`SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    FORM 10-K

/X/   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934 For the fiscal year ended December 31, 2004.

                                       OR

/ /   TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
      For the transition period from __________ to __________

                         Commission file number 0-23970

                            FALCONSTOR SOFTWARE, INC.
             (Exact name of registrant as specified in its charter)

           DELAWARE                                             77-0216135
(State or other jurisdiction of                              (I.R.S. Employer
incorporation or organization)                              Identification No.)

 2 Huntington Quadrangle, Suite 2S01                             11747
     Melville, New York                                        (Zip code)
(Address of principal executive offices)

        Registrant's telephone number, including area code: 631-777-5188

        Securities registered pursuant to Section 12(b) of the Act: None

            Securities  registered  pursuant to Section 12(g) of the Act: Common
Stock, $.001 par value

            Indicate  by check mark  whether  the  Registrant  (1) has filed all
reports  required to be filed by Section 13 or 15(d) of the Securities  Exchange
Act of 1934 during the preceding 12 months (or for such shorter  period that the
Registrant  was required to file such  reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No / /

            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. |X|

            Indicate by check mark  whether  the  registrant  is an  accelerated
filer (as defined in Exchange Act Rule 12b-2). Yes |X| No / /

            Aggregate market value of Common Stock held by non-affiliates of the
Registrant  as of June 30, 2004 was  $182,607,166  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 21, 2005 was
47,798,909 and 47,521,809, 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

                         2004 ANNUAL REPORT ON FORM 10-K

                                TABLE OF CONTENTS

                                                                            Page

PART I.

Item 1.   Business.............................................................4
Item 2.   Properties..........................................................10
Item 3.   Legal Proceedings...................................................10
Item 4.   Submission of Matters to a Vote of Security Holders.................10

PART II.

Item 5.   Market for Registrant's Common Equity and Related
          Stockholder Matters.................................................11
Item 6.   Selected Consolidated Financial Data................................11
Item 7.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations...........................................14
Item 7A.  Qualitative and Quantitative Disclosures About Market Risk..........32
Item 8.   Consolidated Financial Statements and Supplementary Data............33
Item 9.   Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure.................................56
Item 9A.  Controls and Procedures.............................................56
Item 9B.  Other Information...................................................56

PART III.

Item 10.  Directors and Executive Officers of the Registrant..................56
Item 11.  Executive Compensation..............................................57
Item 12.  Security Ownership of Certain Beneficial Owners and Management......57
Item 13.  Certain Relationships and Related Transactions......................57
Item 14.  Principal Accountant Fees and Services..............................57


PART IV.

Item 15.  Exhibits, Financial Statement Schedules ............................58


SIGNATURES....................................................................60






                                     PART I

ITEM 1.     BUSINESS



OVERVIEW

FalconStor  Software,  Inc.  ("FalconStor"  or the "Company")  provides  network
storage  software   solutions  and  related   maintenance,   implementation  and
engineering  services.  FalconStor's  unique open  software  approach to storage
networking  enables  companies to embrace  state-of-the-art  equipment (based on
SCSI, Fibre Channel or iSCSI) from any storage  manufacturer  without  rendering
their existing or legacy solutions  obsolete.  Several  strategic  partners have
recognized the industrial strength of FalconStor's flagship software, IPStor(R),
and have  utilized it to power  their  special  purpose  storage  appliances  to
deliver  a  variety  of  storage  related  services  including  Real  Time  Data
Migration, Continuous Data Replication, Continuous Data Protection, Virtual Tape
Library backup,  and other advanced storage services.  IPStor leverages the high
performance IP- or FC- based network to help corporate IT departments  aggregate
storage   capacity   and   contain   the   escalating   cost  of   administering
business-critical  storage services such as snapshot,  backup, data replication,
and other  storage  services in a  distributed  environment.  Over 500 customers
around the world have deployed FalconStor  solutions in production  environments
to  manage  their  storage  infrastructure  with  minimal  TCO  (Total  Cost  of
Ownership) and optimal ROI (Return on  Investment).  FalconStor's  products have
been certified by such industry leaders as Adaptec, Alacritech, ATTO Technology,
Bell Microproducts,  Brocade, Cisco, Engenio Information  Technologies,  Emulex,
Fujitsu,  Gadzoox,  Hewlett Packard,  Hitachi Data Systems,  Hitachi Engineering
Co., Ltd., IBM, Intel, LSI Logic,  McData Corporation,  Microsoft,  NEC, Network
Appliance,  Novell,  NS Solutions  Corporation  (subsidiary  of The Nippon Steel
Corporation,  Japan), Oracle, QLogic, Quantum, Sony, StorageTek, SUN and Tivoli.
FalconStor  has  agreements  with  original  equipment   manufacturers  ("OEMs")
including  Accton,  Acer, Inc.,  AXIOMTEK,  Copan Systems,  Evesham  Technology,
MaXXan, NEC, Next IT, Runtop StorageTek,  Systex Corp. and others to incorporate
FalconStor's technology with such companies' products.

INDUSTRY BACKGROUND

According   to  storage   industry   experts,   escalating   disaster   recovery
requirements,  increasing government regulations,  and the growing focus on cost
management,  efficiency  and  return on  investment,  are key  spending  factors
driving the overall  growth of the IT storage market for the next several years.
Consolidation  of storage  systems on a common  platform has  consistently  been
cited as the biggest spending driver by a number of industry analysts.  In fact,
enterprises  are buying new  Storage  Area  Network  (SAN)  capacity  from their
preferred vendors to handle data moved off other platforms.  Moreover, companies
of all  sizes  (small/medium  businesses,  as well as  large  enterprises)  have
indicated  that  regulations  such  as  HIPAA  are  forcing  them to  adopt  new
data-retention systems and procedures, which are also driving storage spending.

TheInfoPro (TIP), a technology research network, investigates the storage market
every six months by  conducting  hundreds of in-depth  interviews  with  storage
professionals  from Fortune  1000,  mid-market  and European  enterprises.  This
bi-annual study of the Storage  Networking & Storage  Management markets gathers
data on budgeted  technology  implementations,  future spending plans,  capacity
changes  and  business  drivers  behind the  storage  deployments.  TIP has been
studying the Networked Storage market since 2002 and the two studies released in
2004 provide a "grass roots" perspective of FalconStor's core markets.

The IT  professionals  at  Fortune  1000  companies  interviewed  for the survey
indicated  that they are expecting SAN growth of 50% in 2005.  Expected  Network
Attached Storage (NAS) growth also remains strong,  having doubled in 2004 to an
average of 44 Terabytes, with planned growth of 51% in 2005.

What is driving  Networked Storage growth?  IT and storage  professionals  cited
several factors:

     -   A STRONG MOVE AWAY FROM DIRECT  ATTACHED  STORAGE  (DAS).  Fortune 1000
         companies are moving all servers to a Networked Storage environment and
         the same move is beginning to happen with mid-market companies as well.

                                       4





     -   ORGANIC  GROWTH  OF  DATABASES  AND   APPLICATIONS.   Business-critical
         applications  such  as  Oracle  and  SAP,  as well  as  e-mail  systems
         including  Microsoft  Exchange and Lotus/Notes  Domino, all continue to
         grow substantially year over year. In addition Application  Development
         to enhance the infrastructure requires more capacity.

     -   INFORMATION   LIFECYCLE   MANAGEMENT.   New  and  demanding  Government
         regulations, especially as they relate to archiving, e-mail management,
         and  data  replication  to  remote   locations,   are  driving  storage
         investments and additional capacity requirements.

     -   EASE OF  MANAGEMENT.  Most companies can not  effectively  perform data
         back up procedures if the storage is not networked.

A move to Tiered Storage is underfoot with high  performing,  Fibre Channel SANs
augmented by:

     -   Mid-tier Fibre Channel SANs

     -   IP-based SANs

     -   Serial ATA Disk Drives

     -   NAS

     -   Content Addressed Storage

TheInfoPro  created an industry  standard  "Technology  Heat Index" based on the
current and planned usage of over forty different storage networking and storage
management technologies, prioritizing them based on near term spending.

According to TheInfoPro research, although there was huge interest in Serial ATA
technologies  in 2003,  only a small number of companies  actually  deployed and
used these  technologies.  By the middle of 2004,  usage of ATA drives increased
nearly 40%. Initially, ATA had been used as a staging media before backing up to
tape.  As  the  early   adopters   became  more   comfortable   with  the  usage
characteristics,  including improved performance and greater  reliability,  they
began to plan  other uses for the  technology  such as  replication,  as well as
using it as a medium for less mission critical data.

The move to Serial  ATAs  along  with IP SANs,  gives IT  storage  professionals
options and the ability to store data based on importance  and usage.  Fifty one
percent of surveyed IT professionals  are in the midst of server  consolidation.
In addition, 70% of respondents cited server virtualization as already in use or
under  consideration.  Previously  the  infrastructure  costs,  notably HBAs and
switches,  had been a limiting factor in deploying  additional  server assets on
the SAN. Now with the confluence of tiered  storage,  server  consolidation  and
server  virtualization,  enterprises  can deploy and manage  more  servers,  and
therefore more data, in a networked storage environment.

The  study  also  showed  the  continued  impact  of  regulations  and  business
continuance  as evidenced by the high scores for Archiving,  e-mail  management,
and Remote  Replication  in the survey,  which is reflective of the growing need
for  Information   Lifecycle   Management  (ILM)   solutions.   IT  and  Storage
professionals  are  actively  seeking an "ILM  engine"  that would allow them to
develop  a data  lifecycle  strategy  which  can set  policy  on data  types and
seamlessly  move  data  through  storage  tiers  based on  characteristics  that
include:  Security,  Quality of Service (QoS), Replication and Disaster Recovery
needs, as well as Access Patterns.

The functionality  required by IT and storage  professionals in an effective ILM
solution  include:  Data  Mobility,  Categorization,  and  Classification  Tools
designed to seamlessly transfer and protect data between tiers of storage.

TheInfoPro  also reported  that Fortune 1000 users have,  on average,  138TB and
22TB of SAN  and NAS  capacity,  respectively.  As  expected,  the  numbers  are
different for users in the small to medium-sized  enterprise  (SME) market.  SME
respondents reported an average of 91TB on SAN and 4TB on NAS. Furthermore,  NAS
capacity  at SMEs is expected  to grow 102% on  average,  while SAN  capacity is
expected to grow 43% on average.  (TheInfoPro  characterizes  SMEs as  companies
with revenues between $600 million and $1 billion.)


Storage Resource  Management and Storage Network Management software continue to
gain adoption on a worldwide basis.  Businesses of all sizes, from the small and
medium to the large  enterprise,  are proactively  seeking solutions that enable
them to preserve and optimize their existing IT investments,  while concurrently

                                       5





providing  the   storage-related   services  required  to  meet  data  retention
regulations, establish information lifecycle management and business continuance
strategies, and deploy end-to-end data protection methods.

PRODUCTS AND TECHNOLOGY

IPStor  Enterprise  Edition  (IPStor),  FalconStor's  flagship  product,  is the
foundation  on which all  FalconStor  solutions  are  built.  IPStor  Enterprise
Edition is comprised of a comprehensive  set of state of the art network storage
software designed to deliver an open,  intelligent SAN/NAS infrastructure across
heterogeneous  environments.  FalconStor has also developed and currently offers
turnkey,  IPStor-powered  network  storage  appliances,  which are available and
supported by major OEMs, as well as system integrators and resellers worldwide.

SOFTWARE SOLUTIONS

FalconStor  software  solutions deliver the advanced services needed to optimize
the  protection,  availability  and storage of  enterprise  data, in addition to
maximizing performance and availability of enterprise  applications.  FalconStor
solutions  have been  specifically  designed  to help  enterprise  data  centers
minimize total cost of ownership (TCO) and maximize return on investment (ROI).

The base IPStor software,  running on either a layer of stand-alone or a pair of
clustered  Linux/Solaris  servers (the IPStor  Appliances),  is responsible  for
aggregating  and  provisioning  storage  capacity  and  services to  application
servers via all industry standard protocols with speed,  security,  reliability,
interoperability, and scalability.

o        IPStor  solutions   developed  to  deliver  continuous   PROTECTION  of
         corporate data maintain 24x7  availability and usability of data in the
         event of  non-catastrophic  unplanned or planned  hardware  outage,  or
         software  error.  These solutions also reduce the risk of data loss due
         to a site failure,  media error,  robotic failure,  or human error, and
         allow data to be recovered quickly and accurately.

o        IPStor  solutions  developed  to  deliver  continuous  AVAILABILITY  of
         corporate  data  maintained  via  network  attached  storage  or direct
         attached storage enable rapid  recommencement  of business in the event
         of catastrophic outages, such as, a flood in the main data center.

o        IPStor solutions developed to optimize STORAGE increase overall storage
         performance   to  maximize   return  on  existing   investments  in  IT
         infrastructure, cost effectively migrate data, based on policy, between
         heterogeneous  storage subsystems,  and eliminate system outages caused
         by insufficient storage space.

o        IPStor  solutions  developed to help enterprise  data centers  minimize
         total cost of ownership and maximize  return on investment  consolidate
         heterogeneous  storage environments and servers, and centralize storage
         management under one simple interface.

STORAGE APPLIANCES

Addressing  one  of the  fastest  growing  segments  of  the  storage  industry,
small/medium  businesses  (SMBs),  FalconStor has entered into  agreements  with
resellers and with OEMs to develop  "storage  appliances"  that combine specific
IPStor functionality with third party hardware to create cost effective, turnkey
storage solutions that are easy to deploy and maintain. Currently,  FalconStor's
resellers and/or OEM partners offer the following storage appliances:

o        REALTIME DATA MIGRATION APPLIANCES use a Fibre Channel SAN to transport
         data across different vendors' storage subsystems without reconfiguring
         or shutting down the host.

o        VIRTUALTAPE LIBRARY/VIRTUAL DISK ISCSI AND FIBRE CHANNEL APPLIANCES use
         disk to enhance the  reliability,  speed,  and availability of backups,
         while consolidating the management and provisioning of backup resources
         without  changing  existing tape backup software and  procedures.  With
         backup windows  shrinking and rapid data restoration more critical than
         ever, the VirtualTape  Library  Appliance  allows users to utilize disk
         storage  to  emulate  multiple  tape  libraries   concurrently  and  to
         accelerate backup/restore speed.

o        ISCSI STORAGE APPLIANCES  leverage the industry standard iSCSI protocol
         and an existing IP network to create a reliable  SAN solution for small
         or remote  offices,  as well as small data  centers,  at an  affordable
         price.  These appliances  aggregate and provision  storage capacity and
         provide   services  that  deliver  rapid   recovery,   continuous  data
         protection and disaster recovery capabilities.

                                       6





BUSINESS STRATEGY

FalconStor  intends  to  continue  its  position  as a leading  network  storage
software provider to enterprises worldwide. FalconStor also intends to enter the
non-enterprise  storage market by offering  products for use in the Small/Medium
Business (SMB) and Small Office/Home  Office (SOHO) markets.  FalconStor intends
to achieve these objectives through the following strategies:

o        MAINTAIN A LEADERSHIP POSITION IN NETWORK STORAGE SOFTWARE.  FalconStor
         intends to leverage its  protocol-agnostic  architecture  to maintain a
         leadership position in the network storage software market. The network
         storage  software  market is defined by rapid  change,  and  FalconStor
         plans to  continue to focus its  research  and  development  efforts to
         invent and to bring to market innovative solutions.

o        EXPAND  PRODUCT  OFFERINGS.  During the past year,  FalconStor  offered
         additional  options for its IPStor  software.  In addition,  FalconStor
         expanded its offerings of storage appliances  consisting of third-party
         hardware  loaded  with  IPStor  functionality.  FalconStor  intends  to
         continue  to expand  the  options  available  for  IPStor  and to offer
         additional storage appliances.

o        INCREASE MARKET PENETRATION AND BRAND RECOGNITION.  FalconStor plans to
         promote its products and corporate awareness by:

         o  forming strategic partnerships with leading industry players;

         o  participating in industry events, conferences and trade shows; and

         o  continuing targeted promotions and public relations campaigns.

         FalconStor  believes  that  establishing  a strong brand  identity as a
         network storage software  solution  provider is important to its future
         success.

o        ESTABLISH  A GLOBAL  PRESENCE.  FalconStor  believes  that  significant
         market  share can be achieved in Europe and Asia.  FalconStor,  through
         its European headquarters, plans to expand its operational capabilities
         in Europe.  In  addition,  through  its Asia  headquarters,  FalconStor
         believes  that it is  developing  a  strong  business  presence  in the
         Asia/Pacific Rim.

o        EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND
         ALLIANCES.  FalconStor  believes that opportunities exist to expand its
         technological  capabilities,  product  offerings  and services  through
         acquisitions  of  businesses  or  software   technology  and  strategic
         alliances.   When  evaluating  potential   acquisitions  and  strategic
         alliances,  FalconStor  will focus on  transactions  that  enable it to
         acquire:

         o  important enabling technology;

         o  complementary applications;

         o  marketing, sales, customer and technological synergies; and/or

         o  key personnel.

o        SEEK OEM  RELATIONSHIPS  WITH INDUSTRY LEADERS.  FalconStor  intends to
         continue  to  enter  into  original  equipment   manufacturer   ("OEM")
         agreements  with  strategic  switch,  storage,  appliance and operating
         system vendors.  Besides accelerating overall marketing growth, the OEM
         relationships   should  bolster   FalconStor's   product   recognition,
         corporate credibility and revenue stream.

                                       7





o        OFFER  PRODUCTS  AND SERVICES TO THE SMB AND SOHO  MARKETS.  FalconStor
         intends to work with industry partners so that these partners can offer
         storage  solutions  or  services  to the SMB and  SOHO  markets.  These
         solutions and services may take the form of special purpose  appliances
         or applications, or hosted storage.

SALES, MARKETING AND CUSTOMER SERVICE

FalconStor plans to continue to sell its products  primarily through  agreements
with OEMs,  value-added  resellers  (sometimes called "solution  providers") and
distributors.

o        ORIGINAL EQUIPMENT  MANUFACTURER  RELATIONSHIPS.  OEMs collaborate with
         FalconStor  to integrate  FalconStor's  products into their own product
         offerings or resell FalconStor's products under their own label.

o        VALUE-ADDED  RESELLER AND  DISTRIBUTOR  RELATIONSHIPS.  FalconStor  has
         entered into  value-added  reseller and distributor  agreements to help
         sell its product in various geographic areas.  FalconStor's value-added
         resellers  and  distributors  market  various  FalconStor  products and
         receive a discount off list price on products sold.

o        STORAGE  APPLIANCES.   FalconStor  has  entered  into  agreements  with
         strategic partners in which various FalconStor  products are adapted to
         the strategic partner's  special-purpose  storage appliances to provide
         various services to end users.

o        DIRECT  SALES TO END  USERS.  In a  limited  number  of  circumstances,
         FalconStor has entered into software license  agreements  directly with
         end users for FalconStor's products.

FalconStor's marketing department consists of marketing  professionals dedicated
to advertising,  public relations, marketing communications,  events and channel
partner  programs.  FalconStor's  marketing  efforts  focus  on  building  brand
recognition and developing leads for the sales force.

FalconStor   Professional  Services  personnel  are  also  available  to  assist
customers and partners  throughout the product life cycle of IPStor deployments.
The Professional  Services team includes seasoned  "Storage  Architects" who can
assist in the assessment, planning/design,  deployment, and testing phases of an
IPStor deployment  project,  and a Technical  Support group for  post-deployment
assistance and on-going trouble-shooting.

RESEARCH AND DEVELOPMENT

The storage software  industry is subject to rapid  technological  advancements,
changes in customer requirements, developing industry standards, and regular new
product  introductions and enhancements.  As a result,  FalconStor's success, in
part,  depends upon its ability to continue to improve existing solutions and to
develop  and  introduce  new  products  on a  cost-effective  and timely  basis.
FalconStor  believes its  continued  investment in research and  development  is
critical  to its  ability to  continue  to  provide  new and  enhanced  products
addressing emerging market needs. There can be no assurance that FalconStor will
successfully  develop  new  products to address new  customer  requirements  and
technological  changes,  or that such products will achieve  market  acceptance.
FalconStor's  research and  development  staff  consisted of 105 employees as of
December 31, 2004. Research and development  expenses,  primarily  consisting of
personnel  expenses,  were  approximately  $6.3  million,  $7.1 million and $9.1
million  in 2002,  2003 and  2004,  respectively.  FalconStor  anticipates  that
research and development expenses will increase in 2005.

COMPETITION

As the demand for 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 to application
hosts attached to CIFS,  NFS, iSCSI and Fibre Channel (FC) networks,  FalconStor
believes it is the only software-based solution capable of accommodating storage
devices with  industry-standard  interfaces  and  provisioning  the  virtualized
resource over FC, IP/iSCSI, NFS and CIFS with comprehensive storage services and

                                       8





end-to-end  manageability.  However,  some of FalconStor's  product capabilities
compete with  products  from a number of companies  with  substantially  greater
financial  resources,  such as Network  Appliance,  Inc.,  and Veritas  Software
Corporation.  FalconStor is not aware of any other  software  company  providing
unified storage services running on a standard Linux or Solaris based appliance.
FalconStor believes that the principal  competitive factors affecting its market
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,  the Company has  experienced
competitive  pressures  from smaller,  niche  players in the industry.  However,
FalconStor believes these potential competitors currently do not offer the depth
or breadth of 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  moves 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  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 competing technologies. FalconStor's future and existing competitors
could introduce products with superior  features,  scalability and functionality
at lower prices than FalconStor's products and could also bundle existing or new
products  with other more  established  products  to  compete  with  FalconStor.
Increased  competition  could  result  in price  reductions  and  reduced  gross
margins, which could harm FalconStor's business.

INTELLECTUAL PROPERTY

FalconStor's  success  is  dependent  in part upon its  proprietary  technology.
Currently,  the IPStor software suite is the core of its proprietary technology.
FalconStor  currently has one patent and numerous  pending patent  applications,
nine registered trademarks - including  "FalconStor,"  "FalconStor Software" and
"IPStor" - and many pending trademark applications related to FalconStor and its
products.

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

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

MAJOR CUSTOMERS

For the year ended December 31, 2004, FalconStor had one customer that accounted
for 16% of revenues.  For the year ended  December 31, 2003  FalconStor  did not
have any customers that  accounted for over 10% of revenues.  For the year ended
December  31,  2002,  FalconStor  had one  customer  that  accounted  for 16% of
revenues. As of December 31, 2004, the Company had three customers with accounts
receivable balances greater than 5% of gross accounts  receivable,  which in the
aggregate were 30% of the accounts  receivable balance. As of December 31, 2003,
the Company had two customers with accounts  receivable balances greater than 5%
of gross  accounts  receivable,  which in the aggregate were 11% of the accounts
receivable balance.

                                       9





EMPLOYEES

As of December 31, 2004,  FalconStor had 217 full-time employees,  consisting of
61 in sales and marketing, 38 in service, 105 in research and development and 13
in  general  administration.   FalconStor  is  not  subject  to  any  collective
bargaining agreements and believes its employee relations are good.

INTERNET ADDRESS AND AVAILABILITY OF FILINGS

FalconStor's internet address is www.falconstor.com.  FalconStor makes available
free of charge on or through its Internet website, FalconStor'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 soon as reasonably  practicable
after  FalconStor  electronically  files such material with, or furnishes it to,
the SEC.  FalconStor complied with this policy for every Securities Exchange Act
of 1934 report filed during the year ended December 31, 2004.

ITEM 2.  PROPERTIES

FalconStor's  headquarters  are located in an  approximately  45,000 square foot
facility located in Melville, New York, of which 34,000 square feet is currently
being  utilized.  Offices are also leased for  development,  sales and marketing
personnel,  which total an aggregate of  approximately  24,500 square feet in Le
Chesnay,  France; Taichung,  Taiwan; Tokyo, Japan; Beijing and Shanghai,  China;
Munich,  Germany;  and Seoul, Korea. Initial lease terms range from one to eight
years, with multiple renewal options.

ITEM 3.  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 or liquidity.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

                                       10





                                     PART II

ITEM 5.     MARKET  FOR  REGISTRANT'S  COMMON  EQUITY  AND  RELATED  STOCKHOLDER
            MATTERS

MARKET INFORMATION

            Our Common Stock is listed on The Nasdaq National 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:

                                            2004                    2003
                                     ---------------------    ------------------
                                      High           Low       High       Low
                                      ----           ---       ----      -----
               Fourth Quarter        $ 9.57        $ 6.21     $ 9.15    $ 6.11
               Third Quarter         $ 7.85        $ 5.13     $ 6.89    $ 4.54
               Second Quarter        $ 8.35        $ 6.15     $ 7.11    $ 3.56
               First Quarter         $10.15        $ 6.57     $ 4.57    $ 3.47

HOLDERS OF COMMON STOCK

            We had  approximately  184  holders of record of Common  Stock as of
            February 21, 2005.  This does not reflect  persons or entities  whom
            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.

ITEM 6.     SELECTED FINANCIAL DATA

            The  selected  consolidated  financial  data  with  respect  to  our
            consolidated  balance  sheets as of December 31, 2004,  2003,  2002,
            2001 and 2000 and the related consolidated  statements of operations
            data for the years ended December 31, 2004,  2003, 2002 and 2001 and
            the period from inception  (February 10, 2000) through  December 31,
            2000 have  been  derived  from our  audited  consolidated  financial
            statements.  The  following  selected  consolidated  financial  data
            should  be read  in  conjunction  with  the  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."

                                       11




CONSOLIDATED STATEMENTS OF OPERATIONS DATA:


                                                                                                                     PERIOD FROM
                                                                                                                 INCEPTION (FEBRUARY
                                                          YEAR ENDED     YEAR ENDED    YEAR ENDED     YEAR ENDED   10, 2000) THROUGH
                                                           DECEMBER 31,  DECEMBER 31,   DECEMBER 31   DECEMBER 31,     DECEMBER 31,
                                                              2004           2003         2002         2001             2000
                                                           -------------------------------------------------------------------------
                                                                               (IN THOUSANDS, EXCEPT PER SHARE DATA)

Revenues:
Software license revenue ...............................     $ 21,488      $ 12,251      $  8,667      $  4,714      $   --
Maintenance revenue ....................................        4,443         2,473         1,297            17          --
Software services and other revenue ....................        2,778         2,220           665           861           143
                                                             --------      --------      --------      --------      --------
                                                               28,709        16,944        10,629         5,592           143
                                                             --------      --------      --------      --------      --------

Operating expenses:
Amortization of purchased and capitalized software .....        1,394         1,394           899           273          --
Cost of maintenance, software services and other revenue        4,150         2,580         1,309           897           224
Software development costs .............................        9,050         7,068         6,281         5,004         1,379
Selling and marketing ..................................       14,277        10,967         9,856         8,085           327
General and administrative .............................        5,109         2,878         2,592         2,732           534
Litigation settlement ..................................        1,300          --            --            --            --
Lease abandonment charge ...............................         --             550          --            --            --
Impairment of prepaid royalty ..........................         --            --             483          --            --
                                                             --------      --------      --------      --------      --------
                                                               35,280        25,437        21,420        16,991         2,464
                                                             --------      --------      --------      --------      --------
           Operating loss ..............................       (6,571)       (8,493)      (10,791)      (11,399)       (2,321)
                                                             --------      --------      --------      --------      --------

Interest and other income ..............................          714         1,122         1,585         1,365           225
Impairment of long-lived assets ........................         --              35        (2,300)         --            --
                                                             --------      --------      --------      --------      --------

Loss before income taxes ...............................       (5,857)       (7,336)      (11,506)      (10,034)       (2,096)

 Provision for income taxes ............................           32            33            37            22          --
                                                             --------      --------      --------      --------      --------

Net loss ...............................................     $ (5,889)     $ (7,369)     $(11,543)     $(10,056)     $ (2,096)
                                                             --------      --------      --------      --------      --------

Beneficial conversion feature
           attributable to convertible preferred
           stock .......................................         --            --            --           3,896          --
                                                             --------      --------      --------      --------      --------

Net loss attributable to common
  shareholders .........................................     $ (5,889)     $ (7,369)     $(11,543)     $(13,952)     $ (2,096)
                                                             ========      ========      ========      ========      ========

 Basic and diluted net loss per share
       attributable to common shareholders .............     $  (0.13)     $  (0.16)     $  (0.26)     $  (0.40)     $  (0.09)
                                                             ========      ========      ========      ========      ========

 Basic and diluted weighted average
           common shares outstanding ...................       46,967        45,968        45,233        35,264        24,383
                                                             ========      ========      ========      ========      ========

                                       12



CONSOLIDATED BALANCE SHEET DATA:

                                 DECEMBER 31,  DECEMBER 31,  DECEMBER 31,     DECEMBER 31,    DECEMBER 31,
                                    2004          2003          2002            2001            2000
                                 -------------------------------------------------------------------------
                                                         (IN THOUSANDS)

Cash and cash equivalents and
   marketable securities          $33,973      $36,685         $51,102         $64,527         $ 7,727

Working capital                    36,452       39,527          47,746          57,518           7,254

Total assets                       56,074       56,493          64,710          74,471           8,594

Long-term obligations               1,290          396           --                283             --

Stockholders' equity               46,364       50,556          55,901          63,562           8,057


                                       13






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

         In 2004,  we  continued  our  growth  and we had our  first  profitable
quarter.  Our revenues for the full year  increased to $28.7  million from $16.9
million in 2003. We are pleased that we were profitable in the fourth quarter of
2004.  However,  our focus will  continue to be on managing our business  with a
view towards  long-term success and growth. To this end, in 2004 we continued to
invest in research and  development  and other areas to position the Company for
future growth.  We will continue to invest in these areas in 2005 and anticipate
that our research and development expenses will increase in 2005.

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

         It is important to our success that our products  meet the needs of end
users  and  that  our  products  are - and  are  viewed  by the  market  to be -
innovative.  In 2004, our products  received  recognition  for their quality and
innovation  from  several  respected,  independent,  industry  publications  and
organizations. This recognition helps us gain access to additional customers and
assists us in closing sales.

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

         The key factors we look to for our future business  prospects  continue
to be our sales pipeline, our ability to establish and expand relationships with
key industry OEMs and resellers,  sales by our OEM partners,  additional  orders
from resellers,  growth in deferred revenue,  re-orders from existing customers,
and the growth of the overall  market for storage  solutions.  Gross margins are
also a key factor in evidencing the growth of our business.

         Our sales "pipeline" consists of inquiries from end users and resellers
for possible  purchases of our  products.  Our overall sales  pipeline  steadily
increased for each quarter of 2004 compared with the same quarter in 2003.

         OEM  relationships  are  important to us for two main  reasons.  First,
sales  by our OEM  partners  contribute  to our  revenues.  Second,  having  our
products  selected  by  respected,   established  industry  leaders  signals  to
potential  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 all of the
competing software solutions  available.  The choice of IPStor by major industry
participants validates the design and the capabilities of our products.

         Overall,  product licenses to OEMs accounted for  approximately  thirty
percent of our revenues in 2004. One OEM customer accounted for over ten percent
of our  revenues.  We  anticipate  that OEMs will  account  for  thirty to forty

                                       14





percent of our  revenues in 2005.  We expect that at least one OEM will  account
for at least ten percent of our revenues in 2005. Accordingly,  the loss of this
customer would have a material adverse effect on our business.

         In 2004,  we signed a new agreement  for our iSCSI  Server  for Windows
Storage Server 2003 (WSS2003) powered by IPStor with a Tier 1 OEM. This product,
which is  private-labeled by the OEM, began shipping towards the end of 2004. In
addition, a Tier 1 OEM with whom we signed an agreement in 2003 began shipping a
private-labeled  storage solution utilizing our VirtualTape  Library software in
the second quarter of 2004. During the fourth quarter of 2004, we also signed an
agreement with an OEM partner for non-enterprise storage solutions.

         These OEM  relationships  are in  addition to the OEM  partnerships  we
already had with CNT, Maxxan and StorageTek,  among others.  We will continue to
seek additional OEM opportunities in the future.

         We were  disappointed  that an OEM with whom we signed an  agreement in
2003 did not launch their solution as planned in 2004.  This decision,  which we
were  informed by the OEM was not  related to any  problems  with our  software,
caused us to have lower than expected revenues for 2004. 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.

         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.  Resellers have wide choices in fulfilling their customers' needs.
We have established strong  relationships with many premier resellers.  In 2004,
we signed  agreements  with many new  resellers  worldwide.  We also  terminated
relationships  with several  resellers who we believed were not properly selling
our products. We will continue to enter into relationships with resellers and to
discontinue relationships with resellers with whom we are not satisfied.

         As service providers to companies, resellers' reputations are dependent
on satisfying their customers' needs  efficiently and effectively.  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 complaining about 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.  We saw growth in the sales by most of our
significant resellers in 2004 and expect that this growth will continue in 2005.

         Our deferred  revenues  consist  primarily of revenue  attributable  to
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 maintenance and support  services.  Our deferred  revenue  increased to $5.4
million as of December 31, 2004,  compared  with $2.6 million as of December 31,
2003. We expect deferred revenue to continue to grow in 2005.

         The level of  re-orders  from  existing  end users of our  products  is
another measure of customer satisfaction.  Information technology  professionals
will only order  additional  products and  services for their  companies if they
determine  that the  products  have  reduced  total cost of  ownership  and have
provided a good return on investment.  Re-orders are thus an indication that our
products  are  delivering  as  promised  and that our support is meeting the end
user's  needs.  In 2004,  many end users  ordered  additional  copies of IPStor,
additional  products or ordered additional  options.  If re-orders  decline,  it
would  indicate that future sales might also decline.  As the  percentage of our
revenues  from OEMs  increases,  the  analytical  value of  re-orders  decreases
because  our  OEM  partners   typically  do  not  provide  us  with  information
identifying the end user for each order.

         The  storage  solutions  market  continues  to  grow.  (Please  see the
discussion on page 4.) As we predicted last year, in addition to growth based on
demand for storage server  consolidation  and  replication,  there was growth in
backup acceleration.  We expect each of these areas to continue growing in 2005.
In addition,  we have  announced new  initiatives in the  small/medium  business
(SMB) and small  office/home  office  (SOHO)  markets.  We  believe  that  these
non-enterprise markets are another growth area for storage software.

                                       15





         One area of  particular  growth in 2004 that we expect to continue,  if
not accelerate,  in 2005, was in VirtualTape  Library software.  Prices for disk
storage continue to fall, and the need for rapid back up, disaster  recovery and
regulatory compliance continues to grow.

         As we expected, 2004 saw the beginning of market acceptance of IP-based
Storage Area Networks,  primarily  using iSCSI.  Previously,  most SANs had been
based on  fibre-channel.  In addition to the solution  offered by our Tier 1 OEM
partner, we plan to continue to tap into the growth in this market through sales
of our products by other strategic partners.

         Another important measure of our business is gross margin.  Among other
things,  gross  margin  measures  our  ability  to scale  our  business.  Unlike
manufacturers  of hardware,  our  incremental  cost for each  additional unit of
software  licensed is a small percentage of the software license revenue.  Thus,
our gross margins tend to increase as our software license revenue increases. We
incur  research  and  development  expenses  before the  product is offered  for
licensing.  These expenses consist  primarily of personnel costs for engineering
and  testing,  but also  include  other items such as the cost of  hardware  and
software used in development. We also have expenses for sales and marketing, and
general and administrative functions.

         Our gross margin  continued to increase in 2004,  ending at 86% for the
fourth quarter of 2004,  compared with 77% for the fourth quarter of 2003.  This
demonstrates  that we were successful in containing the growth of our costs even
as our revenue increased.

         We are  pleased  with our  ability to contain the growth of expenses in
2004.  There were two large expense items in 2004 which we had not  anticipated.
First,  we were subject to a claim that some of our products  infringed a patent
issued to a third party.  While we denied,  and continue to deny,  that,  if the
subject  patent is valid,  our  products  infringe  the patent,  the defense and
settlement  of the claim was  expensive.  As part of the  settlement,  we made a
one-time  payment of $1.3 million.  In addition,  we incurred over $1 million in
related legal expenses.  The need to defend our products  against these types of
claims could result in higher expenses in the future.

         Second, we incurred significant expenses related to compliance with the
provisions of the  Sarbanes-Oxley  Act of 2002.  This Act requires,  among other
things, an annual review of "internal controls" by the Company and our auditors.
The  costs  associated  with  this  review,  including  the  cost of an  outside
consultant and the cost of the review by our auditors, approximated $0.8 million
in 2004. While we believe these costs will be reduced in the future,  there will
be continuing costs related to compliance with the Act in 2005 and beyond.

         One  additional  factor  that we  expect to affect  our  revenues  on a
quarterly,  but  not  annual,  basis,  is the  seasonality  of  the  information
technology  business.  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 were impacted by this  seasonality in 2004,  and we anticipate  that our
quarterly results for 2005 will be affected as well.

         Our  critical   accounting   policies  are  those  related  to  revenue
recognition and accounts  receivable  allowances.  As described in note 1 to our
consolidated  financial statements,  we recognize revenue in accordance with the
provisions  of Statement of Position  97-2,  Software  Revenue  Recognition,  as
amended.  Software license revenue is recognized only when pervasive evidence of
an  arrangement  exists  and the fee is  fixed  and  determinable,  among  other
criteria.  An  arrangement  is  evidenced  by a  signed  customer  contract  for
nonrefundable  royalty advances  received from OEMs or a customer purchase order
or a royalty report summarizing software licenses 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.

         We review  accounts  receivable  to  determine  which are  doubtful  of
collection.  In  making  the  determination  of the  appropriate  allowance  for
uncollectible  accounts  and  returns,  we  consider  historical  return  rates,
specific past due accounts,  analysis of our accounts receivable aging, customer
payment  terms,  historical  collections,  write-offs  and  returns,  changes in
customer demand and  relationships,  concentrations  of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer

                                       16





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.

RESULTS OF  OPERATIONS - FOR THE YEAR ENDED  DECEMBER  31, 2004  COMPARED TO THE
YEAR ENDED DECEMBER 31, 2003

         Revenues for the year ended  December 31, 2004  increased  69% to $28.7
million  compared to $16.9  million for the year ended  December 31,  2003.  Our
operating  expenses increased 39% from $25.4 million in 2003 to $35.3 million in
2004.  Net loss decreased 20% from $7.4 million in 2003 to $5.9 million in 2004.
The increase in revenues was mainly due to an increase in demand for our network
storage  solution  software,  the  introduction  of our  new  products  and  the
successful  launch  by one of our OEMs of a  solution  powered  by our  product.
Revenue  contribution from our OEM partners increased in absolute dollars and as
a percentage of our total revenue for the year ended December 31, 2004.  Revenue
from resellers and  distributors  also increased in absolute  dollars.  Expenses
increased  in all aspects of our  business to support our growth.  In  November,
2003 we moved our  headquarters  to a larger  facility  and,  for the year ended
December 31, 2004,  we increased the number of employees and continued to invest
in infrastructure by purchasing additional computers and equipment. We increased
the number of  employees  from 178  employees  as of  December  31,  2003 to 217
employees as of December  31,  2004.  Included in our results for the year ended
December  31, 2004 is a litigation  settlement  charge of $1.3 million and legal
fees of $1.0  million,  each  associated  with  litigation  relating  to  patent
infringement  that was  resolved in the third  quarter of 2004,  as well as $0.8
million of costs related to compliance with the Sarbanes-Oxley Act of 2002.

REVENUES

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 also 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 75% to $21.5 million in 2004 from
$12.3 million in 2003.  Increased market  acceptance and demand for our product,
the  introduction  of our new products and the  successful  launch by one of our
OEMs of a  solution  powered  by our  product  were the  primary  drivers of the
increase in software  license revenue.  Software license revenue  increased from
both our OEM  partners  and from our  resellers.  Revenue  from our OEM partners
increased  as a percentage  of total  revenue.  We expect our  software  license
revenue  to  continue  to grow and the  percentage  of future  software  license
revenue derived from our OEM partners to increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

         Maintenance,  software  services and other  revenues  are  comprised of
software  maintenance and technical  support,  professional  services  primarily
related to the implementation of our software,  engineering services,  and sales
of computer  hardware.  Revenue derived from  maintenance and technical  support
contracts is deferred and recognized  ratably over the  contractual  maintenance
term. Professional services revenue is recognized in the period that the related
services are performed.  Revenue from engineering  services is primarily related
to customizing  software  product masters for some of our OEM partners.  Revenue
from  engineering  services  is  recognized  in  the  period  the  services  are
completed. In 2004 and 2003, we had a limited number of transactions in which we
purchased  hardware  and bundled  this  hardware  with our software and sold the
bundled solution to a customer. A portion of the contractual fee is recognized

                                       17





as revenue when the  hardware or software is delivered to the customer  based on
the relative fair value of the delivered element(s).  Through December 31, 2004,
the  software  and  hardware in bundled  solutions  have been  delivered  to the
customer in the same quarter.  Maintenance,  software services and other revenue
increased 54% to $7.2 million in 2004 from $4.7 million in 2003.

         The major factor contributing to the increase in maintenance,  software
services  and other  revenue was the increase in the number of  maintenance  and
technical  support  contracts we sold. As we are in business  longer,  and as we
license more software,  we expect these revenues will continue to increase.  The
majority  of our  new  customers  purchase  maintenance  and  support  and  most
customers  renew their  maintenance  and support after their  initial  contracts
expire.  Maintenance  revenue  increased  from $2.5  million  for the year ended
December 31, 2003 to $4.4 million for the year ended  December 31, 2004.  Growth
in our professional services revenue,  which increased from $0.9 million in 2003
to $1.3 million in 2004, 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  that  elected to purchase
professional  services.  Additionally,  our hardware  sales  increased from $1.3
million in 2003 to $1.5  million  in 2004.  This  increase  was the result of an
increase  in  demand  from  our  customers  for  bundled  solutions.  We  expect
maintenance, software services and other revenues to continue to increase.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

         To remain  successful in the network storage  solutions market, we must
continually  upgrade our  software by  enhancing  the  existing  features of our
products and by adding new features and products.  We often evaluate  whether to
develop these new offerings  in-house or whether we can achieve a greater return
on investment by purchasing or licensing  software from third parties.  Based on
our evaluations, we have purchased or licensed various software for resale since
2001.  As of  December  31,  2004 and 2003,  we had $4.9  million  of  purchased
software licenses that are being amortized over three years. For the years ended
December 31, 2004 and 2003, we recorded $1.4 million of amortization  related to
these  purchased  software  licenses.  We will continue to evaluate  third party
software  licenses and may make additional  purchases,  which would result in an
increase in amortization expense.

         The Company did not capitalize any software development costs until our
initial product reached technological  feasibility in March 2001. At that point,
we  capitalized  $0.1 million of software  development  costs,  which were being
amortized  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.  Amortization of capitalized  software was $7,881 and
$31,523 for the years ended December 31, 2004 and 2003, respectively.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

         Cost of  maintenance,  software  services  and other  revenue  consists
primarily of personnel costs and other costs associated with providing  software
implementations,  technical support under maintenance  contracts,  and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware  purchased that was resold.  Cost of maintenance,  software services
and other revenues for the year ended December 31, 2004 increased by 61% to $4.2
million  compared to $2.6  million for the year ended  December  31,  2003.  The
increase  in cost of  maintenance,  software  services  and  other  revenue  was
principally due to an increase in personnel.  As a result of our increased sales
of maintenance and support  contracts and professional  services,  we required a
higher  number of employees to provide  technical  support and to implement  our
software.  Our cost of  maintenance,  software  services and other  revenue will
continue to grow in absolute dollars as our revenue increases.

         Gross profit for the year ended  December 31, 2004 was $23.2 million or
81% of revenues  compared to $13.0 million or 77% of revenues for the year ended
December  31,  2003.  The increase in gross profit and gross margin was directly
related to the increase in revenues relative to the increase in expenses. As our
software license revenues increase, the associated costs as a percentage of

                                       18





those  revenues  tend to decrease.  Additionally,  the  increased  percentage of
revenue  from our OEM  partners  in 2004  contributed  to the  increase in gross
margin since revenues from our OEM partners have higher gross margins.

SOFTWARE DEVELOPMENT COSTS

         Software  development  costs consist  primarily of personnel  costs for
product  development  personnel  and other  related  costs  associated  with the
development  of  new  products,   enhancements  to  existing  products,  quality
assurance and testing.  Software development costs increased 28% to $9.1 million
in 2004 from $7.1 million in 2003.  The increase in software  development  costs
was primarily  due to an increase in employees  required to enhance and test our
network storage software products, as well as to develop new innovative features
and options.  In addition,  as we entered into agreements with new OEM partners,
we required additional employees to test and integrate our software with our OEM
partners'  products.  In 2003, we also opened a  development  office in China to
assist in our  development  work.  We intend to continue  recruiting  and hiring
product development personnel to support our development process.

SELLING AND MARKETING

         Selling and marketing expenses consist primarily of sales and marketing
personnel  and  related  costs,  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  30% to $14.3  million in 2004 from $11.0 million in 2003. As a result
of the increase in revenue and interest in our software,  our commission expense
and travel expenses increased.  In addition,  we continued to hire new sales and
sales support personnel and to expand our worldwide  presence to accommodate our
revenue  growth.  We  believe  that to  continue  to grow  sales,  our sales and
marketing expenses will continue to increase.

GENERAL AND ADMINISTRATIVE

         General and  administrative  expenses  consist  primarily  of personnel
costs of general and  administrative  functions,  public company  related costs,
directors and officers insurance,  legal and professional fees and other general
corporate overhead costs.  General and administrative  expenses increased 77% to
$5.1  million in 2004 from $2.9  million in 2003.  The  increase  in general and
administrative  expenses was partially  due to a $1.0 million  increase in legal
expense  attributable to litigation relating to alleged patent infringement with
Dot Hill Systems  Corporation ("Dot Hill") and Crossroads Systems (Texas),  Inc.
("Crossroads").  Expenses of $0.8 million for the year ended  December 31, 2004,
related to compliance with Section 404 of the  Sarbanes-Oxley Act of 2002 and an
increase in the number employees also contributed to the increase in general and
administrative expenses.

LITIGATION SETTLEMENT CHARGE

         During the third  quarter  of 2004,  we  resolved  claims  relating  to
alleged patent infringement  brought by Dot Hill and by Crossroads against us in
the United States District Court for the Western District of Texas.  Pursuant to
the terms of the  Settlement  Agreement  between  Crossroads and us, we, without
admission of  infringement,  made a one-time payment of $1.3 million and granted
to Crossroads licenses to certain of our technology in exchange for a worldwide,
perpetual license to the technology  underlying the Crossroads' patents at issue
in the  litigation.  All claims against us by both Dot Hill and Crossroads  have
now been dismissed.

INTEREST AND OTHER INCOME

         We invest our cash,  cash  equivalents  and  marketable  securities  in
government securities and other low risk investments.  Interest and other income
decreased  36% to $0.7 million in 2004 from $1.1 million in 2003.  This decrease
in interest  income was due to lower interest rates and lower average cash, cash
equivalent and marketable securities balances.

                                       19





INCOME TAXES

         We did not  record  a tax  benefit  associated  with the  pre-tax  loss
incurred from the period from inception (February 10, 2000) through December 31,
2004, as we deemed that it was more likely than not that the deferred tax assets
will not be realized  based on our early stage of  operations.  Accordingly,  we
provided a full  valuation  allowance  against our net deferred tax assets.  Our
income  tax  provision  consists  of tax  liabilities  related  to  our  foreign
subsidiaries.

LEASE ABANDONMENT CHARGE

         In November 2003, we relocated our headquarters to a larger facility to
accommodate our future growth.  As a result of this  relocation,  we vacated our
previous  office space and recorded a charge for the estimated loss we expect to
incur on the remaining lease obligation. The charge of $0.6 million included the
remaining  lease rental  obligation  reduced by cash flows we expect to generate
from an  agreement  to  sub-lease  the  facility  as well  as the  write  off of
leasehold improvements at our previous facility. This expense is not expected to
recur.

IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

         In October 2001, we entered into an agreement with  Network-1  Security
Solutions,  Inc. ("NSSI"),  a publicly traded company,  whereby $2.8 million was
paid to  NSSI,  of  which  $2.3  million  was for the  purchase  of  convertible
preferred  stock of NSSI  accounted for under the cost method,  and $0.5 million
was for a non-refundable prepaid royalty recoupable against future product sales
of NSSI's  product.  Primarily  due to the decline in the market value of NSSI's
common stock underlying the convertible  preferred stock significantly below the
Company's  cost,  we concluded in 2002 that the decline in the fair value of our
investment in NSSI's preferred stock was other than temporary.  Accordingly,  in
2002 we  recorded an  impairment  charge to  write-off  our  investment  in NSSI
preferred stock. In addition,  due to the lack of market  acceptance of the NSSI
product,  we concluded that the unrecouped  prepaid  royalty was not recoverable
and it was written off. As a result,  in 2002, we recorded a $2.8 million charge
for the impairment of long-lived and other assets related to our NSSI agreement,
of which $0.5 million was an operating  expense.  In 2003, we received a payment
from NSSI of $35,000 in exchange for all of our preferred  stock of NSSI,  which
was  reflected  as a reduction  to the  impairment  charge in the  statement  of
operations.  We do not  expect  to  incur  any  additional  expenses  from  this
investment.

RESULTS OF  OPERATIONS - FOR THE YEAR ENDED  DECEMBER  31, 2003  COMPARED TO THE
YEAR ENDED DECEMBER 31, 2002

REVENUES

SOFTWARE LICENSE REVENUE

         Software  license  revenue  increased 41% to $12.3 million in 2003 from
$8.7 million in 2002.  Increased  market  acceptance  and demand for our product
were the  primary  drivers  of the  increase  in  software  license  revenue.  A
continued  increase in the number of our channel  partners  and OEMs also helped
increase our revenues.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

         Maintenance, software services and other revenue increased 139% to $4.7
million in 2003 from $2.0 million in 2002.  The major factor behind the increase
in  maintenance,  software  services  and other  revenue  was an increase in the
number of  maintenance  and  technical  support  contracts we sold. As we are in
business longer, and as we license more software,  we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and
support and most  customers  renew  their  maintenance  and support  after their
initial  contracts expire.  Maintenance  revenue increased from $1.3 million for
the year ended December 31, 2002 to $2.5 million for the year ended December 31,
2003.  Growth in our  professional  services  sales,  which  increased from $0.4
million in 2002 to $0.9  million in 2003,  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  that
elected to purchase  professional  services.  Additionally,  our hardware  sales
increased  from $0.2 million in 2002 to $1.3 million in 2003.  This increase was
the result of an increase in demand from our customers for bundled solutions.

                                       20





COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

         Amortization of purchased and capitalized  software increased from $0.9
million for the year ended  December 31, 2002 to $1.4 million for the year ended
December 31, 2003. The increase in amortization  expense was due to our purchase
of an additional  $1.8 million of software  licenses in 2003. As of December 31,
2003,  we had $4.9  million  of  purchased  software  licenses  that  are  being
amortized  over three years.  For the year ended  December 31, 2003, we recorded
$1.4 million of amortization related to these purchased software licenses. As of
December  31,  2002,  we had $3.0  million of  purchased  software  licenses and
recorded  approximately $0.9 million of amortization for the year ended December
31,  2002  related  to  these  purchased  software  licenses.   Amortization  of
capitalized  software  was $31,523 and $31,524 for the years ended  December 31,
2003 and 2002, respectively.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

         Cost of maintenance,  software services and other revenues for the year
ended  December  31,  2003  increased  by 97% to $2.6  million  compared to $1.3
million  for  the  year  ended  December  31,  2002.  The  increase  in  cost of
maintenance,  software  services and other  revenue was  primarily  driven by an
increase in hardware  sales.  As we sold more  hardware,  our hardware costs for
resale rose from $0.2 million in 2002 to $1.0  million in 2003.  The increase in
cost of  maintenance,  software  services  and other  revenue was also due to an
increase in personnel.  As a result of our increased  sales of  maintenance  and
support  contracts  and  professional  services,  we required a higher number of
employees to provide technical support and to implement our software.

         Gross profit for the year ended  December 31, 2003 was $13.0 million or
77% of revenues  compared to $8.4  million or 79% of revenues for the year ended
December  31, 2002.  The  increase in gross  profit was directly  related to the
increase in revenues.  The decrease in gross  margins was due to the increase in
amortization of purchased  software  licenses and was also partially  related to
margins  on  hardware  sales,  which are  typically  lower  than the  margins on
software and services.

SOFTWARE DEVELOPMENT COSTS

         Software  development  costs increased 13% to $7.1 million in 2003 from
$6.3 million in 2002. The increase in software  development  costs was primarily
due to an increase in  employees  required to enhance and test our core  network
storage  software  product,  as well as to develop new  innovative  features and
options. In addition,  as we negotiated and signed new OEM partners, we required
additional  employees to test and  customize our software with our OEM partners'
products. In 2003, we also opened a development office in China to assist in our
development work.

SELLING AND MARKETING

         Selling and marketing  expenses  increased 11% to $11.0 million in 2003
from $9.9  million in 2002.  As a result of the increase in revenue and interest
in our  software,  our  commission  expense and travel  expenses  increased.  In
addition,  we continued  to hire new sales and sales  support  personnel  and to
expand our worldwide presence to accommodate our revenue growth.

GENERAL AND ADMINISTRATIVE

         General and  administrative  expenses  increased 11% to $2.9 million in
2003 from $2.6  million  in 2002.  One reason for the  increase  in general  and
administrative expenses is due to an increase in salaries. As our business grew,
we required  additional  general  and  administrative  personnel  to support the
growth.  Another  reason for the  increase  was due to higher  premiums  for our
directors and officers insurance.

                                       21





INTEREST AND OTHER INCOME

         Interest  and other income  decreased  29% to $1.1 million in 2003 from
$1.6 million in 2002. This decrease in interest income was due to lower interest
rates  and  lower  average  cash,  cash  equivalent  and  marketable  securities
balances.

INCOME TAXES

         We did not  record  a tax  benefit  associated  with the  pre-tax  loss
incurred from the period from inception (February 10, 2000) through December 31,
2003, as we deemed that it was more likely than not that the deferred tax assets
will not be realized  based on our early stage of  operations.  Accordingly,  we
provided a full  valuation  allowance  against our net deferred tax assets.  Our
income  tax  provision  consists  of tax  liabilities  related  to  our  foreign
subsidiaries.

LEASE ABANDONMENT CHARGE

         In November 2003, we relocated our headquarters to a larger facility to
accommodate our future growth.  As a result of this  relocation,  we vacated our
previous  office space and recorded a charge for the estimated loss we expect to
incur on the remaining lease obligation. The charge of $0.6 million included the
remaining  lease rental  obligation  reduced by cash flows we expect to generate
from an  agreement  to  sub-lease  the  facility  as well  as the  write  off of
leasehold improvements at our previous facility.

IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

         In October 2001, we entered into an agreement with  Network-1  Security
Solutions,  Inc. ("NSSI"),  a publicly traded company,  whereby $2.8 million was
paid to  NSSI,  of  which  $2.3  million  was for the  purchase  of  convertible
preferred  stock of NSSI  accounted for under the cost method,  and $0.5 million
was for a non-refundable prepaid royalty recoupable against future product sales
of NSSI's  product.  Primarily  due to the decline in the market value of NSSI's
common stock underlying the convertible  preferred stock significantly below the
Company's  cost,  we concluded in 2002 that the decline in the fair value of our
investment in NSSI's preferred stock was other than temporary.  Accordingly,  in
2002 we  recorded an  impairment  charge to  write-off  our  investment  in NSSI
preferred stock. In addition,  due to the lack of market  acceptance of the NSSI
product,  we concluded that the unrecouped  prepaid  royalty was not recoverable
and it was written off. As a result,  in 2002, we recorded a $2.8 million charge
for the impairment of long-lived and other assets related to our NSSI agreement,
of which $0.5 million was an operating  expense.  In 2003, we received a payment
from NSSI of $35,000 in exchange for all of our preferred  stock of NSSI,  which
was  reflected  as a reduction  to the  impairment  charge in the  statement  of
operations.  We do not  expect  to  incur  any  additional  expenses  from  this
investment.

LIQUIDITY AND CAPITAL RESOURCES

         Our cash and cash  equivalents  totaled  $15.5  million and  marketable
securities  totaled $18.5 million at December 31, 2004. As of December 31, 2003,
we had $8.5 million in cash and cash equivalents and $28.2 million in marketable
securities.  The reasons  for this  decrease  in cash and cash  equivalents  and
marketable  securities  are  discussed  below.  Because  we have  not  yet  been
profitable  on a full  year  basis,  the  major use of our cash has been to fund
operations.  Until we reach profitability on a full year basis, we will continue
to use our cash and marketable securities to fund operations.

         In 2004,  we made  investments  in our  infrastructure  to support  our
long-term  growth.  We increased  the total number of employees in 2004 and made
investments  in property and equipment to support our growth.  As we continue to
grow,  we will continue to make  investments  in property and equipment and will
need to continue to increase our headcount.  In the past, we have also used cash
to purchase  software  licenses and to make  acquisitions.  We will  continue to
evaluate  potential software license purchases and acquisitions and if the right
opportunity  presents itself we may continue to use our cash for these purposes.
However,  as of the date of this filing,  we have no agreements,  commitments or
understandings with respect to any such acquisitions. In 2004, we also used cash
to defend and settle a patent  infringement  litigation.  The patent  litigation
settlement  charge was $1.3  million  and we also  incurred  approximately  $1.0
million in legal fees associated with this litigation. If any future patent

                                       22





infringement  litigation  is brought  against  us, we may have to incur  similar
types of expenses.  Additionally, in 2004 we incurred approximately $0.8 million
in professional fees associated with the  Sarbanes-Oxley Act of 2002 compliance.
Although the fees may be lower in 2005, we will  continue to incur  professional
fees to ensure that we are in compliance with that Act.

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

         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.  We have no further payment
obligations.

         In October 2001, our Board of Directors authorized the repurchase of up
to two million  shares of our  outstanding  common  stock.  Since  October 2001,
277,100  shares have been  repurchased  at an aggregate  purchase  price of $1.7
million.  During 2004,  42,100 shares were repurchased at an aggregate  purchase
price of $0.3 million.

         Net cash used in operating activities totaled $1.1 million for the year
ended December 31, 2004 compared to $5.9 million for the year ended December 31,
2003 and $7.5  million  for the year  ended  December  31,  2002.  The  trend of
decreasing  cash used in operations is partially due to our decreasing net loss.
The decrease in net loss is mainly attributable to our increases in revenues. In
addition  to  the  decrease  in  net  loss,  our  non-cash  charges,   including
depreciation and amortization and equity based compensation  increased from $2.5
million  in 2002 to $3.3  million  in 2003  and  $3.8  million  in  2004.  These
increases are mainly due to increases in property and equipment.  Another factor
contributing  to our  decrease  in cash used in  operations  is our  increase in
deferred  revenues of $2.8 million in 2004  compared to $0.4 million in 2003 and
$1.2 million in 2002.  The increase in our deferred  revenue is the result of an
increase in our  maintenance  contracts,  which are deferred and  recognized  as
revenue  ratably over the term of the  contract.  These  amounts were  partially
offset by increases in our net accounts  receivable  balances of $1.7 million in
2002,  $2.8  million in 2003 and $3.2  million  in 2004.  The  increases  in our
accounts receivable balances are due to our revenue growth. In 2002, we incurred
a non-cash  expense of $2.8 million  related to an impairment of long-lived  and
other  assets.  We expect  cash used in  operating  activities  to  continue  to
decrease as we anticipate our net loss will decrease.

         Net cash provided by investing  activities was $6.3 million in 2004 and
$2.5 million in 2003 and net cash used in investing activities was $15.5 million
in 2002.  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.  In 2004 and 2003 the net cash
provided  from the net sale of  securities  was $9.6  million and $8.5  million,
respectively,  and in 2002 the cash used  from the net  purchase  of  marketable
securities  was $10.7  million.  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 $2.8 million,  $3.0 million and $1.3 million
in 2004,  2003  and  2002,  respectively.  The cash  used to  purchase  software
licenses  was $0.1  million in 2004,  $1.8  million in 2003 and $0.8  million in
2002. In 2002, we used $2.6 million in cash related to two acquisitions.  We did
not make any  similar  acquisitions  in 2003 or 2004.  We  continually  evaluate
potential  software  licenses and acquisitions and we may continue to make these
investments if we find opportunities that would benefit our business.

         Net cash provided by financing  activities was $1.8 million in 2004 and
$0.9 million in 2003 and 2002.  We received  proceeds from the exercise of stock
options of $2.0 million in 2004,  $0.9 million in 2003 and $1.1 million in 2002.
We made  payments  of $0.3  million in 2004 and $0.2  million in 2002 to acquire
treasury stock.

         The  Company's  only  contractual  obligations  relate to its operating
leases.  The Company has an operating lease covering its primary office facility
that expires in February,  2012. The Company also has several  operating  leases
related to a domestic  office and offices in foreign  countries.  The expiration
dates for these  leases  ranges  from 2005  through  2012.  The  following  is a
schedule  of  future  minimum  lease  payments  for all  operating  leases as of
December 31, 2004:

                                       23





          YEAR ENDING DECEMBER 31

          2005.............................................. $  1,451,844
          2006..............................................    1,520,105
          2007..............................................    1,348,593
          2008..............................................    1,230,817
          2009..............................................    1,264,449
          Thereafter........................................    3,025,992
                                                             ------------
                                                             $  9,841,800
                                                             ============

         For the years ended  December  31, 2003 and 2002,  we paid $3.0 million
and $2.1  million,  respectively,  related  to  discontinued  operations.  As of
December 31,  2004,  all  significant  obligations  related to our  discontinued
operations have been settled.

         Based on our increasing revenues, decreasing net loss and a decrease in
cash used for  operations,  we believe  that our current  balance of cash,  cash
equivalents and marketable  securities,  and expected cash flows from operations
will be  sufficient to meet our cash  requirements  for at least the next twelve
months.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

         In December,  2004, the Financial  Accounting  Standards Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING  FOR INCOME  TAXES,  TO THE TAX  DEDUCTION  ON  QUALIFIED  PRODUCTION
ACTIVITIES  PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2,  ACCOUNTING  AND DISCLOSURE  GUIDANCE FOR
THE FOREIGN  EARNINGS  REPATRIATION  PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how  companies  should  account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22,  2004.  FSP No. 109-1 states
that the tax relief (special tax deduction for domestic manufacturing) from this
legislation  should be  accounted  for as a "special  deduction"  and reduce tax
expense in the period(s) the amounts are  deductible on the tax return,  instead
of a tax rate  reduction.  FSP No.  109-2  gives a  company  additional  time to
evaluate  the  effects  of the  legislation  on any  plan  for  reinvestment  or
repatriation  of foreign  earnings for purposes of applying  FASB  Statement No.
109. The Company does not plan to repatriate  any of its  undistributed  foreign
earnings as of December 31, 2004.

         In December 2004, the FASB issued SFAS No. 123 (R), SHARE-BASED PAYMENT
("SFAS No. 123 (R)").  This  statement  replaces  SFAS No. 123,  ACCOUNTING  FOR
STOCK-BASED  COMPENSATION and supercedes APB No. 25, ACCOUNTING FOR STOCK ISSUED
TO  EMPLOYEES.  SFAS  123  (R)  requires  all  stock-based  compensation  to  be
recognized  as an  expense  in the  financial  statements  and that such cost be
measured  according to the  grant-date  fair value of the stock options or other
equity  instruments.  SFAS  123 (R)  will be  effective  for  quarterly  periods
beginning  after June 15,  2005.  While the Company  currently  provides the pro
forma  disclosures   required  by  SFAS  No.  148,  ACCOUNTING  FOR  STOCK-BASED
COMPENSATION - TRANSITION AND  DISCLOSURE,  on a quarterly  basis (see "Note 1 -
Accounting for Stock-Based Compensation"), it is currently evaluating the impact
this statement will have on its consolidated financial statements.

         In November  2004, the FASB issued SFAS No. 151,  INVENTORY  COSTS - AN
AMENDMENT OF ARB NO. 43,  Chapter 4 ("SFAS No. 151").  SFAS No. 151 requires all
companies to  recognize a  current-period  charge for  abnormal  amounts of idle
facility expense,  freight,  handling costs and wasted materials. This statement
also requires that the allocation of fixed  production  overhead to the costs of
conversion be based on the normal  capacity of the production  facilities.  SFAS
No. 151 will be effective for fiscal years  beginning  after June 15, 2005.  The
Company  believes  that this  statement  will not have a material  effect on its
consolidated financial statements.

                                       24





                                  RISK FACTORS

WE HAVE  HAD A  HISTORY  OF NET  LOSSES  AND MAY  NOT BE  ABLE TO  MAINTAIN  THE
PROFITABILITY WE ACHIEVED IN THE FOURTH QUARTER OF 2004.

     We were profitable for the first time in the fourth quarter of 2004.  Prior
to that we had a history of losses,  including the full year ended  December 31,
2004, in which we had a net loss of $5.9 million.  For the period from inception
(February  2000),  through  December 31, 2004,  we had a cumulative  net loss of
$37.0  million.   Our  business  model  depends  upon  signing  agreements  with
additional OEM  customers,  further  developing our reseller sales channel,  and
expanding our sales force.  Any  difficulty in obtaining  these OEM and reseller
customers or in attracting  qualified sales personnel will hinder our ability to
generate additional revenues and achieve or maintain profitability.

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:

o     retention of key management, marketing and technical personnel;

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

o     competitive  conditions  in the network  storage  infrastructure  software
      market.

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

WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.

     During the third  quarter of 2003,  we signed a lease for new office  space
that commenced on November 1, 2003 and continues  through  February,  2012. This
commitment  along with several  operating  leases related to our foreign offices
could impact our ability to achieve or to maintain profitability.

DUE TO THE UNCERTAIN AND SHIFTING  DEVELOPMENT OF THE NETWORK  STORAGE  SOFTWARE
MARKET, WE MAY HAVE DIFFICULTY  ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS
AND APPROPRIATELY BUDGETING FOR EXPENSES.

     The rapidly evolving nature of the network storage software market in which
we sell our products, and other factors that are beyond our control, reduces 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.

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

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

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS.

     During the fiscal year ended December 31, 2004, one OEM customer  accounted
for 16% of our  revenues.  While we  believe  that we will  continue  to receive
revenue from this client  during the fiscal year ended  December  31, 2005,  our
agreement with this customer is terminable upon 90 days notice.  If our contract
with  this OEM  terminates  it  would  have a  material  adverse  effect  on our
operating results.

THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK  ATTACHED  STORAGE ARE NEW AND
UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT DEVELOP AS WE EXPECT.

     The rapid  adoption of Storage  Area  Networks  (SAN) and Network  Attached
Storage (NAS) solutions is critical to our future  success.  The markets for SAN
and NAS solutions are still unproven, making it difficult to predict their

                                       25





potential  sizes or future  growth rates.  Most  potential  customers  have made
substantial investments in their current storage networking infrastructure,  and
they may elect to remain  with  current  network  architectures  or to adopt new
architecture  in  limited  stages  or over  extended  periods  of  time.  We are
uncertain  whether  a  viable  market  for  our  products  will  develop  or  be
sustainable.  If these  markets fail to develop,  or develop more slowly than we
expect,  our business,  financial  condition and results of operations  would be
adversely affected.

THE MARKET FOR IP-BASED  STORAGE  AREA  NETWORKS IS NEW AND  UNCERTAIN,  AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

     The rapid  adoption of IP-based  Storage Area Networks (SAN) is critical to
our future success.  The market for IP-based SANs is still  unproven,  making it
difficult to predict the potential  size or future growth rate.  Most  potential
customers have made substantial  investments in their current storage networking
infrastructure,  and they may elect to remain with current network architectures
or to adopt new architecture in limited stages or over extended periods of time.
We are  uncertain  whether a viable  market for our products  will develop or be
sustainable.  If this market fails to develop,  or develops  more slowly than we
expect,  our business,  financial  condition and results of operations  would be
adversely affected.

THE  MARKET  FOR  DISK-BASED  BACKUP  SOLUTIONS  IS NEW AND  UNCERTAIN,  AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

     The rapid adoption of disk-based backup solutions is critical to our future
success. The market for disk-based backup solutions is still unproven, making it
difficult to predict the potential  size or future growth rate.  Most  potential
customers  have  made  substantial  investments  in their  current  tape  backup
infrastructure,  and they may elect to remain with current  infrastructure or to
adopt new solutions in limited  stages or over extended  periods of time. We are
uncertain  whether  a  viable  market  for  our  products  will  develop  or  be
sustainable.  If this market fails to develop,  or develops  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, SMALL OFFICE AND HOME
OFFICE MARKETS.

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

IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.

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

OUR  PRODUCTS  MUST  CONFORM TO  INDUSTRY  STANDARDS  IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.

     Our  current  products  are  only  one  part  of a SAN or NAS  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

                                       26





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 COMPLEX  PRODUCTS  MAY HAVE ERRORS OR DEFECTS  THAT COULD  RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.

     Our IPStor  platform 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  infrastructure.  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  within our  customers'  networks  could  result in lost
profits  or 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.

FAILURE OF STORAGE  APPLIANCES  POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.

     We have entered into  agreements with resellers and OEM partners to develop
storage  appliances that combine certain  aspects of IPStor  functionality  with
third  party  hardware  to create  single  purpose  turnkey  solutions  that are
designed to be easy to deploy. If the storage  appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would suffer.

OUR OEM  CUSTOMERS  REQUIRE  OUR  PRODUCTS  TO UNDERGO A LENGTHY  AND  EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.

     Prior to offering  our products for sale,  our OEM  customers  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  infrastructure  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.

ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.

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

                                       27





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  were 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.

THE  NETWORK  STORAGE   SOFTWARE  MARKET  IS  HIGHLY   COMPETITIVE  AND  INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.

      The network storage  software market is 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:

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

o     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 FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY,  WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.

      While we were profitable in the fourth quarter of 2004, such profitability
is not an indicator of future profitability and our future quarterly results may
fluctuate significantly.

      Our future performance will depend on many factors, including:

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

o     the seasonality of information technology spending;

o     the average unit selling price of our products;

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

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

                                       28





o     new products or enhancements from us or our competitors;

o     import or export restrictions on our proprietary technology; and

o     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, 2004, the closing market price of our common stock as quoted on the
NASDAQ National Market System  fluctuated  between $5.13 and $10.15.  The market
price  of our  common  stock  may be  significantly  affected  by the  following
factors:

o     actual or anticipated fluctuations in our operating results;

o     failure to meet financial estimates;

o     changes in market valuations of other technology  companies,  particularly
      those in the storage networking software market;

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

o     loss of one or more key OEM customers; and

o     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 RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.

      The Financial  Accounting  Standards Board ("FASB") has required companies
to recognize the fair value of stock options and other stock-based  compensation
to employees as compensation  expense in the statement of operations,  effective
July 1, 2005 for  FalconStor.  While it is too early to tell the exact impact of
this requirement, there will be a negative impact on our results of operations.

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.  Finally,  we have  entered  into  change of
control agreements with certain executives.

                                       29





WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING  OPTIONS AND WARRANTS,  THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING  STOCKHOLDERS'  PERCENTAGE  OWNERSHIP OF
OUR COMMON STOCK.

      As of December  31,  2004,  we had  outstanding  options  and  warrants to
purchase an  aggregate  of  9,723,358  shares of our common  stock at a weighted
average  exercise  price of $4.82  per  share.  We also  have  2,698,974  shares
reserved for issuance  under our stock option plans with respect to options that
have not been granted.

      The  exercise  of  all  of  the  outstanding   options  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

      In  August,  2003,  our  business  was  interrupted  due to a large  scale
blackout in the northeastern United States. While the headquarters facilities we
moved in to in November,  2003 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.

THE  INTERNATIONAL  NATURE OF OUR BUSINESS  COULD HAVE AN ADVERSE  AFFECT ON OUR
OPERATING RESULTS.

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

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

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

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 one
patent  issued,  multiple  pending  patent  applications,   numerous  trademarks
registered and multiple  pending  trademark  applications  related to our IPStor
product.  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.

                                       30





      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 have already been subject to one action  alleging  that our  technology
infringes patents held by a third party.  While we settled this litigation,  the
litigation  was  expensive and 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:

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

o     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

o     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.  It may be
necessary in the future to seek or renew licenses relating to various aspects of
these products.  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,

                                       31




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 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.

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 7A.  QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable  securities  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.

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.  We do  not  use
derivative financial instruments to limit our foreign currency risk exposure.

                                       32





ITEM 8.     CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   Index to Consolidated Financial Statements

                                                                            Page

       Reports of Independent Registered Public Accounting Firm ..............34

       Consolidated Balance Sheets as of December 31, 2004 and 2003...........36

       Consolidated Statements of Operations for the years ended
           December 31, 2004, 2003 and 2002...................................37

       Consolidated Statements of Stockholders' Equity and Comprehensive
           Loss for the years ended December 31, 2004, 2003 and 2002..........38

       Consolidated Statements of Cash Flows for the years ended
           December 31, 2004, 2003 and 2002...................................40

       Notes to Consolidated Financial Statements.............................42

                                       33






             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, 2004 and 2003, and
the related  consolidated  statements of  operations,  stockholders'  equity and
comprehensive  loss,  and cash  flows  for each of the  years in the  three-year
period ended December 31, 2004. These consolidated  financial statements are the
responsibility of 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  includes
examining,  on a test basis,  evidence supporting the amounts and disclosures in
the  financial  statements.  An audit also  includes  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,  2004 and 2003,  and the
results  of their  operations  and their cash flows for each of the years in the
three-year  period ended  December 31, 2004, in conformity  with U.S.  generally
accepted accounting principles.

         We also have audited,  in  accordance  with the standards of the Public
Company  Accounting  Oversight  Board  (United  States),  the  effectiveness  of
FalconStor  Software,  Inc.'s  internal  control over financial  reporting as of
December  31,  2004,  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 10, 2005  expressed an
unqualified  opinion on management's  assessment of, and the effective operation
of, internal control over financial reporting.





                                                                  /s/   KPMG LLP



Melville, New York
March 10, 2005

                                       34





            REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


The Board of Directors and Stockholders
FalconStor Software, Inc.:

         We have audited management's  assessment,  included in the accompanying
Management's  Report  on  Internal  Control  Over  Financial   Reporting,   that
FalconStor Software,  Inc. and subsidiaries (the "Company") maintained effective
internal  control over  financial  reporting  as of December 31, 2004,  based on
criteria  established in Internal  Control--Integrated  Framework  issued by the
Committee of Sponsoring  Organizations of the Treadway  Commission  (COSO).  The
Company'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. Our responsibility is to express an opinion on
management's  assessment  and an opinion on the  effectiveness  of 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,  evaluating management's  assessment,  testing
and evaluating the design and operating  effectiveness of internal control,  and
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,  management's  assessment  that the Company  maintained
effective internal control over financial  reporting as of December 31, 2004, is
fairly  stated,  in all  material  respects,  based on criteria  established  in
Internal Control--Integrated Framework issued by COSO. Also, in our opinion, the
Company  maintained,  in all material respects,  effective internal control over
financial  reporting as of December 31, 2004,  based on criteria  established in
Internal Control--Integrated Framework issued by COSO.

         We also have audited,  in  accordance  with the standards of the Public
Company  Accounting  Oversight Board (United States),  the consolidated  balance
sheets  of the  Company  as of  December  31,  2004 and  2003,  and the  related
consolidated  statements of operations,  stockholders'  equity and comprehensive
loss,  and cash  flows  for each of the  years in the  three-year  period  ended
December 31, 2004, and our report dated March 10, 2005, expressed an unqualified
opinion on those consolidated financial statements.

                                                                    /s/ KPMG LLP

Melville, New York
March 10, 2005

                                       35




                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS

                                                                                              DECEMBER 31,
                                                                                        2004              2003
                                                                                   ------------      ------------
                            ASSETS
Current assets:
   Cash and cash equivalents .................................................     $ 15,484,573      $  8,486,144
   Marketable securities .....................................................       18,488,616        28,199,242
   Accounts receivable, net of allowances of $2,551,616 and
     $1,837,934, respectively ................................................       10,269,822         7,109,922
   Prepaid expenses and other current assets .................................          629,036         1,273,125
                                                                                   ------------      ------------

            Total current assets .............................................       44,872,047        45,068,433

Property and equipment, net ..................................................        4,662,269         3,861,069
Goodwill .....................................................................        3,512,796         3,366,642
Other intangible assets, net .................................................          307,620           396,940
Other assets .................................................................        2,719,460         3,799,949
                                                                                   ------------      ------------

            Total assets .....................................................     $ 56,074,192      $ 56,493,033
                                                                                   ============      ============

                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable ..........................................................     $    821,433      $    562,305
   Accrued expenses ..........................................................        3,501,034         2,777,391
   Deferred revenue ..........................................................        4,097,279         2,202,179
                                                                                   ------------      ------------

            Total current liabilities ........................................        8,419,746         5,541,875

Deferred revenue .............................................................        1,290,496           395,609
                                                                                   ------------      ------------

            Total liabilities ................................................        9,710,242         5,937,484
                                                                                   ------------      ------------

 Commitments

 Stockholders' equity:
   Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued             --                --
    Common stock - $.001 par value, 100,000,000 shares authorized,
      47,768,755 and 46,745,330 shares issued, respectively and 47,491,655
      and 46,510,330 shares outstanding, respectively ........................           47,769            46,745
   Additional paid-in capital ................................................       85,400,740        83,277,981
   Deferred compensation .....................................................             --              (7,969)
   Accumulated deficit .......................................................      (36,952,436)      (31,063,589)
   Common stock held in treasury, at cost (277,100 and 235,000 shares,
      respectively) ..........................................................       (1,714,775)       (1,435,130)
   Accumulated other comprehensive loss ......................................         (417,348)         (262,489)
                                                                                   ------------      ------------

            Total stockholders' equity .......................................       46,363,950        50,555,549
                                                                                   ------------      ------------
            Total liabilities and stockholders' equity .......................     $ 56,074,192      $ 56,493,033
                                                                                   ============      ============

           See accompanying notes to consolidated financial statements

                                       36





                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS



                                                                              YEARS ENDED DECEMBER 31,

                                                                    2004               2003               2002
                                                              -----------------------------------------------------

Revenues:
   Software license revenue ................................     $ 21,487,866      $ 12,250,616      $  8,666,583
   Maintenance revenue .....................................        4,442,724         2,473,504         1,297,146
   Software services and other revenue .....................        2,778,088         2,220,015           665,163
                                                                 ------------      ------------      ------------
                                                                   28,708,678        16,944,135        10,628,892
                                                                 ------------      ------------      ------------

Operating expenses:
   Amortization of purchased and capitalized software.......        1,393,908         1,394,301           899,024
   Cost of maintenance, software services and other revenue         4,150,309         2,580,141         1,309,139
   Software development costs ..............................        9,050,092         7,067,605         6,280,936
   Selling and marketing ...................................       14,277,167        10,966,548         9,856,496
   General and administrative ..............................        5,108,516         2,878,192         2,591,430
   Litigation settlement ...................................        1,300,000              --                --
   Lease abandonment charge ................................             --             550,162              --
   Impairment of prepaid royalty ...........................             --                --             482,715
                                                                 ------------      ------------      ------------
                                                                   35,279,992        25,436,949        21,419,740
                                                                 ------------      ------------      ------------
           Operating loss ..................................       (6,571,314)       (8,492,814)      (10,790,848)
                                                                 ------------      ------------      ------------

Interest and other income ..................................          714,412         1,121,391         1,585,351
Impairment of long-lived assets ............................             --              35,000        (2,300,062)
                                                                 ------------      ------------      ------------

         Loss before income taxes ..........................       (5,856,902)       (7,336,423)      (11,505,559)

 Provision for income taxes ................................           31,945            32,532            37,606
                                                                 ------------      ------------      ------------

         Net loss ..........................................     $ (5,888,847)     $ (7,368,955)     $(11,543,165)
                                                                 ------------      ------------      ------------

 Basic and diluted net loss per share ......................     $      (0.13)     $      (0.16)     $      (0.26)
                                                                 ============      ============      ============

 Basic and diluted weighted average common shares
   outstanding .............................................       46,967,422        45,967,830        45,232,595
                                                                 ============      ============      ============


          See accompanying notes to consolidated financial statements.

                                       37

                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

     CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS

                                                                                                                        Accumulated
                                                                                                                           other
                                                                                                                          compre-
                                                     Additional        Deferred                                           hensive
                                      Common          paid-in          compen-        Accumulated        Treasury         income
                                      stock           capital           sation          deficit           stock           (loss)
                                  ---------------  ---------------  --------------- ----------------- ---------------  -------------

Balance, December 31, 2001              $ 45,049     $ 77,991,996     $ (1,026,674)    $ (12,151,469)   $ (1,220,730)     $ (76,600)

Issuance of stock options to
     non-employees                             -           32,890                -                 -               -              -

Compensation expense for accelerated
     vesting of stock options                  -          231,415                -                 -               -              -

Exercise of stock options                    479        1,112,970                -                 -               -              -

Amortization of deferred
     compensation and option forfeitures       -          (95,610)         555,229                 -               -              -

Net loss                                       -                -                -       (11,543,165)              -              -

Acquisition of treasury stock                  -                -                -                 -        (214,400)             -

Adjustment to the fair value of the
     net tangible assets acquired
     in the NPI merger                         -        2,150,000                -                 -               -              -

Net unrealized gain on
     marketable securities                     -                -                -                 -               -         90,904

Foreign currency translation
     adjustment                                -                -                -                 -               -         18,769
                                  ---------------  ---------------  --------------- ----------------- ---------------  -------------

Balance, December 31, 2002              $ 45,528     $ 81,423,661       $ (471,445)    $ (23,694,634)   $ (1,435,130)       $33,073


Issuance of stock options to
     non-employees                             -           86,875                -                 -               -              -

Exercise of stock options                  1,217          850,600                -                 -               -              -

Amortization of deferred
     compensation                              -                -          463,476                 -               -              -

Net loss                                       -                -                -        (7,368,955)              -              -

Adjustment to the fair value of the
     net tangible assets acquired
     in the NPI merger                         -          916,845                -                 -               -              -

Net unrealized loss on
     marketable securities                     -                -                -                 -               -       (214,394)

Foreign currency translation
     adjustment                                -                -                -                 -               -        (81,168)
                                  ---------------  ---------------  --------------- ----------------- ---------------  -------------

Balance, December 31, 2003              $ 46,745     $ 83,277,981         $ (7,969)    $ (31,063,589)   $ (1,435,130)    $ (262,489)


Issuance of stock options to
     non-employees                             -           87,023                -                 -               -              -

Exercise of stock options                  1,024        2,035,736                -                 -               -              -

Amortization of deferred
     compensation                              -                -            7,969                 -               -              -

Net loss                                       -                -                -        (5,888,847)              -              -

Acquisition of treasury stock                  -                -                -                 -        (279,645)             -

Net unrealized loss on
     marketable securities                     -                -                -                 -               -       (148,849)

Foreign currency translation
     adjustment                                -                -                -                 -               -         (6,010)
                                  ---------------  ---------------  --------------- ----------------- ---------------  -------------

Balance, December 31, 2004              $ 47,769     $ 85,400,740              $ -     $ (36,952,436)   $ (1,714,775)    $ (417,348)
                                  ===============  ===============  =============== ================= ===============  =============

                                       38


                                                  Total
                                              stockholders'    Comprehensive
                                                 equity            loss
                                             ----------------  ----------------

Balance, December 31, 2001                  $ 63,561,572                 -

Issuance of stock options to
     non-employees                                32,890                 -

Compensation expense for accelerated
     vesting of stock options                    231,415                 -

Exercise of stock options                      1,113,449                 -

Amortization of deferred
     compensation and option forfeitures         459,619                 -

Net loss                                     (11,543,165)      (11,543,165)

Acquisition of treasury stock                   (214,400)                -

Adjustment to the fair value of the
     net tangible assets acquired
     in the NPI merger                         2,150,000                 -

Net unrealized gain on
     marketable securities                        90,904            90,904

Foreign currency translation
     adjustment                                   18,769            18,769
                                          ---------------  ----------------

Balance, December 31, 2002                  $ 55,901,053     $ (11,433,492)
                                                           ================

Issuance of stock options to
     non-employees                                86,875                 -

Exercise of stock options                        851,817                 -

Amortization of deferred
     compensation                                463,476                 -

Net loss                                      (7,368,955)       (7,368,955)

Adjustment to the fair value of the
     net tangible assets acquired
     in the NPI merger                           916,845                 -

Net unrealized loss on
     marketable securities                      (214,394)         (214,394)

Foreign currency translation
     adjustment                                  (81,168)          (81,168)
                                          ---------------  ----------------

Balance, December 31, 2003                  $ 50,555,549      $ (7,664,517)
                                                           ================

Issuance of stock options to
     non-employees                                87,023                 -

Exercise of stock options                      2,036,760                 -

Amortization of deferred
     compensation                                  7,969                 -

Net loss                                      (5,888,847)       (5,888,847)

Acquisition of treasury stock                   (279,645)                -

Net unrealized loss on
     marketable securities                      (148,849)         (148,849)

Foreign currency translation
     adjustment                                   (6,010)           (6,010)
                                          ---------------  ----------------

Balance, December 31, 2004                  $ 46,363,950      $ (6,043,706)
                                          ===============  ================

          See accompanying notes to consolidated financial statements.

                                       39




                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                                                             YEARS ENDED DECEMBER 31,


                                                                               2004            2003              2002
                                                                          -------------------------------------------------

Cash flows from operating activities:
   Net loss .........................................................     $ (5,888,847)     $ (7,368,955)     $(11,543,165)
      Adjustments to reconcile net loss to net cash used in operating
         activities:
         Depreciation and amortization ..............................        3,656,212         2,759,030         1,747,380
         Non-cash professional services expenses ....................           87,023            86,875            32,890
         Equity-based compensation expense ..........................            7,969           463,476           691,034
         Provision for returns and doubtful accounts ................        3,296,275         1,700,100           930,150
         Impairment of long-lived and other assets ..................             --                --           2,782,777
      Changes  in  operating assets and liabilities, net
         of effects of acquisitions:
         Accounts receivable ........................................       (6,456,175)       (4,524,130)       (2,658,455)
         Prepaid expenses and other current assets ..................          636,208          (137,115)         (571,635)
         Other assets ...............................................         (251,038)         (227,711)           (9,119)
         Accounts payable ...........................................          259,128           125,217          (121,685)
         Accrued expenses ...........................................          791,498           761,827            55,868
         Deferred revenue ...........................................        2,789,987           415,059         1,175,735
                                                                          ------------      ------------      ------------

            Net cash used in operating activities ...................       (1,071,760)       (5,946,327)       (7,488,225)
                                                                          ------------      ------------      ------------

Cash flows from investing activities:
   Purchase of marketable securities ................................      (33,897,295)       (8,537,284)      (39,507,257)
   Sale of marketable securities ....................................       43,459,072        17,034,096        28,843,893
   Purchase of investments ..........................................             --            (137,710)          (75,000)
   Purchase of property and equipment ...............................       (2,842,792)       (2,998,908)       (1,272,104)
   Purchase of software licenses ....................................          (50,000)       (1,821,000)         (800,000)
   Purchase of intangible assets ....................................         (131,392)         (246,697)         (145,534)
   Net cash paid for acquisition of IP Metrics ......................         (214,009)         (287,130)       (2,381,726)
   Net cash paid for acquisition of FarmStor ........................             --                --            (169,640)
   Security deposits ................................................           (4,500)         (500,000)          (35,802)
                                                                          ------------      ------------      ------------

      Net cash provided by (used in) investing
       activities....................................................        6,319,084         2,505,367       (15,543,170)
                                                                          ------------      ------------      ------------

Cash flows from financing activities:
   Proceeds from exercise of stock options ..........................        2,036,760           851,817         1,113,449
   Payments to acquire treasury stock ...............................         (279,645)             --            (214,400)
                                                                          ------------      ------------      ------------

      Net cash provided by financing activities .....................        1,757,115           851,817           899,049
                                                                          ------------      ------------      ------------

                                       40





Cash flows from discontinued operations:
      Payments of liabilities of discontinued operations.............              --         (3,034,620)       (2,066,285)
                                                                          ------------      ------------      ------------

Effect of exchange rate changes .....................................           (6,010)          (81,168)           18,769
                                                                          ------------      ------------      ------------

Net increase (decrease) in cash and cash equivalents.................        6,998,429        (5,704,931)      (24,179,862)

Cash and cash equivalents, beginning of year ........................        8,486,144        14,191,075        38,370,937
                                                                          ------------      ------------      ------------

Cash and cash equivalents, end of year ..............................     $ 15,484,573      $  8,486,144      $ 14,191,075
                                                                          ============      ============      ============

Increase in additional  paid-in capital  resulting
   from an adjustment to reduce the fair value of the
   liabilities of discontinued  operations assumed in
   the merger with NPI (Notes 2 and 12) .............................     $        --       $    916,845      $  2,150,000
                                                                          ============      ============      ============

Cash paid for income taxes ..........................................     $     24,554      $     48,351      $     34,082
                                                                          ============      ============      ============


      The Company did not pay any interest expense for the three years ended December 31, 2004.

                     See accompanying notes to consolidated financial statements

                                       41





                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 2004


(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) CASH EQUIVALENTS AND MARKETABLE SECURITIES

    The Company considers all highly liquid investments with a maturity of three
months  or  less  when  purchased  to be  cash  equivalents.  Cash  equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$10.9  million  and $8.2  million at December  31, 2004 and 2003,  respectively.
Marketable  securities  at December 31, 2004 and 2003  amounted to $18.5 million
and $28.2 million, respectively, and consisted of corporate bonds and government
securities,  which  are  classified  as  available  for sale,  and  accordingly,
unrealized  gains  and  losses  on  marketable  securities  are  reflected  as a
component of stockholders' equity.

(d)  REVENUE RECOGNITION

    The Company  recognizes  revenue from software  licenses in accordance  with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE  RECOGNITION.  Accordingly,
revenue for  software  licenses is  recognized  when  persuasive  evidence of an
arrangement exists, the fee is fixed and determinable, 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 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 based
on the  contractual  maintenance  renewal rate.  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  revenues.  The Company  provides an allowance  for software  product
returns as a reduction of revenue.

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

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

    For the years ended  December  31, 2004 and 2003,  the Company had a limited
number of transactions in which it purchased  hardware and bundled this hardware
with the Company's software and sold the bundled solution to its customer. Since

                                       42





the software is not essential for the functionality of the equipment included in
the Company's bundled  solutions,  and both the hardware and software have stand
alone value to the customer,  a portion of the  contractual fee is recognized as
revenue when the software or hardware is  delivered  based on the relative  fair
value of the delivered element(s).

(e) PROPERTY AND EQUIPMENT

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

(f) GOODWILL AND OTHER INTANGIBLE ASSETS

    Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and  identifiable  intangible  assets acquired in business
combinations.  Consistent  with  Statement  of  Financial  Accounting  Standards
("SFAS")  142,  GOODWILL  AND  OTHER  INTANGIBLE  ASSETS,  the  Company  has not
amortized  goodwill  related to its  acquisitions,  but has  instead  tested the
balance for impairment.  The Company's annual impairment assessment is performed
on  December  31st of each  year,  and  additionally  if  events or  changes  in
circumstances  indicate  that it is more  likely  than  not  that  the  asset is
impaired.  Identifiable intangible assets are amortized over a three-year period
using the straight-line method.  Amortization expense was $220,712, $159,248 and
$52,893 for 2004,  2003 and 2002,  respectively.  The gross carrying  amount and
accumulated  amortization of other intangible assets as of December 31, 2004 and
December 31, 2003 are as follows:

                                                    December 31,    December 31,
                                                        2004            2003
                                                    ------------    ------------

Customer relationships and purchased technology:

Gross carrying amount                                $ 216,850      $ 216,850
Accumulated amortization                              (180,708)      (108,425)
                                                     ---------      ---------

  Net carrying amount                                $  36,142      $ 108,425
                                                     =========      =========


Patents:

Gross carrying amount                                $ 523,623      $ 392,231
Accumulated amortization                              (252,145)      (103,716)
                                                     ---------      ---------

  Net carrying amount                                $ 271,478      $ 288,515
                                                     =========      =========

    As of December  31,  2004,  amortization  expense on  existing  identifiable
intangible assets and purchased software technology will be $965,629,  $361,427,
and $26,370 for the years ended December 31, 2005, 2006 and 2007,  respectively.
Such assets will be fully amortized at December 31, 2007.

(g) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY

    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.  The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released,  the Company capitalized
$94,570 of software development costs, of which $7,881,  $31,523 and $31,524 was
amortized for the years ended  December 31, 2004,  2003 and 2002,  respectively.
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.

                                       43





    Purchased  software   technology  of  $1,045,806  and  $2,381,833,   net  of
accumulated  amortization  of $3,865,194  and  $2,479,167,  is included in other
assets in the balance  sheets as of December  31, 2004 and  December  31,  2003,
respectively.  Amortization  expense was $1,386,027,  $1,362,778 and 867,499 for
the years ended December 31, 2004, 2003 and 2002, respectively.

(h) 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.

(i)  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.

(j)  ACCOUNTING FOR STOCK-BASED COMPENSATION

    The  Company  applies  the   intrinsic-value   based  method  of  accounting
prescribed by Accounting  Principles Board (APB) Opinion No. 25,  ACCOUNTING FOR
STOCK  ISSUED  TO  EMPLOYEES,   and  related   interpretations   including  FASB
Interpretation  No. 44,  ACCOUNTING  FOR CERTAIN  TRANSACTIONS  INVOLVING  STOCK
COMPENSATION,  AN  INTERPRETATION  OF APB  OPINION  No.  25 to  account  for its
fixed-plan stock options.  Under this method,  compensation  expense is recorded
only if on the date of grant the current  market price of the  underlying  stock
exceeded  the  exercise  price.   SFAS  No.  123,   ACCOUNTING  FOR  STOCK-BASED
COMPENSATION,   established  accounting  and  disclosure  requirements  using  a
fair-value-based  method of accounting  for  stock-based  employee  compensation
plans.  As allowed by SFAS No. 123, the Company has elected to continue to apply
the intrinsic-value-based  method of accounting described above, and has adopted
the disclosure requirements of SFAS No. 123.

    Had the Company determined stock-based compensation cost based upon the fair
value method under SFAS No. 123,  the  Company's  pro forma net loss and diluted
net loss per share would have been adjusted to the pro forma  amounts  indicated
below:

                                                                2004             2003              2002
                                                           -------------     -------------     -------------

Net loss as reported                                       $ (5,888,847)     $ (7,368,955)     $(11,543,165)

Add stock-based employee compensation expense included
      in reported net loss, net of tax                            7,969           463,476           691,034

Deduct total stock-based employee compensation expense
      determined under fair-value-based method for all
      awards, net of tax                                     (8,268,471)       (4,930,656)       (3,689,789)
                                                           ------------      ------------      ------------

Net loss -pro forma                                        $(14,149,349)     $(11,836,135)    $ (14,541,920)
                                                           ============      ============      ============

Diluted net loss per common share-as reported              $      (0.13)     $      (0.16)     $      (0.26)


Diluted net loss per common share-pro forma                $      (0.30)     $      (0.26)     $      (0.32)

                                       44





The per share weighted  average fair value of stock options granted during 2004,
2003 and 2002 was  $6.55,  $5.60 and $2.29,  respectively,  on the date of grant
using  the  Black-Scholes  option-pricing  method  with the  following  weighted
average  assumptions:  2004 - expected  dividend yield of 0%, risk free interest
rate of  3.5%,  expected  stock  volatility  ranging  from  166% to 176%  and an
expected  option  life of five years for  options  granted to  employees  of the
Company, and an option life of ten years for options granted to non-employees;

2003 - expected  dividend  yield of 0%, risk free interest rate of 3%,  expected
stock  volatility  ranging from 68% to 153% and an expected  option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees;

2002 - expected  dividend  yield of 0%, risk free interest rate of 3%,  expected
stock  volatility  of 44% and an expected  option life of five years for options
granted to employees of the Company, and an option life of ten years for options
granted to non-employees;

(k)   FINANCIAL INSTRUMENTS

      As of  December  31,  2004  and  2003,  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.

(l)   FOREIGN CURRENCY

      Assets and  liabilities  of foreign  operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average  exchange  rates in effect for the period.  Unrealized  gains and losses
from the  translation  of foreign  assets and  liabilities  are  classified as a
separate  component  of  stockholders'  equity.  Realized  gains and losses from
foreign currency transactions are included in the statements of operations.

(m)   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 net  losses for the  periods  presented,  all common  stock
equivalents  were excluded  from diluted net loss per share.  As of December 31,
2004,  2003 and 2002,  potentially  dilutive common stock  equivalents  included
8,973,358,  9,860,425 and 9,387,579 stock options outstanding,  respectively. As
of December 31, 2004 and 2003,  potentially  dilutive  common stock  equivalents
also included 750,000 warrants outstanding.

(n)   COMPREHENSIVE INCOME (LOSS)

      Comprehensive  loss  includes the  Company's  net loss,  foreign  currency
translation adjustments and unrealized (losses) gains on marketable securities.

(o)   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. Actual results could differ from those estimates.

                                       45





(p)   NEW ACCOUNTING PRONOUNCEMENTS

      In December,  2004,  the Financial  Accounting  Standards  Board  ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING  FOR INCOME  TAXES,  TO THE TAX  DEDUCTION  ON  QUALIFIED  PRODUCTION
ACTIVITIES  PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2,  ACCOUNTING  AND DISCLOSURE  GUIDANCE FOR
THE FOREIGN  EARNINGS  REPATRIATION  PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how  companies  should  account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22,  2004.  FSP No. 109-1 states
that the tax relief (special tax deduction for domestic manufacturing) from this
legislation  should be  accounted  for as a "special  deduction"  and reduce tax
expense in the period(s) the amounts are  deductible on the tax return,  instead
of a tax rate  reduction.  FSP No.  109-2  gives a  company  additional  time to
evaluate  the  effects  of the  legislation  on any  plan  for  reinvestment  or
repatriation  of foreign  earnings for purposes of applying  FASB  Statement No.
109. The Company does not plan to repatriate  any of its  undistributed  foreign
earnings as of December 31, 2004.

      In December  2004, the FASB issued SFAS No. 123 (R),  SHARE-BASED  PAYMENT
("SFAS No. 123 (R)").  This  statement  replaces  SFAS No. 123,  ACCOUNTING  FOR
STOCK-BASED  COMPENSATION and supercedes APB No. 25, ACCOUNTING FOR STOCK ISSUED
TO  EMPLOYEES.  SFAS  123  (R)  requires  all  stock-based  compensation  to  be
recognized  as an  expense  in the  financial  statements  and that such cost be
measured  according to the  grant-date  fair value of the stock options or other
equity  instruments.  SFAS  123 (R)  will be  effective  for  quarterly  periods
beginning  after June 15,  2005.  While the Company  currently  provides the pro
forma  disclosures   required  by  SFAS  No.  148,  ACCOUNTING  FOR  STOCK-BASED
COMPENSATION - TRANSITION AND  DISCLOSURE,  on a quarterly  basis (see "Note 1 -
Accounting for Stock-Based Compensation"), it is currently evaluating the impact
this statement will have on its consolidated financial statements.

      In November  2004,  the FASB issued  SFAS No.  151,  INVENTORY  COSTS - AN
AMENDMENT OF ARB NO. 43,  CHAPTER 4 ("SFAS No. 151").  SFAS No. 151 requires all
companies to  recognize a  current-period  charge for  abnormal  amounts of idle
facility expense,  freight,  handling costs and wasted materials. This statement
also requires that the allocation of fixed  production  overhead to the costs of
conversion be based on the normal  capacity of the production  facilities.  SFAS
No. 151 will be effective for fiscal years  beginning  after June 15, 2005.  The
Company  believes  that this  statement  will not have a material  effect on its
consolidated financial statements.

(q)   RECLASSIFICATIONS

      Certain  reclassifications  have  been made to prior  years'  consolidated
financial statements to conform to the current year's presentation.

(2)   ACQUISITIONS

      On July  3,  2002,  FalconStor  AC,  Inc.,  a  newly  formed  wholly-owned
subsidiary  of the  Company,  acquired  all of the  common  stock of IP  Metrics
Software,  Inc. ("IP Metrics"),  a provider of intelligent trunking software for
mission-critical  networks,  for $2,432,419 in cash plus payments  contingent on
the level of revenues  from IP Metrics'  products  and  services for a period of
twenty-four  months. The acquisition was accounted for under the purchase method
and the results of IP Metrics are  included  with those of the Company  from the
date of  acquisition.  As of December 31, 2004, the Company made final aggregate
contingent  acquisition  payments  totaling  $501,139  related to the sale of IP
Metrics'  products  and  services.  Contingent  consideration  incurred  through
December 31, 2004 in excess of the amount accrued at the time of acquisition was
$211,197,  of which $146,154 and $65,043 was added to goodwill in 2004 and 2003,
respectively.


      The fair value of the net tangible  liabilities of IP Metrics  assumed was
$898,305, including $289,942 of accrued contingent consideration recorded at the
time of acquisition.  The Company purchased certain intangible assets, including
customer  relationships and purchased  technology with a fair value of $216,850.
These intangible assets are being amortized under the straight-line  method over
an  estimated  useful  life of 3 years,  the  expected  period of  benefit.  The

                                       46



purchase  price in excess of the fair value of the net tangible  and  intangible
assets  acquired and liabilities  assumed by the Company  amounted to $3,325,071
and has been recorded as goodwill.

      On November 12,  2002,  FalconStor  AC,  Inc.,  acquired all of the common
stock of FarmStor,  a software sales  organization  in the Republic of Korea for
$180,000 in cash.  The fair value of the net  tangible  liabilities  of FarmStor
assumed was $7,725.  The  purchase  price in excess of the fair value of the net
tangible  assets  acquired and  liabilities  assumed by the Company  amounted to
$187,725 and has been recorded as goodwill.

      On August  22,  2001,  pursuant  to an  Agreement  and Plan of Merger  and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged
with Network Peripherals,  Inc. ("NPI"), with NPI as the surviving  corporation.
Although NPI acquired  FalconStor,  as a result of the  transaction,  FalconStor
stockholders held a majority of the voting interests in the combined  enterprise
after the merger.  Accordingly,  for accounting purposes,  the acquisition was a
"reverse  acquisition"  and  FalconStor  was  the  "accounting   acquirer."  The
transaction was accounted for as a  recapitalization  of FalconStor and recorded
based on the fair value of NPI's net  tangible  assets  acquired by  FalconStor,
with no goodwill or other intangible assets being recognized. At the time of the
merger, NPI had no continuing operations and, thus, any post-merger transactions
related to NPI have been  classified as discontinued  operations.  In connection
with the merger, the name of NPI was changed to FalconStor Software, Inc.

(3)   PROPERTY AND EQUIPMENT

      Property and equipment consist of the following:


                                    DECEMBER 31,     DECEMBER 31,
                                        2004            2003
                                   ------------------------------

Computer hardware and software     $ 8,542,374      $ 5,746,303

Furniture and equipment                503,819          473,774

Leasehold improvements                 314,101          297,425
                                   -----------      -----------

                                     9,360,294        6,517,502

Less accumulated depreciation       (4,698,025)      (2,656,433)
                                   -----------      -----------

                                   $ 4,662,269      $ 3,861,069
                                   ===========      ===========


      Depreciation  expense was  $2,041,592,  $1,205,839,  and $826,989 in 2004,
2003, and 2002, respectively.

(4)   MARKETABLE SECURITIES

      The Company  accounts for its short-term  investments  in accordance  with
SFAS 115,  ACCOUNTING  FOR  CERTAIN  INVESTMENTS  IN DEBT AND EQUITY  SECURITIES
("SFAS 115"). SFAS 115 establishes the accounting and reporting requirements for
all debt securities and for investments in equity securities that have a readily
determinable  fair market value.  All short-term  marketable  securities must be
classified  as one of the  following:  held-to-maturity,  available-for-sale  or
trading   securities.   The   Company's   short-term   investments   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  basis  of  the  specific
identification  method.  Realized  gains,  realized losses and declines in value

                                       47



judged to be  other-than-temporary,  are included in other  income.  The cost of
available-for-sale  securities  sold are  based on the  specific  identification
method and interest earned is included in interest and other income.

      The cost and fair  values of the  Company's  marketable  securities  as of
December 31, 2004 and 2003 are as follows:

                                              Aggregate          Cost      Unrealized    Unrealized
                                             Fair Value          Basis        Gains       Losses
                                            ------------     -----------   ---------  --------------

         Available-for-sales securities:

         December 31, 2004                   $18,488,616     $18,756,422     $--       $  (267,806)

         December 31, 2003                   $28,199,242     $28,318,199     $--       $  (118,957)


      Marketable  securities  at December 31, 2004 and 2003 consist of corporate
bonds and government securities.

(5)   ACCRUED EXPENSES

      Accrued expenses are comprised of the following:


                                                 DECEMBER 31,   DECEMBER 31,
                                                    2004           2003
                                                 -----------    ----------

Accrued compensation                             $1,088,656     $  697,839

Accrued consulting and professional fees            899,678        302,425

Accrued marketing and promotion                     193,592         50,000

Other accrued expenses                              770,821        965,774

Accrued IP Metrics contingent purchase price           --           67,855

Accrued hardware purchases                           73,252        253,682

Accrued and deferred rent                           475,035        439,816
                                                 ----------     ----------

                                                 $3,501,034     $2,777,391
                                                 ==========     ==========

(6)   INCOME TAXES

      The provision for income taxes for the years ended December 31, 2004, 2003
and 2002 are  comprised  solely of  foreign  income  taxes.  The tax  effects of
temporary  differences  that  give rise to the  Company's  deferred  tax  assets
(liabilities) as of December 31, 2004 and 2003 are as follows:

                                       48



                                                            2004              2003
                                                       ------------      ------------


U.S. net operating loss carryforwards (FalconStor)     $ 13,379,600      $ 12,525,600
U.S. net operating loss carryforwards (NPI)              31,711,100        31,756,000
Start-up costs not currently deductible for taxes           384,800           714,300
Depreciation                                               (584,300)         (584,500)
Compensation                                                361,300           367,900
Tax credit carryforwards                                  1,433,200         1,067,100
Deferred revenue                                          1,977,400           957,700
Capital loss carryforward                                   883,400           951,300
Lease abandonment charge                                    111,800           231,100
Allowance for receivables                                   995,100           771,900
Other                                                         8,100           103,600
                                                       ------------      ------------
                                                         50,661,500        48,862,000
     Valuation allowance                                (50,661,500)      (48,862,000)
                                                       ------------      ------------

                                                       $         --      $         --
                                                       ============      ============

      The  difference  between the  provision  for income taxes  computed at the
Federal  statutory rate and the reported  amount of tax expense  attributable to
loss before income taxes for the years ended  December 31, 2004,  2003 and 2002,
are as follows:

                                                                 2004            2003                2002
                                                             -------------    ------------     -------------


Tax recovery at Federal statutory rate                       $(1,991,300)     $(2,494,400)     $(3,911,900)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit         809,300         (318,000)        (788,400)
Non-deductible expenses                                           47,600           41,900           41,400
Compensation                                                       2,700          157,600          389,800
Foreign tax credit                                                (6,100)         (90,000)        (125,800)
Net effect of foreign operations                                 164,800             (900)          75,700
Research and development credit                                 (360,100)        (272,200)        (233,500)
Increase in valuation allowance                                1,365,000        3,008,600        4,590,300
                                                             -----------      -----------      -----------

                                                             $    31,900      $    32,600      $    37,600
                                                             ===========      ===========      ===========

      Income  (loss)  before  provision  for  income  taxes for the years  ended
December 31, 2004, 2003 and 2002 are as follows:

                               2004            2003             2002
                          -------------     --------------    ------------

Domestic loss             $ (5,466,000)     $ (7,434,000)     $(11,393,000)
Foreign income (loss)         (391,000)           98,000          (113,000)
                          ------------      ------------      ------------

                          $ (5,857,000)     $ (7,336,000)     $(11,506,000)
                          ============      ============      ============

      As of  December  31,  2004,  the  Company  had  U.S.  net  operating  loss
carryforwards of approximately  $34,307,000 which expire from 2020 through 2024.
In addition,  as of the date of the merger described in Note 2, NPI had U.S. net
operating loss  carryforwards  of $93,268,000  that start to expire in December,
2012.  At  December  31,  2004 and 2003,  the  Company  established  a valuation
allowance  against  its net  deferred  tax assets due to the  Company's  pre-tax
losses  and  the  resulting  likelihood  that  the  deferred  tax  asset  is not
realizable. Due to the Company's various equity transactions,  which resulted in
a change of  control,  the  utilization  of certain  tax loss  carryforwards  is
subject to annual limitations imposed by Internal Revenue Code Section 382. NPI

                                       49





experienced  such an ownership  change as a result of the merger.  As such,  the
Company's  ability to use its NOL  carryforwards to offset taxable income in the
future  may be  significantly  limited.  If the entire  deferred  tax asset were
realized,  $4,618,000 would be allocated to  paid-in-capital  with the remainder
reducing  income  tax  expense.  Of the  amount  allocable  to  paid-in-capital,
$2,327,000  related  to the tax effect of the  deductions  for  payments  of the
liabilities of discontinued  operations and the balance of $2,291,000 related to
the tax  effect of  compensation  deductions  from  exercises  of  employee  and
consultant stock options.

(7)   STOCKHOLDERS' EQUITY

      In  September,  2003,  the Company  entered into a worldwide OEM agreement
with a major technology  company (the "OEM"),  and issued warrants to the OEM to
purchase  750,000 shares of the Company's common stock with an exercise price of
$6.18 per share.  A portion of the warrants  will vest  annually  subject to the
OEM's  achievement of pre-defined and mutually agreed upon sales objectives over
a three-year  period  beginning  June 1, 2004. If the OEM  generates  cumulative
revenues to the Company in the mid-eight  figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the  three-year  period  will  expire.  If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants  earned will be recorded as a reduction  of revenue.  Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. As of December 31, 2004,
the Company had not generated any revenues from this OEM.

(8)   STOCK OPTION PLANS

      As of May 1, 2000, the Company adopted the FalconStor Software,  Inc. 2000
Stock  Option  Plan  (the  "Plan").  The Plan is  administered  by the  Board of
Directors and, as amended, provides for the issuance of up to 14,162,296 options
to employees,  consultants and non-employee directors.  Options may be incentive
("ISO") or non-qualified. Exercise prices of ISOs granted must be 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.

      Certain of the options  granted to employees had exercise prices less than
the fair  value of the  common  stock on the date of grant,  which  resulted  in
deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively.
The  amortization  of deferred  compensation  amounted to $7,969,  $463,476  and
$459,619 in 2004, 2003 and 2002, respectively.

      The Company  granted  options to purchase an aggregate of 50,000 shares of
common stock to certain  non-employee  consultants in exchange for  professional
services  during 2002.  The aggregate  fair value of these options as determined
using the fair value  method  under SFAS No.  123,  is being  expensed  over the
periods the  services are  provided.  The related  expense  amounted to $87,023,
$86,875 and $32,890 in 2004, 2003 and 2002, respectively.

      In February 2002, the Company  accelerated the vesting of stock options of
one employee upon his death.  Compensation costs of $231,415 were recorded based
on the intrinsic value of the options on the date of acceleration.

      On May 14, 2004 the Company adopted a 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. The 2004 Plan has
a term of three years.


                                       50



      Stock option activity for the periods indicated is as follows:

                                                                    Weighted
                                                                     average
                                                    Number of       exercise
                                                     Options          price
                                                    ------------  ------------

Outstanding at December 31, 2001 ...............      7,274,717      $   3.28
Granted ........................................      3,088,500      $   4.60
Exercised ......................................       (478,038)     $   2.32
Canceled .......................................       (497,600)     $   7.53
                                                     ----------
Outstanding at December 31, 2002 ...............      9,387,579      $   3.55
                                                     ----------
Granted ........................................      2,678,300      $   7.01
Exercised ......................................     (1,224,833)     $    .70
Canceled .......................................       (980,621)     $   9.19
                                                     ----------
Outstanding at December 31, 2003 ...............      9,860,425      $   4.29
                                                     ----------
Granted ........................................      1,227,000      $   6.91
Exercised ......................................     (1,023,425)     $   1.99
Canceled .......................................     (1,090,642)     $   6.01
                                                     ----------
Outstanding at December 31, 2004 ...............      8,973,358      $   4.71
                                                     ==========

Vested at December 31, 2002 ....................      3,829,793      $   3.21
                                                     ==========

Vested at December 31, 2003 ....................      4,950,046      $   2.47
                                                     ==========

Vested at December 31, 2004 ....................      5,521,469      $   3.60
                                                     ==========

Options available for grant at December 31, 2004      2,698,974
                                                     ==========

      During 2003, one employee paid for the exercise  price of certain  options
with 7,094 shares of common  stock that were held greater than six months.  Such
shares which had a market value of $28,744 were retired.

      The following table summarizes information about stock options outstanding
at December 31, 2004:

                                        OPTIONS OUTSTANDING                                      OPTIONS EXERCISABLE
               ----------------------------------------------------------------------     -----------------------------------------

                                        Weighted-Average             Weighted
    Range of            Number         Remaining Contractual      Average Exercise           Number              Weighted - Average
Exercise Prices       Outstanding           Life (Years)               Price               Exercisable             Exercise Price
-----------------    ---------------   ---------------------    --------------------      -----------------    ---------------------

 $0.35 - $1.01         2,391,130              5.52                      $0.35                2,391,130               $0.35
 $3.95 - $4.04         1,222,381              7.88                      $4.03                  746,861               $4.04
 $5.07 - $5.86         1,899,646              7.68                      $5.24                  961,459               $5.18
 $6.20 - $6.90         1,276,190              7.88                      $6.30                  675,790               $6.20
 $7.44 - $8.43         1,663,150              9.14                      $8.09                  372,075               $8.41
 $8.74 - $9.72           375,045              7.10                      $9.16                  228,338               $9.41
     $10.95              145,816              6.37                     $10.95                  145,816              $10.95
                     -----------                                                            ----------
                       8,973,358              7.39                      $4.71                5,521,469               $3.60
                     ===========                                                            ==========

(9)   LEASE ABANDONMENT CHARGE

      In November  2003,  the Company  relocated  its  headquarters  to a larger
facility.  As a result of this  relocation,  the Company  vacated  its  previous
office  space  and  recorded  a lease  abandonment  charge of  $550,162  for the
estimated loss expected to be incurred on the remaining lease obligation through

                                       51






July 2007. The charge included the remaining lease rental obligation  reduced by
cash flows the Company  expects to generate  from an agreement to sub-lease  the
facility,  as well as the write-off of leasehold  improvements  at the Company's
previous  facility.  As of  December  31,  2004,  the  remaining  amounts due of
$217,429 associated with this charge were included in accrued expenses.

(10)  IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS

      In October  2001,  the Company  entered into an agreement  with  Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2,800,062
was paid to NSSI,  of  which  $2,300,062  was for the  purchase  of  convertible
preferred  stock  accounted  for under the cost  method and  $500,000  was for a
nonrefundable  prepaid royalty recoupable against future product sales of NSSI's
product.  Primarily due to the decline that commenced in May, 2002 in the market
value of NSSI's common stock  underlying the  convertible  preferred  stock to a
value which was significantly below the Company's cost, the Company concluded in
2002 the decline in the fair value of its investment in NSSI's  preferred  stock
was  other  than  temporary.  Accordingly,  in  2002  the  Company  recorded  an
impairment  charge of  $2,300,062  to write down its  investment in NSSI to fair
value. In addition,  due to the lack of market acceptance of the NSSI product in
its then current state,  the unrecouped  prepaid royalty was not recoverable and
in 2002 the Company recorded an impairment  charge of $482,715 to write off this
prepaid royalty.  In 2003, the Company sold all its NSSI  convertible  preferred
stock for $35,000,  which was reflected as a reduction to the impairment  charge
in the statement of operations.

(11)  LITIGATION SETTLEMENT CHARGE

      During the third quarter of 2004, the Company  resolved claims relating to
alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill")
and by  Crossroad  Systems  (Texas),  Inc.  ("Crossroads")  against the Company.
Pursuant  to the terms of the  Settlement  Agreement  between  the  Company  and
Crossroads,  the Company,  without  admission of  infringement,  made a one-time
payment of $1.3 million and granted to  Crossroads  licenses to certain  Company
technology  in exchange for a  worldwide,  perpetual  license to the  technology
underlying the Crossroads patents at issue in the litigation. All claims against
the Company by both Dot Hill and Crossroads were dismissed.

(12)  LIABILITIES OF DISCONTINUED OPERATIONS

      Liabilities of NPI's discontinued  operations at December 31, 2002 totaled
$4.2  million and  consisted of warranty  related  liabilities,  foreign  income
taxes,   severance  related  payments,   professional  fees  and  other  related
liabilities,  including estimated settlement costs for disputes.  As of December
31, 2002,  the Company had reduced  liabilities of  discontinued  operations and
increased additional  paid-in-capital by $2,150,000 for its then estimate of the
excess of the remaining liabilities for discontinued operations over the amounts
estimated to be paid.

      On February  14, 2003,  the Company  settled a claim  associated  with the
liabilities of discontinued  operations for $2,850,000.  As of December 31, 2003
all significant contingent liabilities related to the discontinued operations of
NPI were resolved and paid. As a result,  on December 31, 2003 the excess of the
remaining  liabilities  for  discontinued  operations  over the amounts  paid of
$916,845 was reflected as an increase to additional  paid-in-capital  since this
liability  was  related to the merger  with NPI,  which was  accounted  for as a
recapitalization.

(13)  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 a domestic  office and offices in foreign  countries.  The expiration
dates for these  leases  ranges  from 2005  through  2012.  The  following  is a
schedule  of  future  minimum  lease  payments  for all  operating  leases as of
December 31, 2004:



                                       52




           YEAR ENDING DECEMBER 31,

           2005................................................ $  1,451,844
           2006................................................    1,520,105
           2007................................................    1,348,593
           2008................................................    1,230,817
           2009................................................    1,264,449
           Thereafter..........................................    3,025,992
                                                                ------------
                                                                $  9,841,800
                                                                ============

      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  $1,103,008,  $673,949,  and $596,578 for the years ended December 31, 2004,
2003 and 2002, 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.  Except for the  alleged  patent
infringement  claim discussed in note 11, through  December 31, 2004, there have
not been any claims under such indemnification provisions.

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

(14)  STOCK REPURCHASE PROGRAM

      On October 25,  2001,  the Company  announced  that its Board of Directors
authorized  the  repurchase  of  up to  two  million  shares  of  the  Company's
outstanding  common stock. The repurchases may be made from time to time in open
market  transactions  in such amounts as  determined  at the  discretion  of the
Company's  management.  The terms of the stock repurchases will be determined by
management based on market conditions.  During the year ended December 31, 2004,
the Company purchased 42,100 shares of its common stock in open market purchases
for a total cost of $279,645. As of December 31, 2004, the Company repurchased a
total of 277,100 shares for $1,714,775.

(15)  SEGMENT REPORTING

      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, 2004,  2003 and 2002 and the  location of  long-lived  assets as of
December 31, 2004, 2003 and 2002 are summarized as follows:

                                                            2004              2003            2002
                                                         -------------------------------------------

Revenues:

United States                                            $18,140,465     $ 9,834,526     $ 6,629,147

Asia                                                       5,821,902       3,580,741       2,878,108


                                       53





Other international                                        4,746,311       3,528,868       1,121,637
                                                         -----------     -----------     -----------

  Total Revenues                                         $28,708,678     $16,944,135     $10,628,892
                                                         ===========     ===========     ===========


Long-lived assets (includes all non-current assets):

United States                                            $ 9,929,214     $10,329,876     $ 7,655,900

Asia                                                         950,387         760,148         425,791

Other international                                          322,544         334,576          73,706
                                                         -----------     -----------     -----------

  Total long-lived assets                                $11,202,145     $11,424,600     $ 8,155,397
                                                         ===========     ===========     ===========

      For the year ended  December 31, 2004,  the Company had one customer  that
accounted for 16% of revenues. For the year ended December 31, 2003, the Company
did not have any customers that accounted for over 10% of revenues. For the year
ended  December 31, 2002, the Company had one customer that accounted for 16% of
revenues. As of December 31, 2004, the Company had three customers with accounts
receivable balances greater than 5% of gross accounts  receivable,  which in the
aggregate were 30% of the accounts  receivable balance. As of December 31, 2003,
the Company had two customers with accounts  receivable balances greater than 5%
of gross  accounts  receivable,  which in the aggregate were 11% of the accounts
receivable balance.

(16)   VALUATION  AND  QUALIFYING  ACCOUNTS - ALLOWANCE FOR RETURNS AND DOUBTFUL
       ACCOUNTS

                        Balance at   Additions                      Balance at
                       Beginning of   charged                         End of
  Period Ended,           Period     to Expense     Deductions        Period
------------------    -----------    -----------    ----------     ------------

December 31, 2004     $1,837,934     $3,296,275     $2,582,593     $2,551,616
December 31, 2003     $  813,645     $1,700,100     $  675,811     $1,837,934
December 31, 2002     $  375,541     $  930,150     $  492,046     $  813,645


(17)  QUARTERLY FINANCIAL DATA (UNAUDITED)

      The following is a summary of selected  quarterly  financial  data for the
years ended December 31, 2004 and 2003:

                                                                  Fiscal Quarter
                                     First                Second                Third               Fourth
---------------                  --------------      ---------------     -----------------     ----------------

2004

Revenue                         $     5,258,798      $    6,483,137      $      7,469,999      $    9,496,744
                                ===============      ==============      ================      ==============
Net income (loss)               $    (2,221,507)     $   (1,713,091)     $     (2,293,083)     $      338,834
                                ===============      ==============      =================     ==============
Basic net income
   (loss) per share             $         (0.05)     $        (0.04)     $          (0.05)     $        0.01
                                ===============      ==============      ================      =============


                                       54




Diluted net income
  (loss) per share              $         (0.05)     $        (0.04)     $          (0.05)     $        0.01
                                ===============      ==============      ================      =============
Basic weighted average
   common shares
    outstanding                      46,638,740          46,859,326            47,054,294         47,307,612
                                ===============      ==============      ================      =============
Diluted weighted average
   common shares
    outstanding                      46,638,740          46,859,326            47,054,294         51,249,985
                                ===============      ==============      ================      =============

2003

Revenue                         $     3,678,907      $    4,090,877      $      4,082,617      $   5,091,734
                                ===============      ==============      ================      =============
Net loss                        $    (1,738,853)     $   (1,578,925)     $     (1,894,198)     $  (2,156,979)
                                ===============      ==============      ================     ==============
Basic and diluted net
   loss per share               $         (0.04)     $        (0.03)     $          (0.04)     $       (0.05)
                                ===============      ===============     =================    ==============
Basic and diluted
   weighted average common
    shares outstanding               45,499,862          45,848,994            46,134,816         46,376,183
                                ===============      ==============      =================    ==============

      The sum of the  quarterly  net loss per share  amounts do not always 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 such period.

                                       55





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

             Internal Control Over Financial Reporting
             -----------------------------------------

             MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

             The  Company's  management  is  responsible  for  establishing  and
             maintaining  adequate internal control over financial reporting for
             the  Company.  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, 2004,  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.

             KPMG LLP, the registered  public  accounting  firm that has audited
             the  Company's  financial  statements  included  in this report has
             issued their attestation  report on management's  assessment of the
             Company's  internal  control  over  financial  reporting,  which is
             included herein.

ITEM 9B.     OTHER INFORMATION

             Not applicable.

                                    PART III

ITEM 10.     DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

             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


                                       56




             in  May  2005,  and  is  incorporated  herein  by  reference.   The
             information  appears  in the Proxy  Statement  under  the  captions
             "Election of Directors",  "Management" and "Committees of the Board
             of Directors". The Proxy Statement will be filed within 120 days of
             December 31, 2004, our year-end.

ITEM 11.     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 2005,  and is  incorporated  herein by
             reference. The information appears in the Proxy Statement under the
             caption "Executive Compensation." The Proxy Statement will be filed
             within 120 days of December 31, 2004, our year-end.

ITEM 12.     SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

             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 2005,  and is  incorporated  herein by
             reference. The information appears in the Proxy Statement under the
             captions "Beneficial  Ownership of Shares" and "Equity Compensation
             Plan  Information."  The Proxy  Statement  will be filed within 120
             days of December 31, 2004, our year-end.

ITEM 13.     CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

             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 2005,  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, 2004, our year-end.

ITEM 14.     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 2005,  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, 2004,  our
             year-end.


                                       57




                                     PART IV



ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES

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

            (b)    Exhibits

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

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

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

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

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

                   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.

                   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.

                  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.



                                       58




                  10.2         Amended and Restated Employment Agreement,  dated
                               September 1, 2004 between  Registrant and ReiJane
                               Huai, incorporated herein by reference to Exhibit
                               10.1 to the Registrant's quarterly report on Form
                               10-Q for the period  ended  September  30,  2004,
                               filed on November 9, 2004.

                  10.3         Change of Control  Agreement  dated  December 10,
                               2001  between the  Registrant  and ReiJane  Huai,
                               incorporated  herein by reference to Exhibit 10.4
                               to the  Registrant's  annual  report on Form 10-K
                               for the year ended  December 31,  2001,  filed on
                               March 27, 2002.

                  10.4         Change of Control  Agreement  dated  December  7,
                               2001  between  the   Registrant  and  Wayne  Lam,
                               incorporated  herein by reference to Exhibit 10.5
                               to the  Registrant's  annual  report on Form 10-K
                               for the year ended  December 31,  2001,  filed on
                               March 27, 2002.

                  10.5         Change of Control  Agreement  dated  February  2,
                               2004  between  the   Registrant  and  Jim  Weber,
                               incorporated herein by reference to Exhibit 99 to
                               the  Registrant's  quarterly  report on Form 10-Q
                               for the period ended March 31, 2004, filed on May
                               10, 2004.

                  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. ss. 1350)

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


                               *- filed herewith.


                                       59




                                   SIGNATURES

            Pursuant  to  the  requirements  of  Section  13  or  15(d)  of  the
Securities  Exchange Act of 1934,  the  registrant has signed this report by the
undersigned,  thereunto duly authorized in Melville,  State of New York on March
10, 2005.

FALCONSTOR SOFTWARE, INC.

By:  /s/ ReiJane Huai                                    March 16, 2005
     -----------------------------------------           --------------
     ReiJane Huai, President, Chief  Executive           Date
     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 16, 2005
     ----------------------------------------------------   -----------------
     ReiJane Huai, President, Chief Executive Officer and   Date
     Chairman of the Board
     (Principal Executive Officer)

By:  /s/ James Weber                                        March 16, 2005
     -----------------------------------------------------  -----------------
     James Weber, Chief Financial Officer, Vice President   Date
     and Treasurer
     (Principal Accounting Officer)

By:  /s/ Steven L. Bock                                     March 16, 2005
     -----------------------------------------------------  ----------------
     Steven L. Bock, Director                               Date

By:  /s/ Patrick B. Carney                                  March 16, 2005
     -----------------------------------------------------  ----------------
     Patrick B. Carney, Director                            Date

By:  /s/ Lawrence S. Dolin                                  March 16, 2005
     -----------------------------------------------------  ----------------
     Lawrence S. Dolin, Director                            Date

By:  /s/ Steven R. Fischer                                  March 16, 2005
     -----------------------------------------------------  ----------------
     Steven R. Fischer, Director                            Date


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