased the
authorization to repurchase the Company’s outstanding common stock by 3 million
shares and 3 million shares, respectively, to an aggregate of 8 million shares.
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, 2008, the Company repurchased
5,639,950 shares of its common stock in open market purchases for a total cost
of $33,874,504. 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. Since October 2001, the Company had repurchased a total of 6,824,050
shares of its common stock at an aggregate purchase price of $42,928,328. As of
December 31, 2008, the Company had the ability to repurchase an additional
1,175,950 shares of our common stock based upon our judgment and market
conditions.
  On
February 4, 2009, the Company’s Board of Directors again increased the
authorization to repurchase the Company’s outstanding common stock from 8
million shares to 14 million shares in the aggregate, with the result being that
as of such date, the Company may repurchase up to 7.2 million shares of its
outstanding common stock.
  Preferred
Stock
  The
Company is authorized to issue two million shares of $0.001 par value Preferred
Stock. No preferred stock has been issued or outstanding for any period
presented.
  68
  Warrants
  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 up to 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 since expired.
  (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, 2008, 1,630,121
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. As of December 31, 2008, options to purchase
250,000 shares remain outstanding from the 2004 Plan and 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 and on May 8, 2008. The 2006 Plan is administered by the Board of Directors
and provides for the grant of incentive and nonqualified stock options, shares
of restricted stock, and restricted stock units 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
as to which options, restricted shares and restricted stock units 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, 2008, the total number of
outstanding shares of the Company’s common stock totaled 47,952,855. Pursuant to
the 2006 Plan, as amended, the total shares available for issuance under the
2006 Plan thus increased by 2,368,287 shares to 2,397,643 shares available for
issuance as of July 1, 2008. As of December 31, 2008, 1,777,917 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, shares
of restricted stock, and restricted stock units granted under the 2006 Plan
must be granted within ten years of the adoption of the 2006 Plan.
  On May 8,
2007, the Company adopted the FalconStor Software, Inc. 2007 Outside Directors
Equity Compensation Plan (the “2007 Plan”). The 2007 Plan was amended on May 8,
2008. 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, 2008, 185,000 shares were available for grant under the 2007
Plan.
  69
  A summary
of the Company’s stock option activity for 2008 is as follows:
  Number
      of
                              Options
                            
                            
                            Weighted
                              Average
                              Exercise
                              Price
                            
                            
                            Weighted
                              Average
                              Remaining
                              Contractual
                              Life (Years)
                            
                            
                            Aggregate
                              Intrinsic
                              ValueOptions
      Outstanding at December 31, 2007
                            
                            
                            9,667,374
                            
                            
                            $
                            6.79Granted
                            
                            
                            2,543,700
                            
                            
                            $
                            5.99Exercised
                            
                            
                            (401,754
                            )
                            
                            $
                            2.04Canceled
                            
                            
                            (1,604,199
                            )
                            
                            $
                            8.25Forfeited
                            
                            
                            (529,976
                            )
                            
                            $
                            9.00Options
      Outstanding at December 31, 2008
                            
                            
                            9,675,145
                            
                            
                            $
                            6.41
                            
                            
                            
                            6.20
                            
                            
                            $
                            2,474,602Options
      Exercisable at December 31, 2008
                            
                            
                            6,242,610
                            
                            
                            $
                            5.77
                            
                            
                            
                            4.60
                            
                            
                            $
                            2,343,352Options
      Expected to Vest at December 31, 2008 (1)
                            
                            
                            2,616,279
                            
                            
                            $
                            7.59
                            
                            
                            
                            9.09
                            
                            
                            $
                            -
  (1)
Options expected to vest after December 31, 2008 reflect an estimated forfeiture
rate
  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, 2008, 2007
and 2006 was $821,282, $10,007,174 and $2,501,156, respectively. The total
intrinsic value of stock options exercised during the years ended December 31,
2008, 2007 and 2006 was $2,091,768, $14,398,460 and $2,697,850,
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:
  Years
      ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006Cost
      of maintenance, software services and other revenue
                            
                            $
                            1,449,065
                            
                            
                            $
                            1,034,424
                            
                            
                            $
                            1,342,970Software
      development costs
                            
                            
                            3,240,711
                            
                            
                            
                            3,279,065
                            
                            
                            
                            4,331,902Selling
      and marketing
                            
                            
                            3,531,375
                            
                            
                            
                            2,615,503
                            
                            
                            
                            2,803,585General
      and administrative
                            
                            
                            863,365
                            
                            
                            
                            1,008,531
                            
                            
                            
                            914,697$
                            9,084,516
                            
                            
                            $
                            7,937,523
                            
                            
                            $
                            9,393,154
  The
Company recognized approximately $506,000 and $1,025,000 of tax benefits related
to share-based compensation expense during the years ended December 31, 2008 and
2007, respectively. The Company did not recognize any tax benefits related to
share-based compensation expense in 2006.
  The
Company began issuing restricted stock in 2006 and restricted stock units during
2008. The fair value of the restricted stock awards / restricted stock units is
expensed at either the fair value per share at date of grant (outside director,
officers and employees), or at the fair value per share as of each reporting
period (non-employee consultants.) 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,
which were expensed at a fair value per share ranging from $9.87 to $15.30 per
share. During 2008, the Company granted a total of 542,000 and 45,750 shares of
restricted stock and restricted stock units, respectively, at various times to
certain officers, employees and non-employee consultants, which were expensed at
a fair value per share ranging from $2.78  to $9.29 per
share.
  70
  As of
December 31, 2008, an aggregate of 1,140,000 shares of restricted stock have
been issued, of which, 306,410 have vested and 390,500 have been canceled. As of
December 31, 2007, an aggregate of 598,000 shares of restricted stock had been
issued, of which, 75,350 had vested and 25,000 had been canceled. As of December
31, 2006, 225,000 shares of restricted stock had been issued, of which none had
vested or been forfeited.
  As of
December 31, 2008, an aggregate of 45,750 restricted stock units have been
issued, of which none had vested or been forfeited.
  A summary
of the Company’s restricted stock activity for 2008 is as follows:
 Number
      of RestrictedStock
      Awards / UnitsNon-Vested
      at December 31, 2007
                                        
                                        
                                        497,650Granted
                                        
                                        
                                        587,750Vested
                                        
                                        
                                        (231,060
                                        )Canceled
                                        
                                        
                                        (365,500
                                        )Non-Vested
      at December 31, 2008
                                        
                                        
                                        488,840
  Restricted
stock and restricted stock units are fulfilled with new shares of common stock.
The total intrinsic value of restricted stock for which the restrictions lapsed
during the years ended December 31, 2008 and 2007 was $1,542,308 and $767,756
respectively. As of December 31, 2006, there was no intrinsic value of
restricted stock for which the restrictions lapsed.
  During
the first quarter of 2008, the Company issued restricted stock awards to certain
executives and other officers, which vested over three-year terms dependent upon
the Company achieving certain performance targets for the full-year 2008. During
the first and second quarters of 2008, the Company recorded the related
compensation costs associated with the performance awards in accordance with
SFAS No. 123(R). During the three-months ended September 30, 2008, the Company
determined the performance criteria to be improbable of achievement and
accordingly reversed compensation cost of approximately $606,000 previously
recognized within its consolidated statement of operations.
  During
the third quarter of 2008, certain executives and other officers of the Company
voluntarily forfeited 1,505,046 shares of previously granted stock option awards
(the “awards”). No replacement stock option awards were made, nor did the
Company enter into any agreements for future replacement awards for the
voluntary forfeiture. The voluntarily forfeited awards were fully vested as of
the date of forfeiture, therefore, no adjustment to stock based compensation
expense was recorded in accordance with SFAS No. 123(R). The voluntarily
forfeited stock options were awarded during dates ranging from November 2001 to
January 2005, and were expensed at fair market values ranging from $5.10 to
$8.03 per share.
  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, 2008, 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, 2008, 2007, and 2006 was $3.91, $7.79 and $4.32,
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:
  71
  Years
      ended December 31,2008
                                                                  
                                                                  2007
                                                                  
                                                                  2006Expected
      dividend yield
                                                                  0%
                                                                  
                                                                  0%
                                                                  
                                                                  0%Expected
      volatility
                                                                  48
      - 58%
                                                                  
                                                                  54
      -57%
                                                                  
                                                                  57
      – 60%Risk-free
      interest rate
                                                                  1.7
      -4.0%
                                                                  
                                                                  3.4
      - 5.0%
                                                                  
                                                                  4.4
      – 5.1%Expected
      term (years)
                                                                  5.5
                                                                  
                                                                  6
                                                                  
                                                                  6Discount
      for post-vesting restrictions
                                                                  N/A
                                                                  
                                                                  N/A
                                                                  
                                                                  N/A
  Options
granted to officers, employees and directors during fiscal 2008, 2007, and 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 generally 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, a vesting
period of generally three years and an estimated forfeiture rate 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 a 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.
The fair values of the share-based awards are being expensed at their fair value
per share, which was $2.78, $11.26 and $8.65 at December 31, 2008, 2007, and
2006, respectively. Vesting periods for share-based awards granted to
non-employee consultants range from one month to three years depending on
service requirements. As of December 31, 2008, 2007, and 2006, the Company
recognized expenses of $140,975, $209,218, and $17,914, respectively, related to
share-based awards granted to non-employee consultants, which are included in
the Company’s total share-based compensation expense for each respective
year.
  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, 2007, was determined
based upon an estimate of the expected term of “plain vanilla” options as
prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110. The
expected term of the awards issued prior to January 1, 2008, was determined
using the “simplified method”prescribed in SAB
No. 107.
  As of
December 31, 2008, there was approximately $12,571,239 of total unrecognized
compensation cost related to the Company’s unvested stock options, restricted
stock and restricted stock unit awards granted under the Company’s stock plans.
The unrecognized compensation cost is expected to be recognized over a
weighted-average period of 2.05 years.
  As of
December 31, 2008, the Company has 13,757,023 shares of common stock reserved
for issuance upon the exercise of stock options, restricted stock and restricted
stock units.
  (9)           Acquisitions
  On July
1, 2008, the Company acquired
certain assets of World Venture Limited (“World Venture”), a network storage
software business based in Hong Kong, at an aggregate purchase price of $1.7
million including transaction costs. The Company has accounted for the
acquisition under the purchase method of accounting and the assets acquired have
been included in our consolidated financial statements at fair value, including
acquired intangible assets with estimated useful lives of three years. The
excess of the purchase price over the fair value of the net assets acquired was
classified as goodwill on the Company’s consolidated balance
sheets.
  The
following table summarizes the
allocation of the purchase price of World Venture on July 1, 2008. The Company
obtained a valuation of certain acquired tangible and intangible assets and has
finalized the allocations below to reflect such valuations. In addition, net
assets acquired have been finalized to reflect all adjustments identified during
the year of acquisition.
  72
  Value
      atJuly
      1, 2008Purchase
      price, including transaction costs
                                
                                $
                                1,716,000Net
      assets acquired
                                
                                
                                (23,000
                                )Intellectual
      property (estimated useful life, 3 years)
                                
                                
                                (467,000
                                )Customer
      contracts (estimated useful life, 3 years)
                                
                                
                                (589,000
                                )Goodwill,
      including transaction costs (indefinite lived)
                                
                                $
                                637,000
  The Company’s identifiable
intangible assets, customer contracts and intellectual property, have a weighted
average useful life of three years. During the year ended December 31, 2008, the
Company recorded amortization expense of $77,867 and $98,100 for intellectual
property and customer contracts, respectively. Goodwill is not amortized for
book or tax purposes.
  The results of
operations for World Venture have been included in the Company’s consolidated
financial statements commencing in the third quarter of 2008. The results of
operations for periods prior to the acquisition were not material to the
Company’s consolidated financial statements and, accordingly, pro forma
information has not been presented.
  (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 2009 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of December 31, 2008:
  Year ending December 31,2009
                                  
                                  $
                                  2,319,6902010
                                  
                                  
                                  1,696,5222011
                                  
                                  
                                  1,304,0702012
                                  
                                  
                                  234,430$
                                  5,554,712
  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
$2,512,346, $2,177,927, and $1,945,991 for the years ended December 31, 2008,
2007 and 2006, 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, 2008, there are no claims
outstanding under such indemnification provisions.
  73
  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 provided 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 personnel 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, 2008,
2007, and 2006, the Company did not make any contributions to the
Plan.
  Effective
July 1, 2007, the Company, in accordance with the labor pension system in
Taiwan, contributes 6% of salaries to individual pension accounts managed by the
Bureau of Labor Insurance. The Plan covers all Taiwan employees that elect the
new pension system and all employees hired after July 1, 2005. For the years
ended December 31, 2008, 2007, and 2006, the Company contributed $117,000,
$76,000, and $59,000, respectively.
  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, 2008 and 2007, $141,953 and $203,407, 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 $52,233 and $57,985 at December 31, 2008
and 2007, respectively, and unrecognized actuarial losses of $89,720 and
$145,422 at December 31, 2008 and 2007, respectively. During 2008, the total
amount recorded in other comprehensive income related to the pension plan was
$61,454 (net of tax), which consisted of an actuarial gain of $55,702 and the
recognition of $5,752 of transition obligations recognized during 2008 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, 2009,
is $5,432 and $3,966, respectively.
  74
  Pension
information for the years ended December 31, 2008 and 2007, is as
follows:
  2008
                        
                        
                        2007Accumulated
      benefit obligation
                        
                        $
                        128,038
                        
                        
                        $
                        132,231Changes
      in projected benefit obligation:Projected
      benefit obligation at beginning of year
                        
                        
                        284,686
                        
                        
                        
                        157,122Interest
      cost
                        
                        
                        8,068
                        
                        
                        
                        4,282Actuarial
      (gain)/loss
                        
                        
                        (47,409
                        )
                        
                        
                        119,971Benefits
      paid
                        
                        
                        -
                        
                        
                        
                        -Service
      cost
                        
                        
                        3,452
                        
                        
                        
                        1,570Currency
      translation and other
                        
                        
                        (1,018
                        )
                        
                        
                        1,741Projected
      benefit obligation at end of year
                        
                        $
                        247,779
                        
                        
                        $
                        284,686Changes
      in plan assets:Fair
      value of plan assets at beginning of year
                        
                        $
                        33,592
                        
                        
                        $
                        19,571Actual
      return on plan assets
                        
                        
                        971
                        
                        
                        
                        329Benefits
      paid
                        
                        
                        -
                        
                        
                        
                        -Employer
      contributions
                        
                        
                        14,808
                        
                        
                        
                        13,495Currency
      translation and other
                        
                        
                        (915
                        )
                        
                        
                        197Fair
      value of plan assets at end of year
                        
                        $
                        48,456
                        
                        
                        $
                        33,592Funded
      status
                        
                        $
                        199,323
                        
                        
                        $
                        251,094Components
      of net periodic pension cost:Interest
      cost
                        
                        $
                        8,068
                        
                        
                        $
                        4,282Expected
      return on plan assets
                        
                        
                        (951
                        )
                        
                        
                        (533
                        )Amortization
      of net loss
                        
                        
                        14,703
                        
                        
                        
                        5,947Service
      cost
                        
                        
                        3,452
                        
                        
                        
                        1,570Net
      periodic pension cost
                        
                        $
                        25,272
                        
                        
                        $
                        11,266
  The
Company makes contributions to the plan so that minimum contribution
requirements, as determined by government regulations, are met. Company
contributions of approximately $15,000 are expected to be made during 2009.
Benefit payments of approximately $231,000 are expected to be paid in 2014
through 2018.
  The
Company utilized the following assumptions in computing the benefit obligation
at December 31, 2008 and 2007 as follows:
  December 31, 2008
                          December 31, 2007Discount
      Rate
                          2.50%
                          2.75%Rate
      of increase in compensation levels
                          3.00%
                          4.37%Expected
      long-term rate of return on plan assets
                          2.50%
                          2.75%
  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, 2008, 2007 and 2006, and the location of long-lived assets as of December
31, 2008, 2007, and 2006, are summarized as follows:
  2008
                      
                      
                      2007
                      
                      
                      2006Revenues:United
      States
                      
                      $
                      52,540,234
                      
                      
                      $
                      51,078,007
                      
                      
                      $
                      37,461,247Asia
                      
                      
                      14,143,622
                      
                      
                      
                      12,329,395
                      
                      
                      
                      8,352,382Other
      international
                      
                      
                      20,341,004
                      
                      
                      
                      13,991,820
                      
                      
                      
                      9,252,399Total revenues
                      
                      $
                      87,024,860
                      
                      
                      $
                      77,399,222
                      
                      
                      $
                      55,066,028Long-lived
      assets (includes all non-current assets):United
      States
                      
                      $
                      20,682,794
                      
                      
                      $
                      18,483,890
                      
                      
                      $
                      10,113,633Asia
                      
                      
                      1,869,963
                      
                      
                      
                      1,720,098
                      
                      
                      
                      1,498,534Other
      international
                      
                      
                      386,981
                      
                      
                      
                      499,632
                      
                      
                      
                      279,695Total
      long-lived assets
                      
                      $
                      22,939,738
                      
                      
                      $
                      20,703,620
                      
                      
                      $
                      11,891,862
  For the
year ended December 31, 2008, the Company had two customers that together
accounted for a total of 33% of revenues. 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. As of December 31, 2008, the
Company had two customers with accounts receivable balances greater than 10%,
which totaled 22% of the gross accounts receivable balance. 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.
  (13)         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.
  76
  (14)        
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, 2008
                                      
                                      $
                                      8,780,880
                                      
                                      
                                      $
                                      4,088,575
                                      
                                      
                                      $
                                      4,395,027
                                      
                                      
                                      $
                                      8,474,428December
      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
                                      
                                      
                                      $
                                      6,016,298
 (15)        Quarterly
Financial Data (Unaudited)
   The
following is a summary of selected quarterly financial data for the years ended
December 31, 2008 and 2007:
  Fiscal
      QuarterFirst
                          
                          
                          Second
                          
                          
                          Third
                          
                          
                          Fourth2008Revenue
                          
                          $
                          21,806,660
                          
                          
                          $
                          22,226,946
                          
                          
                          $
                          19,611,493
                          
                          
                          $
                          23,379,761Net
      income (loss)
                          
                          $
                          1,333,757
                          
                          
                          $
                          793,211
                          
                          
                          $
                          (1,562,244
                          )
                          
                          $
                          638,088Basic
      net income (loss) per share
                          
                          $
                          0.03
                          
                          
                          $
                          0.02
                          
                          
                          $
                          (0.03
                          )
                          
                          $
                          0.01Diluted
      net income (loss) per share
                          
                          $
                          0.03
                          
                          
                          $
                          0.02
                          
                          
                          $
                          (0.03
                          )
                          
                          $
                          0.01Basic
      weighted average common shares outstanding
                          
                          
                          49,590,008
                          
                          
                          
                          48,066,451
                          
                          
                          
                          47,522,085
                          
                          
                          
                          46,277,252Diluted
      weighted average common shares outstanding
                          
                          
                          51,690,245
                          
                          
                          
                          50,249,824
                          
                          
                          
                          47,522,085
                          
                          
                          
                          46,866,3812007Revenue
                          
                          $
                          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
                          
                          
                          
                          54,283,386
  The sum
of the quarterly net income (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.
  77
  Item 9.
                Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
  None.
  Item 9A.
                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’sReport 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, 2008, 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.
  Item 9B.
                Other
      Information
  On March
9, 2009, the Compensation Committee of the Company’s Board of Directors awarded
cash bonuses to certain officers, including the Chief Financial Officer, the
Vice President for Business Development and the Vice President and Co-Founder
(the “Named Officers”). Each of the Named Officers received a cash bonus in the
amount of $75,000. None of these individuals has an employment agreement with
the Company.
  On March
9, 2009, the Compensation Committee of the Company’s Board of Directors made
grants of restricted shares of the Company’s Common Stock and grants of
non-qualified stock options to certain officers, including the Named Officers.
Each Named Officer received 90,000 restricted shares of stock, and options to
purchase 160,000 shares of common stock at an exercise price of $2.25 per share.
The restrictions on the restricted shares of stock will lapse, and the options
will vest, in accordance with the Company’s 2006 Incentive Stock Plan, as
amended.
  78
 PART III
 
 Item 10.
                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 2009, 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, 2008, 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 2009,
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, 2008, our
year-end.
  Item 12.
                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 2009, 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, 2008, 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 2009, 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,
2008, 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 2009,
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, 2008, our
year-end.
  79
 PART IV
 
  Item 15.
              Exhibits
      and Financial Statement Schedules
  The
      information r`equired 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.
  80
  4.7
              2007
      Outside Directors Equity Compensation Plan, as amended May 8,
      2008,  incorporated herein by reference to Exhibit 99.2 to the
      Registrant’s quarterly report on Form 10-Q for the quarter ended June 30,
      2008, filed on August 11, 2008.
  4.8
              Form
      of Restricted Stock Letter Agreement for Executive Officers, incorporated
      herein by reference to Exhibit 99.1 to the Registrant’s quarterly report
      on Form 10-Q for the period ended March 31, 2008, filed May 9,
      2008.
  10.1
                Agreement
      of lease between Huntington Quadrangle 2, LLC, and FalconStor Software,
      Inc., 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.
 
 81
  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 11, 2009.
  FALCONSTOR
      SOFTWARE, INC.By:
                            /s/
      ReiJane Huai
                            
                            March
      11, 2009ReiJane
      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
      11, 2009ReiJane
      Huai, President, Chief Executive Officer and Chairman of the
      Board
                  (Principal
      Executive Officer)
                
                Date
 
 
 By:
                /s/ James Weber
                
                March
      11, 2009James
      Weber, Chief Financial Officer, Vice President and Treasurer
                  (Principal
      Financial Officer and Principal Accounting Officer)
                
                Date
 
 
 By:
                /s/ Steven L. Bock
                
                March
      11, 2009Steven
      L. Bock, Director
                
                Date
 
 
 By:
                /s/ Patrick B. Carney
                
                March
      11, 2009Patrick
      B. Carney, Director
                
                Date
 
 
 By:
                /s/ Lawrence S. Dolin
                
                March
      11, 2009Lawrence
      S. Dolin, Director
                
                Date
 
 
 By:
                /s/ Steven R. Fischer
                
                March
      11, 2009Steven
      R. Fischer, Director
                
                Date
 
 
 By:
                /s/ Alan W. Kaufman
                
                March
      11, 2009Alan
      W. Kaufman, Director
                
                Date
 
 82