`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, 2006.

                                       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 if the registrant is a well-known  seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes |_| No |X|

      Indicate by check mark if the  registrant  is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X|

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

      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 a large  accelerated
filer,  an accelerated  filer,  or a  non-accelerated  filer.  See definition of
"accelerated  filer and large  accelerated  filer" in Rule 12b-2 of the Exchange
Act.

Large Accelerated Filer |_|    Accelerated Filer |X|   Non-Accelerated Filer |_|

      Indicate  by check mark  whether  the  registrant  is a shell  company (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|



      Aggregate  market  value of Common  Stock  held by  non-affiliates  of the
Registrant  as of June 30, 2006 was  $173,209,810  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, 2007 was
49,129,542 and 48,264,342, 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

                         2006 ANNUAL REPORT ON FORM 10-K

                                TABLE OF CONTENTS

                                                                            Page

PART I.

Item 1.    Business........................................................    4
Item 1A.   Risk Factors....................................................   10
Item 1B.   Unresolved Staff Comments.......................................   19
Item 2.    Properties......................................................   19
Item 3.    Legal Proceedings...............................................   19
Item 4.    Submission of Matters to a Vote of Security Holders.............   19

PART II.

Item 5.    Market for Registrant's Common Equity and Related
           Stockholder Matters.............................................   20
Item 6.    Selected Consolidated Financial Data............................   21
Item 7.    Management's Discussion and Analysis of Financial Condition
           and Results of Operations.......................................   24
Item 7A.   Qualitative and Quantitative Disclosures About Market Risk......   34
Item 8.    Financial Statements and Supplementary Data.....................   36
Item 9.    Changes in and Disagreements with Accountants on
           Accounting and Financial Disclosure.............................   59
Item 9A.   Controls and Procedures.........................................   59
Item 9B.   Other Information...............................................   59

PART III.

Item 10.   Directors and Executive Officers of the Registrant..............   59
Item 11.   Executive Compensation..........................................   60
Item 12.   Security Ownership of Certain Beneficial Owners and Management..   60
Item 13.   Certain Relationships and Related Transactions..................   60
Item 14.   Principal Accountant Fees and Services..........................   60

PART IV.

Item 15.   Exhibits and Financial Statement Schedules......................   61

SIGNATURES.................................................................   63


                                       3


                                     PART I

ITEM 1. BUSINESS

OVERVIEW

FalconStor Software, Inc. ("FalconStor",  the "Company", "we", "our" or "us") is
a  leader  in  disk-based  data  protection  solutions  that  maximize  business
continuity and data center efficiency within all IT infrastructures, integrating
seamlessly to ensure rapid data recovery while simplifying  storage  management.
FalconStor's  comprehensive  data  protection  solutions,  developed on a single
platform,    IPStor(R),    include    award-winning,    easy-to-deploy   storage
virtualization, Continuous Data Protection (CDP), VirtualTape Library (VTL) with
Single Instance Repository (SIR), and Replication software solutions and related
implementation, maintenance, and engineering services. In addition, FalconStor's
PrimeVaultSM  services provide customers with a safe secondary location to which
they can replicate their data securely and  cost-effectively  for rapid recovery
and  archiving.  From the  Fortune  1000 to small  and  medium-size  businesses,
customers  across  a  vast  range  of  industries   worldwide  have  implemented
FalconStor  solutions in their production IT environments in order to meet their
most stringent  recovery time  objectives  (RTO) and recovery  point  objectives
(RPO),  as well as to manage their  storage  infrastructures  with minimal total
cost of ownership (TCO) and optimal return on investment (ROI).

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

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

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

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

FalconStor was incorporated in Delaware as Network  Peripherals,  Inc., in 1994.
Pursuant to a merger with  FalconStor,  Inc.,  in 2001,  the former  business of


                                       4


Network Peripherals,  Inc., was discontinued,  and the newly re-named FalconStor
Software,  Inc.,  continued  the storage  software  business  started in 2000 by
FalconStor,   Inc.  FalconStor's   headquarters  are  located  at  2  Huntington
Quadrangle,  Suite 2S01, Melville,  NY 11747. The Company also maintains offices
throughout Europe and Asia.

PRODUCTS AND TECHNOLOGY

The FalconStor  IPStor platform is a network  infrastructure  software  platform
that provides the most reliable and complete disk-based  platform for delivering
data protection  solutions.  FalconStor data protection  solutions accelerate or
eliminate  the backup  window  which allows users to recover data in 30 minutes,
anytime,  anywhere,  with 100% data integrity.  FalconStor  offers the following
core products:  VTL with SIR for  de-duplications,  CDP, NSS and Replication for
disaster recovery and remote branch office  protection.  The IPStor platform and
subsequent  solutions  share  several  key  technologies  that  foster  seamless
integration and offer a competitive edge.

      o     ONE  INDEPENDENT,  OPEN  PLATFORM  -  Built  on the  IPStor  storage
            virtualization  platform,   FalconStor's  solutions  are  completely
            independent of any storage or connectivity, delivering comprehensive
            data protection.

      o     RAPID  RECOVERY - Unique to  FalconStor  is the  ability to return a
            file, full system,  or entire array to service in 30 minutes and, in
            some cases, 5 minutes or less. This is due to the  application-aware
            snapshot  ability of  TimeMark(R)  technology  as well as bare metal
            recovery capabilities.

      o     AFFORDABLE,  SCALABLE  PROTECTION FROM THE DATA CENTER TO THE REMOTE
            OFFICE - FalconStor data protection  technology scales from the data
            center to the remote  office or single user laptop.  FalconStor  and
            its  partners  have  deployed  solutions  as small as a 2TB  desktop
            network   storage   server   and  as  large   as   multiple-petabyte
            architectures.   FalconStor's  MicroScan(TM)  technology  eliminates
            redundant data across the network.  This  eliminates  70%-90% of the
            bandwidth  requirements,  making disk based protection for remote or
            disaster recovery sites highly affordable and practical.

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

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

SOFTWARE PRODUCTS

NETWORK STORAGE SERVER (NSS)

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


                                       5


VIRTUALTAPE LIBRARY (VTL)

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

In  2006  FalconStor  introduced  the  Single  Instance  Repository  (SIR)  as a
de-duplication enhancement to VTL. Because backup by nature copies data over and
over again, de-duplication minimizes storage and bandwidth needs. By eliminating
duplicate  copies,  VTL with SIR  allows  customers  to keep more  data  online,
longer.  Instead  of a month  of data on disk  for  recovery,  they can now keep
several months or more.

CONTINUOUS DATA PROTECTION (CDP)

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

REPLICATION

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

DISKSAFE(TM)AND FILESAFE(TM)

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

APPLICATION-AWARE SNAPSHOT AGENTS

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

OFFSITE, ONLINE DATA PROTECTION FACILITY

PrimeVaultSM  by FalconStor is an offsite,  online data  protection  service for
organizations  that either do not have their own disaster recovery sites or wish
to  replicate  their data to an  additional  site for a  supplementary  layer of
redundancy. PrimeVault grants small, medium, and large businesses the ability to
protect  and  archive  their  data to a secure  facility  at an  affordable  and
predetermined  price  based on  individualized  needs.  By cutting  the costs of
deploying and  maintaining an alternate site,  PrimeVault  makes alternate sites
practical for most, if not all businesses. PrimeVault services are sold directly
to FalconStor customers or through partners.


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PrimeVault offerings include:

o     Rapid 24x7x365 data recovery with maximum BC/DR capabilities

o     Immediate BC/DR solution deployment

            o     Cost-effective, flexible pricing

            o     Minimal upfront IT investment and operating overhead

            o     Rapid  deployment and compliance  with minimal  implementation
                  costs

o     Seamless scalability of offsite data storage as business expands

o     Offsite replication of virtual tapes

o     Data export from  virtual to physical  tapes with  offsite  archiving  for
      compliance or other purposes

o     End-to-end security

            o     Encryption  for  data  replication,  virtual  tapes,  and data
                  storage

            o     Closed-circuit video surveillance 24x7x365

            o     Encrypted, multi-point verified access to facility

BUSINESS STRATEGY

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

DISK-BASED DATA PROTECTION LEADERSHIP

FalconStor  intends to  continue  to  leverage  the  protocol-agnostic,  unified
architecture, and robust data protection technology of its solutions to maintain
a leadership  position in the enterprise  disk-based  data  protection  software
market. The disk-based data protection market is rapidly growing.  IDC forecasts
the VTL market will reach $1.2B by 2011,  a 30% CAGR.  Polls by Gartner at their
customer  summits show CDP to be adopted by 17% to 19% of the customers in 2007.
FalconStor  plans to continue  its  leadership  in this market  through its deep
commitment  to  research  and  development   and  continued   rapid   technology
innovation.

EXPAND PRODUCT OFFERINGS

In the  spring of 2006,  FalconStor  released  CDP,  complementing  the  already
successful  TimeMark  snapshot  technology.   This  along  with  the  Continuous
Replication delivers a remote data center and remote branch office offering. For
the SMB market,  FalconStor  released Express versions of our products,  sold by
our OEM partners and also used by our  enterprise  customers  for remote  office
data protection.

In  addition,   FalconStor  introduced  SIR  de-duplication   technology  as  an
enhancement to its VTL offering for improved storage and network efficiency.  We
expect  many  VTL  solutions  to  be  sold  with  this  critical  functionality.
FalconStor also enhanced its VTL with optimized scalability to meet the needs of
the  largest  enterprises.  In 2006 the largest  VTL  cluster  managed  1.5PB of
storage.  As our customers grow, we expect their  requirement for scalability to
grow as well.

EXPAND CORPORATE VISIBILITY

In late  2006,  FalconStor  made  significant  steps in  increasing  its  market
presence and awareness. First, we invested in experienced marketing staff. A new
Chief Marketing  Officer was hired along with  additional  staff for product and
partner  marketing.  Second,  we  increased  our  engagement  with the press and
analyst community to bring our comprehensive  disk based data protection message
to the market.  This broad effort will continue  throughout 2007, as we hone our
message and market  deliverables.  We are relying  significantly  on our success
with  customers  and partners  throughout  the world.  Third,  we increased  our
investment in our partners, both OEMs and channel, for joint marketing and field
engagement.

EXPAND  TECHNOLOGIES  AND  CAPABILITIES   THROUGH  STRATEGIC   ACQUISITIONS  AND
ALLIANCES.

FalconStor  believes that  opportunities  may exist to expand its  technological
capabilities,  product offerings,  and services whether through  acquisitions of


                                       7


businesses or software technology,  or through strategic  alliances.  FalconStor
will focus on opportunities that enable it to acquire or to license:

      o     Important enabling technology;

      o     Complementary applications;

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

      o     Key personnel.

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

EXPAND INSIDE AND FIELD SALES ORGANIZATION

FalconStor  intends to expand its  worldwide  sales  force in 2007.  Field sales
expansion  should  provide  increased  coverage for end user  opportunities  and
partners.  FalconStor is increasing its  investment in partners with  additional
training,  lead generation and market  development.  Inside sales has been added
for lead generation and incremental revenue  opportunities for current end users
and mid-size businesses.

IDENTIFY AND NURTURE NEW GROWTH DRIVERS

FalconStor  has made key  investments  in  several  areas,  from which we expect
growth in the  coming  years.  We  believe we are  uniquely  positioned  to take
advantage  of  the  rapid  storage  growth  in  China.  OEM  relationships  with
Huawei-3com  and  a  major  telecommunications  equipment  provider,  and  joint
development  with  Chinese  Academy  of  Sciences  for  remote  data  protection
services, will continue to expand this market.

InfiniBand is a new promising  protocol used by the High  Performance  Computing
market.  We are in early stages with  customers,  but  potentially  leading this
market in tying in the large  InfiniBand  clusters to traditional  Fibre Channel
SANs. Our  non-disruptive  approach protects our customer's  investments,  while
delivering speeds over 1GBs. As the Inifiband clusters  proliferate,  we believe
we will lead in managing the storage with our partners.

We expect the PrimeVault Service Provider Channel to expand in 2007, by bringing
online several large network service  providers.  Similar to the Chinese Academy
of  Sciences,   these  offerings  will  be  for  disaster   recovery  for  large
institutions and primary data protection for small and mid size businesses.

SALES, MARKETING AND CUSTOMER SERVICE

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

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

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

STORAGE  APPLIANCES.  FalconStor has agreements with strategic partners to adapt
FalconStor products for use in the strategic partners'  special-purpose  storage
appliances.

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

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


                                       8


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

COMPETITION

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

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

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

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

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

INTELLECTUAL PROPERTY

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

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

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


                                       9


MAJOR CUSTOMERS

For the year ended December 31, 2006, FalconStor had one customer that accounted
for 27% of revenues.  For the year ended  December 31, 2005,  FalconStor had two
customers  that  together  accounted  for 31% of  revenues.  For the year  ended
December  31,  2004,  FalconStor  had one  customer  that  accounted  for 16% of
revenues.  As of December 31, 2006,  the Company had two 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, 2005,
the Company had two customers with accounts  receivable balances greater than 5%
of gross  accounts  receivable,  which in the aggregate were 28% of the accounts
receivable balance.

EMPLOYEES

As of December 31, 2006,  FalconStor had 340 full-time employees,  consisting of
167 in research and development,  95 in sales and marketing,  59 in service, and
19 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 amended, 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, as amended,  report filed during the year ended
December 31, 2006.

ITEM 1A. RISK FACTORS

      We are affected by risks specific to us as well as factors that affect all
businesses  operating in a global market.  The  significant  factors known to us
that could materially  adversely affect our business,  financial  condition,  or
operating results are set forth below,  whether or not there has been a material
change in any Risk Factor.

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

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

THE MARKET FOR STORAGE  AREA  NETWORKS  AND NETWORK  ATTACHED  STORAGE ARE STILL
MATURING,  AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.

      The continued adoption of Storage Area Networks (SAN) and Network Attached
Storage (NAS) solutions is critical to our future  success.  The markets for SAN
and NAS  solutions  are still  maturing,  making it difficult  to predict  their
potential  sizes or future  growth rates.  If these markets  develop more slowly
than we expect,  our  business,  financial  condition  and results of operations
would be adversely affected.

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

      The  continued  adoption  of  disk-based  backup  solutions,  such  as our
VirtualTape Library software,  is critical to our future success. The market for
disk-based  backup  solutions is still maturing,  making it difficult to predict
its potential  size or future  growth rate. If this market  develops more slowly
than we expect,  our  business,  financial  condition  and results of operations
would be adversely affected.


                                       10


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 important 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. 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 InfiniBand SOLUTIONS IS NEW AND UNCERTAIN,  AND OUR BUSINESS WILL
SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

      The rapid  adoption of  InfiniBand  solutions  is  important to our future
success.  The market  for  InfiniBand  solutions  is still  unproven,  making it
difficult to predict the potential  size or future growth rate. 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 AND SMALL OFFICE/HOME
OFFICE MARKETS.

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

THE MARKET FOR OUR  PRIMEVAULTSM  SERVICES IS  COMPETITIVE  AND IT IS  UNCERTAIN
WHETHER WE WILL  ATTRACT  ENOUGH  CUSTOMERS  TO PROVIDE  AN  ADEQUATE  RETURN ON
INVESTMENT.

      We have continued to make investments in infrastructure  and in operating,
sales and marketing personnel for our PrimeVault disaster recovery, data backup,
and VTL replication services.  The market for these services is competitive with
a number of vendors  offering  similar  services.  Despite  what we believe  are
competitive   advantages  offered  by  our  PrimeVault  services  based  on  our
proprietary IPStor and VTL families of software,  there can be no assurance that
we will be able to attract enough customers,  or earn enough revenues,  to cover
our investment in PrimeVault  services or to provide an adequate  return on that
investment.

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

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

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

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


                                       11


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

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

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

FAILURE OF STORAGE  APPLIANCES  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 or VTL  functionality
with third party  hardware to create single purpose  turnkey  solutions that are
designed to be easy to deploy. In addition, in certain instances, we install our
software  onto third  party  hardware  for resale to end users.  If the  storage
appliances  are not easy to deploy or do not  integrate  smoothly  with end user
systems, the basic premise behind the appliances will not be met and sales would
suffer.

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

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

WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.

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

OUR OEM CUSTOMERS ARE NOT OBLIGATED TO CONTINUE TO SELL OUR PRODUCTS.

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


                                       12


THE FAILURE OF OUR RESELLERS TO EFFECTIVELY SELL OUR SOFTWARE APPLICATIONS COULD
HAVE A MATERIAL ADVERSE EFFECT ON OUR REVENUES AND RESULTS OF OPERATIONS.

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


WE ARE  DEPENDENT  ON CERTAIN KEY  CUSTOMERS  AND A  SIGNIFICANT  PORTION OF OUR
RECEIVABLES IS CONCENTRATED WITH TWO CUSTOMERS.

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

      In addition,  as of December 31, 2006, two customers accounted for a total
of 30% of our  outstanding  receivables,  21% and  9%,  respectively.  While  we
currently have no reason to question the collectibility of these receivables,  a
business failure or  reorganization  by either of these customers could harm our
ability to collect these receivables and could damage our cash flow.

THE  REPORTING  TERMS OF SOME OF OUR OEM  AGREEMENTS  MAY CAUSE US DIFFICULTY IN
ACCURATELY  PREDICTING  REVENUE FOR FUTURE  PERIODS,  BUDGETING  FOR EXPENSES OR
RESPONDING TO TRENDS.

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

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

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

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


                                       13


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.

CONSOLIDATION   IN  THE  NETWORK  STORAGE  INDUSTRY  COULD  HURT  OUR  STRATEGIC
RELATIONSHIPS.

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

THE  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 ABILITY TO SELL OUR SOFTWARE APPLICATIONS IS HIGHLY DEPENDENT ON THE QUALITY
OF OUR SERVICES  OFFERINGS,  AND OUR FAILURE TO OFFER HIGH  QUALITY  SUPPORT AND
PROFESSIONAL  SERVICES  WOULD  HAVE A  MATERIAL  ADVERSE  AFFECT ON OUR SALES OF
SOFTWARE APPLICATIONS AND RESULTS OF OPERATIONS.

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

FAILURE TO ACHIEVE  ANTICIPATED  GROWTH COULD HARM OUR  BUSINESS  AND  OPERATING
RESULTS.

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

o     retention of key management, marketing and technical personnel;


                                       14


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.

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

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

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

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

      Historically,  information  technology  spending  has been  higher  in the
fourth and second  quarters of each calendar  year,  and somewhat  slower in the
other quarters,  particularly the first quarter. Our quarterly results reflected
this seasonality in 2006, and we anticipate that our quarterly  results for 2007
will show the effects of seasonality as well.

      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,  including  network  storage
      products, 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;

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, 2006, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $6.06 and $9.78 per share and subsequent
to December  31, 2006 the closing  market  price had a high of $11.23 per share.
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;


                                       15


o     changes in market valuations of other technology  companies,  particularly
      those in the network storage 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  ABILITY  TO  FORECAST  EARNINGS  IS  LIMITED  BY THE  IMPACT OF  ACCOUNTING
REQUIREMENTS.

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

THE AMOUNT OF INCOME TAXES WE HAVE TO PAY MAY INCREASE.

      We currently have net operating loss carryforwards which reduce the amount
of income  taxes that we are  required  to pay.  The  availability  of these net
operating  losses are limited.  If we generate  taxable  income in the future in
excess of our ability to utilize our net operating losses,  the amount of income
tax we pay will likely increase significantly.

WE HAVE A SIGNIFICANT  AMOUNT OF AUTHORIZED BUT UNISSUED  PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

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

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

      As of December 31, 2006,  we had an  aggregate of  11,810,975  outstanding
options and  outstanding  restricted  shares and warrants to purchase our common
stock.  The  weighted  average  exercise  price of the  outstanding  options and
warrants is $5.65 per share.  We also have  794,573  shares of our common  stock
reserved  for  issuance  under our stock  plans  with  respect  to  options  (or
restricted stock) that have not been granted.

      The exercise of all of the  outstanding  options and  warrants  and/or the
grant and exercise of additional  options or  restricted  stock would dilute the
then-existing  stockholders' percentage ownership of common stock, and any sales
in the public  market of the common  stock  issuable  upon such  exercise  could
adversely affect  prevailing market prices for the common stock.  Moreover,  the
terms upon which we would be able to obtain  additional  equity capital could be
adversely  affected  because the holders of such  securities  can be expected to
exercise or convert them at a time when we would, in all likelihood,  be able to
obtain any needed  capital on terms more  favorable  than those provided by such
securities.


                                       16


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

      Any   interruption  in  power  supply  or   telecommunications   would  be
particularly   disruptive  to  our  PrimeVault   backup  and  disaster  recovery
operations.  If PrimeVault customers are unable to access their data, confidence
in our ability to provide disaster  recovery and backup services will be damaged
which  will  impair  our  ability  to  retain  existing  customers,  to gain new
customers and to expand our operations.

      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.

UNITED STATES  GOVERNMENT EXPORT  RESTRICTIONS  COULD IMPEDE OUR ABILITY TO SELL
OUR SOFTWARE TO CERTAIN END USERS.

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

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

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

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

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

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 six
patents  issued,  we have received a notice of allowance for one patent,  and we
have multiple pending patent  applications,  numerous trademarks  registered and
multiple  pending  trademark  applications  related to our  products.  We cannot
predict  whether  we will  receive  patents  for our  pending  or future  patent
applications,  and  any  patents  that we own or that  are  issued  to us may be
invalidated,  circumvented  or  challenged.  In  addition,  the laws of  certain
countries  in which we sell and  manufacture  our  products,  including  various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.

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


                                       17


OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.

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

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

            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,
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.


                                       18


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 1B. UNRESOLVED STAFF COMMENTS

None

ITEM 2. PROPERTIES

FalconStor's  headquarters  are located in an  approximately  45,000 square foot
facility located in Melville, New York. Offices are also leased for development,
sales and marketing personnel,  which total an aggregate of approximately 44,000
square feet in Le Chesnay,  France;  Taipei and Taichung,  Taiwan; Tokyo, Japan;
Beijing,  Shenzhen and Shanghai,  China;  Munich,  Germany;  Seoul, Korea; Kuala
Lumpur,  Malaysia; and North Sydney,  Australia.  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,  results  of
operations, cash flows or liquidity.

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

None


                                       19


                                     PART II

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

MARKET INFORMATION

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

                                                   2006              2005
                                             --------------    --------------
                                             High      Low     High      Low
                                             -----    -----    -----    -----
     Fourth Quarter                          $8.83    $7.25    $8.02    $5.81
     Third Quarter                           $7.95    $6.06    $6.87    $5.66
     Second Quarter                          $9.25    $6.15    $7.43    $5.23
     First Quarter                           $9.78    $7.54    $9.67    $5.78

HOLDERS OF COMMON STOCK

      We had  approximately 178 holders of record of Common Stock as of February
      21, 2007. 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.

EQUITY COMPENSATION PLAN INFORMATION

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

                                   Number of
                                Securities to be      Weighted -         Number of Securities
                                  Issued upon      Average exercise   Remaining Available for
                                  Exercise of         Price of           Future Issuance Under
                                  Outstanding        Outstanding        Equity Compensation Plans
                                Options, Warrans   Options, Warrants  (Excluding Securities
                                and Rights (1)      and Rights (1)     Reflected in Column (a)(1)
      Plan Category                   (a)                 (b)                    (c)
      -------------             ----------------   -----------------  ---------------------------
      Equity compensation
      plans approved by
      security holders           10,835,975           $     5.62              794,573

      (1) As of December 31, 2006

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


                                       20


          FALCONSTOR SOFTWARE, INC. COMPARATIVE CUMULATIVE TOTAL RETURN

                     ASSUMES $100 INVESTED ON DEC. 31, 2001
                           ASSUMES DIVIDEND REINVESTED
                      FISCAL YEAR ENDING DECEMBER 31, 2006

                                           Fiscal Year Ending
                                           ------------------
                             2001    2002     2003    2004     2005     2006
                             ----    ----     ----    ----     ----     ----
FALCONSTOR SOFTWARE, INC.   100.00   42.83   96.74   105.63    81.57    95.47
COREDATA GROUP INDEX        100.00   68.11   88.07    96.72    96.96   112.58
RUSSELL 3000 INDEX          100.00   77.19   99.37   109.39   114.06   129.80

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

ITEM 6. SELECTED FINANCIAL DATA

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


                                       21


CONSOLIDATED STATEMENTS OF OPERATIONS DATA:

                                                                Year Ended    Year Ended    Year Ended     Year Ended    Year Ended
                                                               December 31,  December 31,  December 31,   December 31,  December 31,
                                                                  2006           2005          2004           2003           2002
                                                                -------------------------------------------------------------------
                                                                               (In thousands, except per share data)
Revenues:
Software license revenue .................................      $ 38,317       $ 29,544      $ 21,488       $ 12,251       $  8,667
Maintenance revenue ......................................        12,475          7,594         4,443          2,473          1,297
Software services and other revenue ......................         4,274          3,826         2,778          2,220            665
                                                                --------       --------      --------       --------       --------
                                                                  55,066         40,964        28,709         16,944         10,629
                                                                --------       --------      --------       --------       --------

Operating expenses:
  Amortization of purchased and capitalized software .....           362            782         1,394          1,394            899
  Cost of maintenance, software services and other revenue         9,048          6,114         4,150          2,580          1,309
  Software development costs .............................        20,022         12,039         9,050          7,068          6,281
  Selling and marketing ..................................        23,713         16,109        14,277         10,967          9,856
  General and administrative .............................         5,828          4,213         5,109          2,878          2,592
  Litigation settlement ..................................           799             --         1,300             --             --
  Lease abandonment charge ...............................            --             --            --            550             --
  Impairment of prepaid royalty ..........................            --             --            --             --            483
                                                                --------       --------      --------       --------       --------
                                                                  59,772         39,257        35,280         25,437         21,420
                                                                --------       --------      --------       --------       --------
    Operating income (loss) ..............................        (4,706)         1,707        (6,571)        (8,493)       (10,791)
                                                                --------       --------      --------       --------       --------

Interest and other income ................................         1,650            705           714          1,122          1,585
Impairment of long-lived assets ..........................            --             --            --             35         (2,300)
                                                                --------       --------      --------       --------       --------

    Income (loss) before income taxes ....................        (3,056)         2,412        (5,857)        (7,336)       (11,506)

Provision for income taxes ...............................           319            119            32             33             37
                                                                --------       --------      --------       --------       --------

    Net income (loss) ....................................      $ (3,375)      $  2,293      $ (5,889)      $ (7,369)      $(11,543)
                                                                ========       ========      ========       ========       ========

Basic net income (loss) per share ........................      $ (0.07)         $ 0.05      $ (0.13)       $ (0.16)       $ (0.26)
                                                                ========       ========      ========       ========       ========

Diluted net income (loss) per share ......................      $ (0.07)         $ 0.05      $ (0.13)       $ (0.16)       $ (0.26)
                                                                ========       ========      ========       ========       ========

Basic weighted average common shares outstanding .........        48,045         47,662        46,967         45,968         45,233
                                                                ========       ========      ========       ========       ========

Diluted weighted average common shares outstanding .......        48,045         50,776        46,967         45,968         45,233
                                                                ========       ========      ========       ========       ========


                                       22


CONSOLIDATED BALANCE SHEET DATA:

                           December 31,  December 31,  December 31,  December 31,  December 31,
                           2006          2005          2004          2003          2002
                           --------------------------------------------------------------------
                                                  (In thousands)
Cash and cash
  equivalents and
  marketable securities    $40,960      $36,631        $33,973       $36,685        $51,102

Working capital             46,934       39,730         36,452        39,527         47,746

Total assets                78,231       63,974         56,074        56,493         64,710

Long-term obligations        3,783        2,316          1,290           396             --

Stockholders' equity        55,043       48,658         46,364        50,556         55,901


                                       23


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

      We were pleased with our continued  revenue  growth in 2006.  Our revenues
for the full year increased to $55.1 million from $41.0 million in 2005. This is
a  thirty-four  percent year over year  increase in revenues.  This increase was
driven by sales of our core products. We reached our revenue target for the year
even though  revenues  from  certain  areas in which we had  anticipated  seeing
growth, such as iSCSI and the SMB/SOHO market, were not significant contributors
to our revenue.  We believe that our ability to grow our revenues by thirty four
percent  even  without  significant  contributions  from these  areas  shows the
strength  of our core  products.  We  believe  we are on the right  track and we
anticipate further revenue growth in 2007.

      We had a net loss of $3.4 million in 2006.  Due to a change in  accounting
rules,  it is difficult to compare this result with results in prior years.  New
accounting  rules that went into effect for us in 2006 required us to include in
our consolidated  financial  statements an expense for the grant date fair value
of share-based compensation for the first time. This expense -- which relates to
stock  options  and  restricted  stock  we  grant  to  employees  as part of our
incentive compensation plan -- totaled $9.4 million in 2006.

      As it has been in the past,  our focus will continue to be on managing our
business with a view towards long-term success and growth. In 2006, we continued
to invest in research and  development and other areas to build on our momentum,
to design new  products,  and to enhance our  existing  products to position the
Company for future growth. We will continue to invest in these areas in 2007 and
we anticipate that our research and development and sales and marketing expenses
will increase in 2007.

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

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

      The key factors we look to for our future business  prospects  continue to
be our sales pipeline,  our ability to establish and 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 scalability 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 2006 compared with the same quarter in 2005.

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


                                       24


      First,  sales by our OEM partners  contribute  to our  revenues.  Overall,
product  licenses to OEMs accounted for  approximately  forty two percent of our
revenues in 2006.  One OEM customer  accounted  for twenty seven  percent of our
revenues.  We  anticipate  that OEMs will account for over forty  percent of our
revenues in 2007.  We expect that at least one OEM will account for at least ten
percent of our revenues in 2007.  Accordingly,  the loss of this customer  would
have a material adverse effect on our business.

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

      In 2006, we renewed and extended our OEM agreement  with EMC  Corporation,
to 2013.  EMC also  launched a new range of products  that  incorporate  our VTL
technology.  In  2006 we also  extended  our  strategic  relationship  with  Sun
Microsystems  by  entering  into  a  joint  development  agreement.  Sun's  next
generation open systems virtual tape solution will incorporate  FalconStor's VTL
technology.  In 2006,  we entered  into OEM  agreements  with  other  companies,
including  companies  in  Asia  and  companies  focused  on the SMB  market,  as
discussed  below.  We also  renewed or extended  agreements  with  existing  OEM
partners. We will continue to seek additional OEM opportunities in the future.

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

      Many  enterprises  look to value added resellers or solution  providers to
assist them in making their information  technology  purchases.  These resellers
typically  review an  enterprise's  needs and suggest a hardware,  software,  or
combined   hardware   and   software   solution  to  fulfill  the   enterprise's
requirements.

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

      In 2006,  we  signed  agreements  with new  resellers  worldwide.  We also
terminated  relationships  with  resellers  who we  believed  were not  properly
selling  our  products.  We will  continue  to  enter  into  relationships  with
resellers and to discontinue  relationships  with resellers with whom we are not
satisfied.

      Our deferred revenues consist primarily of amounts  attributable to future
support and  maintenance  of our products.  The level of deferred  revenue is an
important indicator of our success.  Maintenance and support for our products is
sold for fixed periods of time. Maintenance and support agreements are typically
for one year,  although some  agreements are for terms in excess of one year. If
we do not deliver the support  needed by end users of our products or by our OEM
partners and resellers,  then they will not renew their  maintenance and support
agreements. If end users stop using our products, they also will not renew their
maintenance  and support  agreements.  An increase  in  deferred  revenues  thus
indicates  growth in our installed base and end user and OEM  satisfaction  with
our products and our  maintenance  and support  services.  Our deferred  revenue
increased to $15.1  million as of December 31, 2006,  compared with $9.6 million
as of December 31, 2005. We expect deferred revenue to continue to grow in 2007.

      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


                                       25


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
2006, many end users ordered  additional  copies of our products,  or additional
products or ordered additional  options. If re-orders decline, it would indicate
that future sales might also  decline.  As the  percentage  of our revenues from
OEMs  increases,  our  ability  to gauge  re-orders  decreases  because  our OEM
partners  typically do not provide us with information  identifying the end user
for each order.

      Consolidation  in the  network  storage  market  continued  in  2006.  The
consolidation did not have a significant impact on our revenue.

      The storage  solutions  market  continues  to grow.  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 2007.

      In the fourth  quarter of 2005, we announced the launch of our  PrimeVault
disaster  recovery,  services.  These  services  are  based  on our  IPStor  and
VirtualTape  Library  (VTL)  software and provide a means for us to leverage our
successes with those products to increase our customer base to include end users
who do not have the  resources - either  technical or financial - to undertake a
full  implementation  of our  products.  Initially,  we  intended to offer these
services directly to end users and through  resellers.  In 2006, we modified our
approach to PrimeVault so that we would no longer be the primary provider of the
services.  Instead,  we now license the PrimeVault services to third parties for
resale to end users.  Payment to us is based on either a revenue  share or a fee
based on the amount of storage managed by the third party.  PrimeVault  services
did not provide  significant  revenue in 2006,  but we anticipate an increase in
revenue in 2007.

      In 2005  and  the  beginning  of  2006,  we  launched  initiatives  in the
small/medium  business (SMB) and small  office/home  office (SOHO)  markets.  In
early 2006, we signed an OEM agreement with a leading  computer,  networking and
communications  products  manufacturer to offer an entry-level  data storage and
protection  appliance,  powered  by a version  of IPStor  optimized  to run on a
System-on-Chip  ("SOC")  platform  ("IPStor  Express"),  targeting  the SMB/SOHO
market.  Shortly  after the launch of the  product,  the OEM partner  announce a
major  strategic  review  of its  operations  and  decided  to  scale  back  its
commitment  to this  product  line.  As a result  of this  change  in  strategy,
revenues  from our SMB/SOHO  product line were lower than  expected and were not
significant.  We  continue  to believe  that these  non-enterprise  markets  are
another growth area for storage  software and in 2006 we signed  agreements with
OEM companies,  both in the United States and abroad, whose product lines target
these  markets.  While we  expect  revenue  growth  in 2007  from  our  SMB/SOHO
products,  it is too early to estimate  whether revenues from these markets will
be significant contributors to our revenues in 2007.

      Another area of focus for us in 2006,  and one that will remain an area of
focus in 2007,  was the China  market.  In 2006,  we signed  an  agreement  with
Hangzhou  Huawei-3Com  Technology Co. Ltd, a leading global  manufacturer  of IP
network solutions,  to expand our strategic partnership in IP Network Storage to
include joint R&D  activities in China and a  multi-year,  multi-million  dollar
commitment. In 2006, we also signed an OEM agreement with a Chinese company that
is a leader in  telecommunications  networks.  In early 2007,  we signed a joint
development and research agreement with the Computer Network Information Center,
Chinese  Academy of Sciences  (CNIC,  CAS) to establish a laboratory  to develop
data  protection  and  remote  disaster  recovery   solutions  for  the  Chinese
government  and  enterprises  with the goal of  providing  our  PrimeVault  data
protection services throughout China.

      As we had anticipated,  we saw the greatest  increase in revenues from our
VirtualTape  Library  software.  We  expect  this  growth  to  continue,  if not
accelerate,  in 2007,  as our OEM  partners  introduce  new  products  and as we
introduce  additional features and functionality for the product.  The continued
decline in prices for disk storage,  and the continuing  need for rapid back up,
disaster recovery and regulatory compliance, should contribute to this growth.

      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 software support, sales
and marketing, and general and administrative functions.


                                       26


      Our gross margins for 2006 were 83%. Due to the change in accounting rules
regarding  share-based  compensation (as discussed  above), a direct  comparison
with our gross margins in 2005 is not meaningful. The impact of the equity-based
compensation  expense on gross margin in 2006 was  equivalent  to 2%. We believe
that our  gross  margin  in 2006  demonstrates  that we were  successful  in our
ability to scale our business.

      We believe the change in  accounting  rules also makes any  comparison  of
expenses in 2006 and 2005 not meaningful.  Nonetheless,  we are pleased with our
ability to contain  the  increase of  expenses  in 2006.  Excluding  share-based
compensation  expense,  our expenses grew at a lower rate than our revenues.  We
will continue to invest in infrastructure  and personnel to maintain and enhance
our leading edge designs and to support our  customers,  but we will continue to
do so in a controlled, cost-effective manner.

      One additional factor that we expect to continue 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 reflected this seasonality in 2006, and we anticipate that our quarterly
results for 2007 will show the effects of seasonality as well.

      As discussed  above,  the new  accounting  rules  relating to  share-based
compensation  expense had a negative impact on our earnings in 2006. Both before
the rules  became  effective,  and during  2006,  we  weighed  the impact of the
changes  on  our  consolidated   financial  statements  against  the  impact  of
discontinuing the grant of equity-based compensation to our worldwide workforce.
We decided that we will  continue to apply the criteria and the  methodology  we
have used in the past to determine grants of stock options or other equity-based
compensation to our employees. We believe that the opportunity to participate in
the growth of our  Company is an  important  motivating  factor for our  current
employees and a valuable  recruiting tool for new employees.  For the management
of our business and the review of our progress,  we will continue to look to our
results  before  share-based  compensation  expense.  We will use these non-GAAP
financial  measures  in making  operating  decisions  because  they  measure the
results of our day to day operations and because they provide a more  consistent
basis for evaluating and comparing our results across different periods.

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

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

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


                                       27


      Consistent  with the  provisions  of  Statement  of  Financial  Accounting
Standards No. 109, we regularly  estimate our ability to recover deferred income
taxes,  and  report  such  assets  at  the  amount  that  is  determined  to  be
more-likely-than-not  recoverable.  This evaluation  considers  several factors,
including an estimate of the likelihood of generating  sufficient taxable income
in future  periods  over  which  temporary  differences  reverse,  the  expected
reversal of deferred tax  liabilities,  past and projected  taxable income,  and
available tax planning strategies. As of December 31, 2006, based primarily upon
our  cumulative  losses,  a valuation  allowance has been  recorded  against our
deferred tax assets.  In the event that evidence becomes available in the future
to indicate that our deferred  taxes will likely be recoverable  (e.g.,  taxable
income  generated  in and  projected  for future  periods),  our estimate of the
recoverability of deferred taxes may change, resulting in a reversal of all or a
portion of such valuation allowance.

RESULTS OF  OPERATIONS - FOR THE YEAR ENDED  DECEMBER  31, 2006  COMPARED TO THE
YEAR ENDED DECEMBER 31, 2005

      Revenues  for the year ended  December  31,  2006  increased  34% to $55.1
million  compared with $41.0 million for the year ended  December 31, 2005.  Our
operating  expenses increased 52% from $39.3 million in 2005 to $59.8 million in
2006.  Included in our operating  expenses for the year ended  December 31, 2006
was $9.4 million of  share-based  payment  compensation  expense  related to the
implementation  of SFAS No. 123(R) beginning January 1, 2006. For the year ended
December 31, 2005,  there was  insignificant  share-based  payment  compensation
expense. Net loss for the year ended December 31, 2006 was $3.4 million compared
with net  income of $2.3  million  for the year ended  December  31,  2005.  The
increase in revenues was mainly due to an increase in (i) demand for our network
storage  solution  software  (ii)  maintenance  revenue  from  new and  existing
customers  and  (iii)  sales  from  our  resellers  and  OEM  partners.  Revenue
contribution  from our OEM  partners  increased  in  absolute  dollars  and as a
percentage  of our total revenue for the year ended  December 31, 2006.  Revenue
from resellers and  distributors  also increased in absolute  dollars.  Expenses
increased  in all aspects of our  business  to support our growth.  For the year
ended  December 31, 2006,  we increased the number of employees and continued to
invest in our infrastructure by purchasing  additional  computers and equipment.
We increased the number of employees  from 279 as of December 31, 2005 to 340 as
of December  31, 2006.  Included in our results for the year ended  December 31,
2006 is a litigation  settlement charge of $0.8 million relating to a contingent
purchase price dispute associated with an acquisition we made in 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 sometimes receive  nonrefundable royalty advances
and  engineering  fees from some of our OEM  partners.  These  arrangements  are
evidenced by a signed customer contract,  and the revenue is recognized when the
software product master is delivered and accepted, and the engineering services,
if any, have been performed.

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


                                       28


from  engineering  services  is  recognized  in  the  period  the  services  are
completed. In 2006 and 2005, 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 our  customer.  A  portion  of  the  contractual  fees  is
recognized as revenue when the hardware or software is delivered to the customer
based on the  relative  fair  value of the  delivered  element(s).  Maintenance,
software  services and other revenue increased 47% to $16.7 million in 2006 from
$11.4 million in 2005.

      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 $7.6  million for the year ended  December  31, 2005 to
$12.5 million for the year ended December 31, 2006.  Software services and other
revenue  increased  from  $3.8  million  in 2005 to $4.3  million  in 2006.  The
increase in software  services and other revenue was partially  attributable  to
our hardware sales which  increased from $2.3 million in 2005 to $2.6 million in
2006.  This  increase was the result of an increase in demand from our customers
for  bundled  solutions.  Growth  in  our  professional  services  sales,  which
increased from $1.5 million in 2005 to $1.7 million in 2006, also contributed to
the  increase  in  software  services  and  other  revenues.  This  increase  in
professional  services  revenue  was  related to the  increase  in our  software
license  customers  who elected to  purchase  professional  services.  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, 2006 and 2005,  we had $5.2 million and $5.0  million,
respectively, of purchased software licenses that are being amortized over three
years.  For the year ended  December  31,  2006,  we  recorded  $0.4  million of
amortization  related to these purchased software  licenses.  For the year ended
December 31, 2005,  we recorded  $0.8 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.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Cost  of  maintenance,  software  services  and  other  revenues  consists
primarily of personnel  costs,  other costs  associated with providing  software
implementations, technical support under maintenance contracts and training, and
share-based payment  compensation  expense associated with the implementation of
SFAS No. 123(R). Cost of maintenance,  software services and other revenues also
includes the cost of hardware  that was resold.  Cost of  maintenance,  software
services and other  revenues for the year ended  December 31, 2006  increased by
48% to $9.0 million  compared with $6.1 million for the year ended  December 31,
2005. The increase in cost of maintenance,  software  services and other revenue
was partially due to $1.3 million of share-based payment  compensation  expense.
There  was no  share-based  payment  compensation  expense  included  in cost of
maintenance, software services and other revenue for the year ended December 31,
2005.  Additionally,  cost of maintenance,  software  services and other revenue
increased due to an increase in personnel. As a result of our increased sales of
maintenance and support contracts and professional services, we hired additional
employees  to  provide   technical   support  and  to  implement  our  software.
Additionally,  due to an increase in hardware  sales,  our  associated  hardware
costs  increased  from $1.5 million for the year ended December 31, 2005 to $1.8
million for the year ended December 31, 2006. 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, 2006 was $45.7 million or 83%
of revenues  compared  with $34.1  million or 83% of revenues for the year ended
December 31, 2005.  Gross margin  remained  consistent  despite the inclusion of
share-based payment  compensation  expense in the cost of maintenance,  software
services and other  revenue for the year ended  December  31, 2006.  Share-based
payment  compensation  expense  was equal to 2% of  revenue  for the year  ended
December 31, 2006.


                                       29


SOFTWARE DEVELOPMENT COSTS

      Software  development  costs  consist  primarily  of  personnel  costs for
product  development   personnel,   share-based  payment   compensation  expense
associated with the implementation of SFAS No. 123(R), and costs associated with
the  development of new products,  enhancements  to existing  products,  quality
assurance and testing. Software development costs increased 66% to $20.0 million
in 2006  from  $12.0  million  in 2005.  The  major  contributing  factor to the
increase in software  development costs was $4.3 million of share-based  payment
compensation  expense.  There was no share-based  payment  compensation  expense
included in software development costs for the year ended December 31, 2005. The
increase is also 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,  we required additional employees to test and
integrate our software with our OEM  partners'  products.  We intend to continue
recruiting  and hiring  product  development  personnel  to support our software
development process.

SELLING AND MARKETING

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

GENERAL AND ADMINISTRATIVE

      General and  administrative  expenses consist primarily of personnel costs
of  general  and  administrative  functions,  share-based  payment  compensation
expense  associated with the  implementation of SFAS No. 123(R),  public company
related costs, directors and officers insurance, legal and professional fees and
other general  corporate  overhead costs.  General and  administrative  expenses
increased  38% to $5.8  million  in 2006 from $4.2  million  in 2005.  The major
contributing  factor to the increase in general and administrative  expenses was
$0.9  million  of  share-based  payment  compensation  expense.   There  was  no
share-based payment  compensation expense included in general and administrative
expense for the year ended December 31, 2005.  Additionally,  as our revenue and
number of employees increase,  our legal and professional fees and other general
corporate overheard costs have increased and are likely to continue to increase.

LITIGATION SETTLEMENT CHARGE

      In January  2007,  we  resolved  claims  brought  against us by two former
shareholders of IP Metrics, Inc. ("IP Metrics"). When we purchased IP Metrics in
July 2002, part of the contractual consideration was payments to be made in 2003
and 2004 to the  former IP  Metrics  shareholders  based on sales of IP  Metrics
products and/or payments to be made if certain events occurred. We made payments
to all four former shareholders in 2003 and 2004. Two of the former shareholders
alleged  that they were  entitled to  additional  payments  based on the alleged
occurrence of certain  contingent  events and they brought an action against us.
This action was resolved in January, 2007 without any admission of liability, by
the payment of an additional $0.8 million to the two former  shareholders.  This
amount was recorded as an operating  expense as of December 31, 2006. All claims
in the lawsuit have 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
increased to $1.7 million for the year ended  December  31, 2006  compared  with
$0.7 million for the year ended  December 31, 2005.  This  increase is primarily
due to a higher average cash balance and higher interest rates.


                                       30


INCOME TAXES

      We did not record a tax benefit  associated with our pre-tax loss incurred
for the year ended  December 31, 2006, as we deemed that it was  uncertain  that
the related deferred tax assets would be realized based on our cumulative losses
incurred since inception and our limited period of  profitability.  For the year
ended  December  31,  2005,  our  pre-tax  income  was  substantially  offset by
available  net  operating  losses.  Our income tax  provision  for 2006 and 2005
consists of taxes related to alternative  minimum taxes, state income taxes, and
taxes from our foreign  subsidiaries.  In 2007, in the event that we continue to
generate   taxable   income   and   our   forecasts    indicate   that   it   is
more-likely-than-not  that we will  recover a portion of our deferred tax assets
in the  future,  we will  likely  reverse a portion  of our  deferred  tax asset
valuation allowance.

RESULTS OF  OPERATIONS - FOR THE YEAR ENDED  DECEMBER  31, 2005  COMPARED TO THE
YEAR ENDED DECEMBER 31, 2004

REVENUES

SOFTWARE LICENSE REVENUE

      Software license revenue increased 37% to $29.5 million in 2005 from $21.5
million in 2004.  Increased  market  acceptance  and demand for our  product and
increased  sales from our OEM partners 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.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Maintenance,  software  services and other revenue  increased 58% to $11.4
million in 2005 from $7.2 million in 2004.  The major factor behind 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 $4.4 million for
the year ended December 31, 2004 to $7.6 million for the year ended December 31,
2005. Software services and other revenue increased from $2.8 million in 2004 to
$3.8 million in 2005.  The increase in software  services and other  revenue was
partially  attributable  to our hardware sales which increased from $1.5 million
in 2004 to $2.3 million in 2005.  This increase was the result of an increase in
demand from our  customers  for bundled  solutions.  Growth in our  professional
services  sales,  which  increased  from $1.3 million in 2004 to $1.5 million in
2005, also contributed to the increase in software  services and other revenues.
This increase in  professional  services  revenue was related to the increase in
our software license customers who elected to purchase professional services.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

      As of December 31, 2005 and 2004,  we had $5.0  million and $4.9  million,
respectively, of purchased software licenses that are being amortized over three
years.  For the year ended  December  31,  2005,  we  recorded  $0.8  million of
amortization  related to these purchased software  licenses.  For the year ended
December 31, 2004 amortization was $1.4 million.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Cost of  maintenance,  software  services and other  revenues for the year
ended  December 31, 2005  increased by 47% to $6.1  million  compared  with $4.2
million  for  the  year  ended  December  31,  2004.  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 hired additional  employees to
provide technical support and to implement our software. Additionally, due to an
increase in hardware  sales,  our associated  hardware costs increased from $1.0
million for the year ended  December 31, 2004 to $1.5 million for the year ended
December 31, 2005.


                                       31


      Gross profit for the year ended December 31, 2005 was $34.1 million or 83%
of revenues  compared  with $23.2  million or 81% of revenues for the year ended
December  31,  2004.  The increase in gross profit and gross margin was directly
related to the increase in revenues.  Additionally,  the increased percentage of
revenue  from our OEM  partners  in 2005  contributed  to the  increase in gross
margins  since  revenues  from our OEM  partners  typically  have  higher  gross
margins.

SOFTWARE DEVELOPMENT COSTS

      Software  development  costs  increased  33% to $12.0 million in 2005 from
$9.1 million in 2004. 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, we required additional employees to test and integrate our
software with our OEM partners' products.

SELLING AND MARKETING

      Selling and marketing expenses increased 13% to $16.1 million in 2005 from
$14.3  million in 2004.  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 decreased 18% to $4.2 million in 2005
from $5.1 million in 2004.  The overall  decrease in general and  administrative
expenses was primarily due to a decrease in legal  expenses.  For the year ended
December  31,  2004 we had  $1.0  million  in  legal  expenses  attributable  to
litigation related to alleged patent infringement.

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

      Interest and other income  remained  consistent at $0.7 million.  Interest
income  increased from $0.7 million to $1.0 million due to a higher average cash
balance and slightly  higher interest  rates.  Additionally,  interest and other
income for the year ended December 31, 2005, includes an out-of-period charge of
approximately  $0.2 million to  recognize  investment  losses  realized in prior
years.

INCOME TAXES

      For the year ended December 31, 2005, our pre-tax income was substantially
offset by available net operating losses.  For the year ended December 31, 2004,
we did not record a tax benefit associated with the pre-tax loss incurred, as we
deemed that it was  uncertain  that the  related  deferred  tax assets  would be
realized based on our cumulative losses incurred since inception and our limited
period of  profitability.  Accordingly,  we provided a full valuation  allowance
against our net deferred tax assets.  Our income tax provision for 2005 and 2004
consists of tax expenses  related to  alternative  minimum  taxes,  state income
taxes, and taxes from our foreign subsidiaries.

LIQUIDITY AND CAPITAL RESOURCES

      Our total cash and cash equivalents and marketable  securities  balance as
of December 31, 2006 increased by $4.3 million  compared with December 31, 2005.
Our cash and cash  equivalents  totaled $15.6 million and marketable  securities
totaled  $25.4  million at December  31, 2006.  As of December 31, 2005,  we had
$18.8  million in cash and cash  equivalents  and $17.8  million  in  marketable
securities.


                                       32


      In  2006,  we  made  investments  in our  infrastructure  to  support  our
long-term  growth.  We increased  the total number of employees in 2006 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.

      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.  In 2006, we recorded a
litigation  settlement expense of $0.8 million relating to a contingent purchase
price dispute with two former  shareholders  of IP Metrics.  This settlement was
paid out in the first quarter of 2007.

      In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding  common stock. Since October 2001, 865,200
shares have been  repurchased  at an  aggregate  purchase  price of $5.8 million
including 315,600 shares  repurchased in 2006 at an aggregate  purchase price of
$2.1 million.

      Net cash  provided by  operating  activities  totaled $8.2 million for the
year ended  December  31,  2006,  compared  with net cash  provided by operating
activities  of $6.5  million for the year ended  December  31, 2005 and net cash
used in operating  activities  of $1.1  million for the year ended  December 31,
2004.  The increase in net cash provided by operating  activities  was primarily
due to an increase in non-cash  charges of $9.4 million  related to  share-based
payment  compensation  expense.  There was  insiginificant  share-based  payment
compensation  expense  for the years  ended  December  31,  2005 and 2004.  Also
contributing to the increase in net cash provided by operating activities was an
increase in our deferred revenues, which increased to $5.5 million compared with
$4.2  million  in 2005 and $2.8  million  in 2004,  as well as, an  increase  in
accrued expenses and other  liabilities which increased to $2.0 million compared
with $1.1 million in 2005 and $0.8 million in 2004. These amounts were partially
offset by increases in our net accounts  receivable  balances of $8.9 million in
2006,  $4.9  million in 2005 and $3.2  million  in 2004.  The  increases  in our
accounts receivable balances are due to our continued revenue growth.

      Net cash used in investing  activities  was $11.8 million in 2006 compared
with net cash used in investing  activities of $2.8 million in 2005 and net cash
provided by investing  activities of $6.3 million in 2004. Included in investing
activities  for  each  year  are  the  sales  and  purchases  of our  marketable
securities.  These  represent  the  sales,  maturities  and  reinvesting  of our
marketable  securities.  The net cash used in investing  activities from the net
purchase of  securities  was $7.5  million in 2006 and the net cash  provided by
investing  activities  from the net sale of securities was $0.6 million for 2005
and $9.5  million  in 2004.  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 $3.7 million,  $3.2 million and $2.8 million
in 2006,  2005  and  2004,  respectively.  The cash  used to  purchase  software
licenses  was $0.2  million in 2006 and $0.1  million in both 2005 and 2004.  We
continually  evaluate  potential  software  licenses and we may continue to make
similar investments if we find opportunities that would benefit our business.

      Net cash  provided  by  financing  activities  was $0.4  million  in 2006,
$24,385  in 2005,  and $1.8  million  in 2004.  We  received  proceeds  from the
exercise of stock options of $2.5 million in 2006, $1.9 million in 2005 and $2.0
million in 2004. We made payments of $2.1 million in 2006,  $1.9 million in 2005
and $0.3 million in 2004 to acquire treasury stock.

      The Company's only significant commitments relate to its operating leases.
The Company has an operating  lease  covering its primary  office  facility that
expires in February, 2012. The Company also has several operating leases related
to offices in foreign  countries.  The  expiration  dates for these leases range
from 2007 through  2012.  The  following is a schedule of future  minimum  lease
payments for all operating leases as of December 31, 2006:


                                       33


Year ending december 31

2007.............................................................     $1,875,673
2008.............................................................      1,372,384
2009.............................................................      1,365,163
2010.............................................................      1,331,877
2011.............................................................      1,367,538
Thereafter.......................................................        708,120
                                                                      ----------
                                                                      $8,020,755
                                                                      ==========

      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 September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR
DEFINED  BENEFIT PENSION AND OTHER  POSTRETIREMENT  PLANS - an amendment of FASB
Statements  No. 87, 88, 106 and 132(R)  ("SFAS  158").  SFAS 158  requires  that
employers recognize the funded status of their defined benefit pension and other
postretirement  plans on their  consolidated  balance  sheet and  recognize as a
component  of other  comprehensive  income,  net of tax, the gains or losses and
prior  service  costs or  credits  that  arise  during  the  period  but are not
recognized  as  components  of net  periodic  benefit  cost.  SFAS No.  158 also
requires  additional  disclosures  in the  notes to  financial  statements.  The
Company  adopted SFAS No. 158,  effective  December  31,  2006,  and recorded an
adjustment to accumulated other comprehensive income.

      In September  2006, the FASB issued SFAS No. 157, FAIR VALUE  MEASUREMENTS
("SFAS 157"),  which  defines fair value,  establishes a framework for measuring
fair value and expands the related disclosure requirements. Adoption is required
as of the  beginning  of the first  fiscal year that begins  after  November 15,
2007. SFAS No. 157 applies under other accounting pronouncements that require or
permit  fair  value  measurements  and  does  not  require  any new  fair  value
measurements. Management is evaluating the impact the adoption of this statement
will have on the Company's consolidated financial statements.

      In September 2006, the SEC issued Staff  Accounting  Bulletin  ("SAB") No.
108,  CONSIDERING  THE  EFFECTS OF PRIOR  YEAR  MISSTATEMENTS  WHEN  QUANTIFYING
MISSTATEMENTS  IN CURRENT YEAR FINANCIAL  STATEMENTS  ("SAB No. 108") to provide
guidance  on the  consideration  of the effects of prior year  misstatements  in
quantifying  current  year  misstatements  for  the  purpose  of  a  materiality
assessment. Under SAB No. 108, companies should evaluate a misstatement based on
its impact on the  current  year  income  statement,  as well as the  cumulative
effect of correcting such  misstatements that existed in prior years existing in
the current year's ending balance sheet. The Company adopted SAB No. 108 for the
year  ended  December  31,  2006 with no impact  to the  Company's  consolidated
financial statements.

      In June  2006,  the  FASB  issued  FASB  Interpretation  No.  ("FIN")  48,
ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES - an  Interpretation of SFAS No. 109,
which clarifies the accounting for uncertainty in income taxes recognized in the
financial  statements in  accordance  with SFAS No. 109,  ACCOUNTING  FOR INCOME
TAXES. FIN 48 prescribes a recognition  threshold and measurement  attribute for
the financial  statement  recognition and measurement of a tax position taken or
expected  to be  taken  in a tax  return.  Any  change  in  the  net  assets  or
liabilities recognized as a result of adopting the provisions of FIN 48 would be
recorded as an adjustment to the opening balance of retained earnings. FIN 48 is
effective  for the  Company  as of  January 1,  2007.  Management  is  currently
evaluating the impact, if any, the adoption of FIN 48 will have on the Company's
consolidated financial statements.

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities which aggregated to $41.0 million as of December 31, 2006,
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.


                                       34


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.

We do not believe that our results would be materially  affected by a 10% change
in interest or foreign exchange rates.

                                       35


ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

                                                                            Page

Reports of Independent Registered Public Accounting Firm .................... 37

Consolidated Balance Sheets as of December 31, 2006 and 2005 ................ 39

Consolidated Statements of Operations for the years ended
  December 31, 2006, 2005 and 2004 .......................................... 40

Consolidated Statements of Stockholders' Equity and Comprehensive
  Income (Loss) for the years Ended December 31, 2006, 2005 and 2004 ........ 41

Consolidated Statements of Cash Flows for the years ended
  December 31, 2006, 2005 and 2004 .......................................... 42

Notes to Consolidated Financial Statements................................... 43


                                       36


             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,  2006 and 2005,  and the
related  consolidated   statements  of  operations,   stockholders'  equity  and
comprehensive  income  (loss),  and  cash  flows  for  each of the  years in the
three-year  period  ended  December  31,  2006.  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, 2006 and 2005, and the results of their
operations and their cash flows for each of the years in the  three-year  period
ended December 31, 2006, in conformity with U.S. generally  accepted  accounting
principles.

As discussed  in Notes 1 (k) and 8 to the  accompanying  consolidated  financial
statements,  the Company adopted Statement of Financial Accounting Standards No.
123 (Revised 2004), "SHARED-BASED PAYMENT", as of January 1, 2006.

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,
2006, 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 14, 2007,  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 14, 2007


                                       37


             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, 2006,  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 (i) pertain to
the  maintenance  of records that, in reasonable  detail,  accurately and fairly
reflect the  transactions  and  dispositions of the assets of the company;  (ii)
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 (iii) 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, 2006,  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, 2006,  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,  2006 and 2005,  and the  related  consolidated
statements of operations,  stockholders' equity and comprehensive income (loss),
and cash flows for each of the years in the three-year period ended December 31,
2006, and our report,  dated March 14, 2007, expressed an unqualified opinion on
those consolidated financial statements. As discussed in our report, dated March
14,  2007,  the  Company  adopted  the  provisions  of  Statement  of  Financial
Accounting  Standards  No. 123 (Revised  2004),  "SHARED-BASED  PAYMENT",  as of
January 1, 2006.


                                                                    /s/ KPMG LLP

Melville, New York
March 14, 2007


                                       38


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS

                                                                                                            DECEMBER 31,
                                                                                                      2006                 2005
                                                                                                  ------------         ------------
                                    Assets

Current assets:
  Cash and cash equivalents ..............................................................        $ 15,605,329         $ 18,796,973
  Marketable securities ..................................................................          25,354,259           17,833,683
  Accounts receivable, net of allowances of $6,016,298 and
    $3,846,882, respectively .............................................................          24,134,257           15,187,408
  Prepaid expenses and other current assets ..............................................           1,244,937              911,715
                                                                                                  ------------         ------------

      Total current assets ...............................................................          66,338,782           52,729,779

Property and equipment, net of accumulated depreciation of
  $10,221,780 and $7,150,762, respectively ...............................................           5,960,317            5,277,609
Goodwill .................................................................................           3,512,796            3,512,796
Other intangible assets, net .............................................................             407,316              216,864
Other assets, net ........................................................................           2,011,433            2,236,725
                                                                                                  ------------         ------------

    Total assets .........................................................................        $ 78,230,644         $ 63,973,773
                                                                                                  ============         ============

                      Liabilities and Stockholders' Equity
Current liabilities:
  Accounts payable .......................................................................        $  1,432,510         $  1,152,228
  Accrued expenses .......................................................................           6,505,536            4,446,559
  Deferred revenue .......................................................................          11,466,552            7,401,018
                                                                                                  ------------         ------------

    Total current liabilities ............................................................          19,404,598           12,999,805

Other long-term liabilities ..............................................................             137,317               75,653
Deferred revenue .........................................................................           3,645,482            2,240,208
                                                                                                  ------------         ------------
    Total liabilities ....................................................................          23,187,397           15,315,666
                                                                                                  ------------         ------------

Commitments and Contingencies

Stockholders' equity:
  Preferred stock - $.001 par value, 2,000,000 shares authorized, none issued ............                  --                   --
    Common stock - $.001 par value, 100,000,000 shares authorized,
      49,085,539 and 48,441,614 shares issued, respectively and 48,220,339
      and 47,892,014 shares outstanding, respectively.....................................              49,086               48,442
  Additional paid-in capital .............................................................          99,282,308           87,342,747
  Accumulated deficit ....................................................................         (38,033,857)         (34,659,329)
  Common stock held in treasury, at cost (865,200 and 549,600 shares,
   respectively)..........................................................................          (5,780,163)          (3,632,930)
  Accumulated other comprehensive loss, net ..............................................            (474,127)            (440,823)
                                                                                                  ------------         ------------

      Total stockholders' equity .........................................................          55,043,247           48,658,107
                                                                                                  ------------         ------------
      Total liabilities and stockholders' equity .........................................        $ 78,230,644         $ 63,973,773
                                                                                                  ============         ============

          See accompanying notes to consolidated financial statements.


                                       39


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                                                          Years Ended December 31,

                                                                              2006                   2005                  2004
                                                                          ---------------------------------------------------------
Revenues:
  Software license revenue .....................................          $ 38,317,352           $ 29,544,467          $ 21,487,866
  Maintenance revenue ..........................................            12,475,342              7,593,804             4,442,724
  Software services and other revenue ..........................             4,273,334              3,825,832             2,778,088
                                                                          ------------           ------------          ------------
                                                                            55,066,028             40,964,103            28,708,678
                                                                          ------------           ------------          ------------

Operating expenses:
  Amortization of purchased and capitalized
    software ...................................................               362,159                781,500             1,393,908
  Cost of maintenance, software services
    and other revenue ..........................................             9,048,354              6,114,112             4,150,309
  Software development costs ...................................            20,021,899             12,039,488             9,050,092
  Selling and marketing ........................................            23,712,488             16,109,440            14,277,167
  General and administrative ...................................             5,828,150              4,212,769             5,108,516
  Litigation settlement ........................................               799,317                     --             1,300,000
                                                                          ------------           ------------          ------------
                                                                            59,772,367             39,257,309            35,279,992
                                                                          ------------           ------------          ------------
      Operating income (loss) ..................................            (4,706,339)             1,706,794            (6,571,314)
                                                                          ------------           ------------          ------------

Interest and other income, net .................................             1,650,284                705,063               714,412
                                                                          ------------           ------------          ------------

      Income (loss) before income taxes ........................            (3,056,055)             2,411,857            (5,856,902)

Provision for income taxes .....................................               318,473                118,750                31,945
                                                                          ------------           ------------          ------------

      Net income (loss) ........................................          $ (3,374,528)          $  2,293,107          $ (5,888,847)
                                                                          ------------           ------------          ------------

Basic net income (loss) per share ..............................              $ (0.07)                 $ 0.05              $ (0.13)
                                                                          ============           ============          ============

Diluted net income (loss) per share ............................              $ (0.07)                 $ 0.05              $ (0.13)
                                                                          ============           ============          ============

Basic weighted average common shares
  outstanding ..................................................            48,044,946             47,662,446            46,967,422
                                                                          ============           ============          ============

Diluted weighted average common shares
  outstanding ..................................................            48,044,946             50,776,396            46,967,422
                                                                          ============           ============          ============

          See accompanying notes to consolidated financial statements.


                                       40


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

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

                                                                              Additional           Deferred
                                                            Common              paid-in             compen-            Accumulated
                                                            stock               capital             sation               deficit
                                                         ------------        ------------         ------------         ------------
Balance, December 31, 2003                               $     46,745        $ 83,277,981         $     (7,969)        $(31,063,589)

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                                      --                  --                   --                   --

Change in unrealized losses on
  marketable securities, net                                       --                  --                   --                   --

Foreign currency translation
  adjustment                                                       --                  --                   --                   --
                                                         ------------        ------------         ------------         ------------

Balance, December 31, 2004                               $     47,769        $ 85,400,740         $         --         $(36,952,436)

Issuance of stock options to
  non-employees                                                    --             (32,860)                  --                   --

Exercise of stock options, including
  tax benefit                                                     673           1,974,867                   --                   --

Net income                                                         --                  --                   --            2,293,107

Acquisition of treasury stock                                      --                  --                   --                   --

Change in unrealized losses on
  marketable securities, net                                       --                  --                   --                   --

Foreign currency translation
  adjustment                                                       --                  --                   --                   --
                                                         ------------        ------------         ------------         ------------

Balance, December 31, 2005                               $     48,442        $ 87,342,747         $         --         $(34,659,329)

Exercise of stock options, including
  tax benefit                                                     644           2,546,407                   --                   --

Issuance of stock options to
  non-employees                                                    --              17,914                   --                   --

Share-based compensation                                           --           9,375,240                   --                   --

Net loss                                                           --                  --                   --           (3,374,528)

Acquisition of treasury stock                                      --                  --                   --                   --

Adjustment to initially apply SFAS
  No. 158, net of tax (Note 11)                                    --                  --                   --                   --

Change in unrealized losses on
  marketable securities, net                                       --                  --                   --                   --

Foreign currency translation
  adjustment                                                       --                  --                   --                   --
                                                         ------------        ------------         ------------         ------------

Balance, December 31, 2006                               $     49,086        $ 99,282,308         $         --         $(38,033,857)
                                                         ------------        ------------         ------------         ------------


                                                                             Accumulated
                                                                                other
                                                                                compre-
                                                                                hensive              Total                Compre-
                                                           Treasury             income            stockholders'           hensive
                                                             stock              (loss)               equity            income (loss)
                                                         ------------        ------------         ------------         ------------
Balance, December 31, 2003                               $ (1,435,130)       $   (262,489)        $ 50,555,549

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)                 --             (279,645)                  --

Change in unrealized losses on
  marketable securities, net                                       --            (148,849)            (148,849)            (148,849)

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

Balance, December 31, 2004                               $ (1,714,775)       $   (417,348)        $ 46,363,950         $ (6,043,706)
                                                                                                                       ============

Issuance of stock options to
  non-employees                                                    --                  --              (32,860)                  --

Exercise of stock options, including
  tax benefit                                                      --                  --            1,975,540                   --

Net income                                                         --                  --            2,293,107            2,293,107

Acquisition of treasury stock                              (1,918,155)                 --           (1,918,155)                  --

Change in unrealized losses on
  marketable securities, net                                       --             218,523              218,523              218,523

Foreign currency translation
  adjustment                                                       --            (241,998)            (241,998)            (241,998)
                                                         ------------        ------------         ------------         ------------

Balance, December 31, 2005                               $ (3,632,930)       $   (440,823)        $ 48,658,107         $  2,269,632
                                                                                                                       ============

Exercise of stock options, including
  tax benefit                                                      --                  --            2,547,051                   --

Issuance of stock options to
  non-employees                                                    --                  --               17,914                   --

Share-based compensation                                           --                  --            9,375,240

Net loss                                                           --                  --           (3,374,528)          (3,374,528)

Acquisition of treasury stock                              (2,147,233)                 --           (2,147,233)                  --

Adjustment to initially apply SFAS
  No. 158, net of tax (Note 11)                                    --             (87,482)             (87,482)                  --

Change in unrealized losses on
  marketable securities, net                                       --              25,800               25,800               25,800

Foreign currency translation
  adjustment                                                       --              28,378               28,378               28,378
                                                         ------------        ------------         ------------         ------------

Balance, December 31, 2006                               $ (5,780,163)       $   (474,127)        $ 55,043,247         $ (3,320,350)
                                                         ------------        ------------         ------------         ------------

          See accompanying notes to consolidated financial statements.


                                       41


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                                            Years Ended December 31,

                                                                               2006                  2005                  2004
                                                                           --------------------------------------------------------
Cash flows from operating activities:
  Net income (loss) ..............................................         $ (3,374,528)         $  2,293,107          $ (5,888,847)
    Adjustments to reconcile net loss to net cash
      provided by (used in) operating activities:
      Depreciation and amortization ..............................            3,581,451             3,505,562             3,656,212
      Share-based payment employee compensation...................            9,375,240                    --                 7,969
      Non-cash professional services expenses ....................               17,914               (32,860)               87,023
      Realized loss on marketable securities .....................               28,854               270,026                17,795
      Realized gain on sale of cost method
        investment ...............................................               (3,112)                   --                    --
      Realized gain on sale of warrants ..........................              (38,378)                   --                    --
      Tax benefit from stock option exercise .....................              (45,895)               33,000                    --
      Provision for returns and doubtful accounts ................            4,765,148             4,340,102             3,296,275
    Changes in operating assets and liabilities:
      Accounts receivable ........................................          (13,704,152)           (9,274,971)           (6,456,175)
      Prepaid expenses and other current assets ..................             (326,695)             (291,693)              636,208
      Other assets ...............................................              122,098               (50,401)             (251,038)
      Accounts payable ...........................................              254,211               354,471               259,128
      Accrued expenses and other liabilities .....................            2,018,002             1,104,416               791,498
      Deferred revenue ...........................................            5,492,625             4,234,918             2,789,987
                                                                           ------------          ------------          ------------

        Net cash provided by (used in) operating
          activities .............................................            8,162,783             6,485,677            (1,053,965)
                                                                           ------------          ------------          ------------

Cash flows from investing activities:
  Purchase of marketable securities ..............................          (78,776,443)          (61,264,424)          (33,897,295)
  Sale of marketable securities ..................................           71,252,813            61,867,854            43,441,277
  Sale of cost method investment .................................               96,755                    --                    --
  Purchase of cost method investment .............................             (198,117)                   --                    --
  Purchase of warrants ...........................................             (635,000)                   --                    --
  Sale of warrants ...............................................              673,378                    --                    --
  Purchase of property and equipment .............................           (3,693,756)           (3,161,383)           (2,842,792)
  Purchase of software licenses ..................................             (173,431)             (108,000)              (50,000)
  Purchase of intangible assets ..................................             (373,229)             (126,241)             (131,392)
  Net cash paid for acquisition of IP Metrics ....................                   --                    --              (214,009)
  Security deposits ..............................................               (2,062)                   --                (4,500)
                                                                           ------------          ------------          ------------

    Net cash (used in) provided by investing
      activities .................................................          (11,829,092)           (2,792,194)            6,301,289
                                                                           ------------          ------------          ------------

Cash flows from financing activities:
  Proceeds from exercise of stock options ........................            2,501,156             1,942,540             2,036,760
  Payments to acquire treasury stock .............................           (2,147,233)           (1,918,155)             (279,645)
  Tax benefit from stock option exercise .........................               45,895                    --                    --
                                                                           ------------          ------------          ------------

    Net cash provided by financing activities ....................              399,818                24,385             1,757,115
                                                                           ------------          ------------          ------------

Effect of exchange rate changes ..................................               74,847              (405,468)               (6,010)
                                                                           ------------          ------------          ------------

Net increase (decrease) in cash and cash equivalents..............           (3,191,644)            3,312,400             6,998,429


Cash and cash equivalents, beginning of year .....................           18,796,973            15,484,573             8,486,144
                                                                           ------------          ------------          ------------

Cash and cash equivalents, end of year ...........................         $ 15,605,329          $ 18,796,973          $ 15,484,573
                                                                           ============          ============          ============

Cash paid for income taxes .......................................         $     79,501          $     21,583          $     24,554
                                                                           ============          ============          ============

      The Company did not pay any  interest  for the three years ended  December
31, 2006.

          See accompanying notes to consolidated financial statements.


                                       42


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 2006

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(A) THE COMPANY AND NATURE OF OPERATIONS

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

(B) PRINCIPLES OF CONSOLIDATION

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

(C) USE OF ESTIMATES

      The  preparation  of financial  statements  in conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions  that  affect the  reported  amounts of assets and  liabilities  and
disclosure of  contingent  assets and  liabilities  at the date of the financial
statements  and the  reported  amounts  of  revenues  and  expenses  during  the
reporting period. The Company's  significant  estimates include those related to
revenue  recognition,   accounts  receivable  allowances,   share-based  payment
compensation  and deferred income taxes.  Actual results could differ from those
estimates.

(D) CASH EQUIVALENTS AND MARKETABLE SECURITIES

      The Company  considers  all highly liquid  investments  with 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
$11.0  million and $12.4  million at December  31, 2006 and 2005,  respectively.
Marketable  securities  at December 31, 2006 and 2005  amounted to $25.4 million
and $17.8 million,  respectively,  and consisted of corporate bonds,  government
securities and  certificate  of deposits,  which are classified as available for
sale, and accordingly,  unrealized gains and losses on marketable securities are
reflected  as  a  component  of   accumulated   other   comprehensive   loss  in
stockholders' equity.

(E) REVENUE RECOGNITION

      The Company  recognizes  revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE  RECOGNITION.  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.
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,  based upon
historical experience and known or expected trends.

      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.


                                       43


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

      For the years ended  December 31, 2006 and 2005, 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
the software is not essential for the functionality of the equipment included in
the Company's bundled  solutions,  and both the hardware and software have stand
alone value to the customer,  a portion of the contractual fees is recognized as
revenue when the software or hardware is  delivered  based on the relative  fair
value of the delivered element(s).

(F) PROPERTY AND EQUIPMENT

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

(G) GOODWILL AND OTHER INTANGIBLE ASSETS

      Goodwill  represents  the excess of the purchase  price over the estimated
fair value of net  tangible  and  identifiable  intangible  assets  acquired  in
business  combinations.   Consistent  with  Statement  of  Financial  Accounting
Standards  ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE  ASSETS, the Company does
not  amortize  goodwill,  but has  instead  tested the  balance  for  impairment
annually on December 31st of each year, and more frequently if events or changes
in circumstances indicate that goodwill may be impaired. Identifiable intangible
assets are amortized over a three-year  period using the  straight-line  method.
Amortization  expense was  $182,777,  $216,997 and  $220,712 for 2006,  2005 and
2004,  respectively.  The gross carrying amount and accumulated  amortization of
other  intangible  assets as of December  31, 2006 and  December 31, 2005 are as
follows:

                                                   December 31,     December 31,
                                                      2006             2005
                                                   -----------      -----------

Customer relationships and purchased technology:

Gross carrying amount                              $   216,850      $   216,850
Accumulated amortization                              (216,850)        (216,850)
                                                   -----------      -----------
  Net carrying amount                              $        --      $        --
                                                   ===========      ===========
Patents:
Gross carrying amount                              $ 1,023,093      $   649,864
Accumulated amortization                              (615,777)        (433,000)
                                                   -----------      -----------
  Net carrying amount                              $   407,316      $   216,864
                                                   ===========      ===========

(H) 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. The Company  previously  capitalized  $94,570 of software
development  costs which were fully  amortized as of the first  quarter of 2004.


                                       44


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.

      Purchased software technology of $183,578 and $372,306, net of accumulated
amortization  of $5,008,853 and  $4,646,694,  is included in other assets in the
balance  sheets as of December 31, 2006 and  December  31,  2005,  respectively.
Amortization  expense was $362,159,  $781,500 and $1,386,027 for the years ended
December  31,  2006,  2005 and 2004,  respectively.  Amortization  of  purchased
software  technology  is recorded at the greater of the straight line basis over
the products estimated  remaining life or the ratio of current period revenue of
the related  products to total current and  anticipated  future revenue of these
products.

      As of December 31,  2006,  amortization  expense on existing  identifiable
intangible assets and purchased software technology will be $295,433,  $223,482,
and $71,979 for the years ended December 31, 2007, 2008 and 2009,  respectively.
Such assets will be fully amortized at December 31, 2009.

(I) INCOME TAXES

      Deferred  tax assets and  liabilities  are  recognized  for the future tax
consequences   attributable  to  differences  between  the  financial  statement
carrying  amounts of existing assets and  liabilities  and their  respective tax
bases.  Deferred tax assets and liabilities are measured using enacted tax rates
expected  to apply to  taxable  income  in the  years in which  those  temporary
differences  are expected to be realized or settled.  The effect on deferred tax
assets and  liabilities  of a change in tax rates is recognized in income in the
period that includes the enactment  date. The Company  provides a full valuation
allowance against its deferred tax assets.

(J) LONG-LIVED ASSETS

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

(K) SHARE-BASED PAYMENTS

      Effective January 1, 2006, the Company adopted the provisions of Statement
of  Financial  Accounting  Standards  No. 123 (R) (Revised  2004),  "SHARE-BASED
PAYMENT" (SFAS No. 123(R)), which establishes the accounting for transactions in
which an entity  exchanges its equity  instruments for goods or services.  Under
the provisions of SFAS No. 123(R),  share-based payment compensation is measured
at the grant date, based on the fair value of the award, and is recognized as an
expense  over the  requisite  employee  service  period  (generally  the vesting
period).  The Company  adopted SFAS No.  123(R)  using the modified  prospective
method  and,  as a  result,  periods  prior to  January  1,  2006  have not been
restated.  The adoption of this pronouncement resulted in increased compensation
expense of $9.4 million,  which caused net income to decrease by the same amount
or $0.20 per share for the year ended  December 31, 2006,  as well as cash flows
from financing activities  increasing by $45,895 while cash flows from operating
activities  decreased  by the same amount for the year ended  December 31, 2006.
Prior to the adoption of SFAS No. 123 (R), the Company accounted for stock-based
compensation using the intrinsic-value  based method under Accounting Principles
Board (APB)  Opinion  No. 25,  ACCOUNTING  FOR STOCK  ISSUED TO  EMPLOYEES,  and
related interpretations,  and provided applicable pro-forma disclosures required
by  Statement  of  Financial   Accounting  Standards  No.  123,  ACCOUNTING  FOR
STOCK-BASED  COMPENSATION.  Accordingly,  prior to 2006,  the  Company  recorded
employee  stock-based  compensation  expense only if, on the date of grant,  the
market price of the underlying  stock on the date of grant exceeded the exercise
price.

(L) FINANCIAL INSTRUMENTS

      As of  December  31,  2006  and  2005,  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.


                                       45


(M) FOREIGN CURRENCY

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

(N) EARNINGS PER SHARE (EPS)

      Basic EPS is computed  based on the weighted  average  number of shares of
common stock outstanding.  Diluted EPS is computed based on the weighted average
number  of  common  shares  outstanding   increased  by  dilutive  common  stock
equivalents.  Due to net losses for the years ended  December 31, 2006 and 2004,
all common stock  equivalents  for these  periods were excluded from diluted net
loss per share.  As of December 31, 2006,  2005 and 2004,  potentially  dilutive
common stock  equivalents  included  11,060,975,  10,200,908 and 8,973,358 stock
options and shares of restricted stock outstanding, respectively. As of December
31, 2006,  2005 and 2004,  potentially  dilutive common stock  equivalents  also
included 750,000 warrants outstanding.

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


                                              Year Ended December 31, 2006                    Year Ended December 31, 2005
                                        Net Income        Shares         Per Share        Net Income        Shares        Per Share
                                       (Numerator)     (Denominator)      Amount         (Numerator)    (Denominator)      Amount
                                       ------------      ----------     -----------      -----------      ----------     -----------
Basic EPS                              $(3,374,528)      48,044,946     $     (0.07)     $ 2,293,107      47,662,446     $      0.05
                                                                        ===========                                      ===========
Effect of dilutive securities:
Stock Options and Restricted Stock                               --                                        3,113,950
                                       -----------      -----------     -----------      -----------     -----------     -----------
Diluted EPS                            $(3,374,528)      48,044,946     $     (0.07)     $ 2,293,107      50,776,396     $      0.05
                                       ===========      ===========     ===========      ===========     ===========     ===========

                                               Year Ended December 31, 2004
                                        Net Income       Shares      Per Share
                                       (Numerator)    (Denominator)    Amount
                                       -----------     ----------   -----------
Basic EPS                              $(5,888,847)    46,967,422   $     (0.13)
                                                                    ===========
Effect of dilutive securities:
Stock Options and Restricted Stock                             --
                                       -----------    -----------   -----------
Diluted EPS                            $(5,888,847)    46,967,422   $     (0.13)
                                       ===========    ===========   ===========

(O) COMPREHENSIVE INCOME (LOSS)

      Comprehensive  income (loss)  includes the  Company's  net income  (loss),
foreign  currency  translation  adjustments and unrealized  losses on marketable
securities,  net of tax.  Components of accumulated other  comprehensive  income
(loss) were  comprised  of foreign  currency  translation  adjustment  losses of
$363,163 and $391,540 as of December 31, 2006 and 2005, respectively, unrealized
losses  on  marketable  securities  of  $23,482  and  $49,283,  net of tax as of
December 31, 2006 and 2005, respectively and unrecognized pension adjustments of
$87,482, net of tax as of December 31, 2006.

(P) NEW ACCOUNTING PRONOUNCEMENTS

      In September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR
DEFINED  BENEFIT PENSION AND OTHER  POSTRETIREMENT  PLANS - an amendment of FASB
Statements  No. 87, 88, 106 and 132(R)  ("SFAS  158").  SFAS 158  requires  that
employers recognize the funded status of their defined benefit pension and other
postretirement  plans on their  consolidated  balance  sheet and  recognize as a
component  of other  comprehensive  income,  net of tax, the gains or losses and
prior  service  costs or  credits  that  arise  during  the  period  but are not
recognized  as  components  of net  periodic  benefit  cost.  SFAS No.  158 also
requires  additional  disclosures  in the  notes to  financial  statements.  The
Company  adopted  SFAS No. 158,  effective  December  31,  2006,  and recorded a
$87,482 adjustment to other comprehensive income.

      In September  2006, the FASB issued SFAS No. 157, FAIR VALUE  MEASUREMENTS
("SFAS 157"),  which  defines fair value,  establishes a framework for measuring
fair value and expands the related disclosure requirements. Adoption is required
as of the  beginning  of the first  fiscal year that begins  after  November 15,
2007. SFAS No. 157 applies under other accounting pronouncements that require or
permit  fair  value  measurements  and  does  not  require  any new  fair  value
measurements. Management is evaluating the impact the adoption of this statement
will have on the Company's consolidated financial statements.


                                       46


      In September 2006, the SEC issued Staff  Accounting  Bulletin  ("SAB") No.
108,  CONSIDERING  THE  EFFECTS OF PRIOR  YEAR  MISSTATEMENTS  WHEN  QUANTIFYING
MISSTATEMENTS  IN CURRENT YEAR FINANCIAL  STATEMENTS  ("SAB No. 108") to provide
guidance  on the  consideration  of the effects of prior year  misstatements  in
quantifying  current  year  misstatements  for  the  purpose  of  a  materiality
assessment. Under SAB No. 108, companies should evaluate a misstatement based on
its impact on the  current  year  income  statement,  as well as the  cumulative
effect of correcting such  misstatements that existed in prior years existing in
the current year's ending balance sheet. The Company adopted SAB No. 108 for the
year  ended  December  31,  2006 with no impact  to the  Company's  consolidated
financial statements.

      In June  2006,  the  FASB  issued  FASB  Interpretation  No.  ("FIN")  48,
ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES - an  Interpretation of SFAS No. 109,
which clarifies the accounting for uncertainty in income taxes recognized in the
financial  statements in  accordance  with SFAS No. 109,  ACCOUNTING  FOR INCOME
TAXES. FIN 48 prescribes a recognition  threshold and measurement  attribute for
the financial  statement  recognition and measurement of a tax position taken or
expected  to be  taken  in a tax  return.  Any  change  in  the  net  assets  or
liabilities recognized as a result of adopting the provisions of FIN 48 would be
recorded as an adjustment to the opening balance of retained earnings. FIN 48 is
effective  for the  Company  as of  January 1,  2007.  Management  is  currently
evaluating the impact, if any, the adoption of FIN 48 will have on the Company's
consolidated financial statements.

(Q) RECLASSIFICATIONS

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

(2) ACQUISITION

      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  aggregate
contingent  acquisition  payments  totaling  $501,139  related to the sale of IP
Metrics'  products  and  services.  In 2006,  the Company  recorded a litigation
settlement  expense of $0.8  million  relating to a  contingent  purchase  price
dispute with two former shareholders of IP Metrics.

(3) PROPERTY AND EQUIPMENT

      Property and equipment consist of the following:

                                               December 31,        December 31,
                                                   2006                2005
                                               --------------------------------
Computer hardware and software                 $ 14,845,319        $ 11,410,607

Furniture and equipment                             511,184             501,861

Leasehold improvements                              812,586             502,895

Automobile                                           13,008              13,008
                                               ------------        ------------
                                                 16,182,097          12,428,371

Less accumulated depreciation                   (10,221,780)         (7,150,762)
                                               ------------        ------------
                                               $  5,960,317        $  5,277,609
                                               ============        ============

      Depreciation expense was $3,071,018,  $2,452,737,  and $2,041,592 in 2006,
2005, and 2004, respectively.


                                       47


(4) MARKETABLE SECURITIES

      The Company's 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 specific  identification method. Realized gains, realized losses
and  declines  in value  judged  to be  other-than-temporary,  are  included  in
interest and other income, net. The cost of  available-for-sale  securities sold
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  available-for-sale  marketable
securities as of December 31, 2006, are as follows:

                            Aggregate         Cost        Unrealized      Unrealized
                           Fair Value        Basis          Gains          Losses
                           -----------    -----------    -----------    -----------
Auction rate securities    $10,900,000    $10,900,000    $        --    $        --

Government securities       12,956,804     12,978,952             --         22,148

Corporate bonds                997,455        998,789             --          1,334

Certificate of deposit         500,000        500,000             --             --
                           -----------    -----------    -----------    -----------
                           $25,354,259    $25,377,741    $        --    $    23,482
                           ===========    ===========    ===========    ===========

      As of  December  31,  2006  there  are  two  corporate  bonds  and  twelve
government  securities  that are in an unrealized  loss  position.  Based on the
credit  ratings  of  these   securities  and  the  timing  of  their  respective
maturities,  there is no reason to believe the Company will be unable to collect
all  amounts  due  according  to the  contractual  terms  of  these  securities.
Unrealized losses on the Company's available-for-sales  securities have not been
determined to be  other-than-temporary  due principally to the Company's  intent
and ability to hold these  securities for a period of time sufficient to recover
the value of the investments.

      The cost and fair values of the  Company's  available-for-sale  marketable
securities as of December 31, 2005, are as follows:

                            Aggregate         Cost        Unrealized      Unrealized
                           Fair Value        Basis          Gains          Losses
                           -----------    -----------    -----------    -----------
Auction rate securities    $10,098,031    $10,098,031    $        --    $        --

Government securities        6,394,262      6,431,432             --         37,170

Corporate bonds              1,341,390      1,353,503             --         12,113
                           -----------    -----------    -----------    -----------
                           $17,833,683    $17,882,966    $        --    $    49,283
                           ===========    ===========    ===========    ===========

      The  cost  basis  and  fair  value  of  available-for-sale  securities  by
contractual maturity as of December 31, 2006, were as follows:

                                                                        Fair
                                                     Cost               Value
                                                  -----------        -----------
Due within one year                               $23,328,950        $23,308,021
Due between one and two years                       2,048,791          2,046,238
                                                  -----------        -----------
                                                  $25,377,741        $25,354,259
                                                  ===========        ===========

(5) ACCRUED EXPENSES

      Accrued expenses are comprised of the following:


                                       48


                                                    December 31,    December 31,

                                                        2006            2005
                                                    ----------------------------
Accrued compensation                                $  2,267,222    $  1,517,115

Accrued consulting and professional fees                 606,702         598,674

Accrued marketing and promotion                          220,419         229,675

Other accrued expenses                                 1,052,536       1,245,873

Accrued income taxes                                     247,376          24,000

Accrued other taxes                                      256,989         295,119

Accrued litigation settlement fee                      1,100,000              --

Accrued hardware purchases                               314,101          38,946

Accrued and deferred rent                                440,191         497,157
                                                    ------------    ------------
                                                    $  6,505,536    $  4,446,559
                                                    ============    ============

6) INCOME TAXES

      The provision  for income taxes for the years ended  December 31, 2006 and
2005 is comprised  of Federal  Alternative  Minimum Tax,  state income taxes and
foreign income taxes. The tax effects of temporary differences that give rise to
the Company's deferred tax assets (liabilities) as of December 31, 2006 and 2005
are as follows:

                                                                  2006             2005
                                                              ------------     ------------
U.S. Federal net operating loss carryforwards (FalconStor)    $  7,420,767     $ 11,123,022
U.S. Federal net operating loss carryforwards (NPI)             31,711,302       31,711,302
Foreign net operating loss carryforwards                         1,484,416          941,369
State net operating loss carryforwards                             722,234        1,065,636
Start-up costs not currently deductible for taxes                       --           90,100
Depreciation                                                       (37,943)        (358,207)
Compensation                                                       375,922          348,562
Tax credit carryforwards                                         2,421,810        1,866,248
Alternative minimum tax carryforward                               222,684           23,007
Deferred revenue                                                 1,056,016          650,555
Capital loss carryforward                                          850,134          847,901
Lease abandonment charge                                            34,369           77,327
Allowance for receivables                                        2,258,062        1,440,036
Patent                                                             189,889           99,194
Other                                                                8,065           11,636
Share-based payment compensation                                 1,529,144               --
                                                              ------------     ------------
                                                                50,246,871       49,937,688
  Valuation allowance                                          (50,246,871)     (49,937,688)
                                                              ------------     ------------
                                                              $         --     $         --
                                                              ============     ============

      The  difference  between the  provision  for income taxes  computed at the
Federal  statutory rate and the reported  amount of tax expense  attributable to
income (loss) before  income taxes for the years ended  December 31, 2006,  2005
and 2004, are as follows:


                                       49


                                                                    2006            2005            2004
                                                                -----------     -----------     -----------
Tax at Federal statutory rate                                   $(1,066,688)    $   820,031     $(1,991,300)
Increase (reduction) in income taxes resulting from:
    State and local taxes, net of Federal income tax benefit         62,711         885,733         809,345
    Non-deductible expenses                                         355,144         302,207          47,600
    Compensation                                                         --              --           2,700
    Share-based payment compensation                              1,170,364              --              --
    Foreign tax credit                                                   --              --          (6,100)
    Net effect of foreign operations                                 36,279         128,150         164,800
    Research and development credit                                (568,520)       (433,013)       (360,100)
    AMT tax                                                         199,677          23,007              --
    Change in valuation allowance                                   129,506      (1,607,365)      1,365,000
                                                                -----------     -----------     -----------
                                                                $   318,473     $   118,750     $    31,945
                                                                ===========     ===========     ===========


                                                  2006        2005        2004
                                                --------    --------    --------
Federal                                         $239,411    $ 55,887    $     --
State and local                                   22,862       1,113          --
Foreign                                           56,200      61,750      31,945
                                                --------    --------    --------
                                                $318,473    $118,750    $ 31,945
                                                ========    ========    ========


      Income  (loss)  before  provision  for  income  taxes for the years  ended
December 31, 2006, 2005 and 2004 are as follows:

                                      2006             2005             2004
                                  -----------      -----------      -----------
Domestic income (loss)            $(1,599,446)     $ 4,390,212      $(5,465,902)
Foreign loss                       (1,456,609)      (1,978,355)        (391,000)
                                  -----------      -----------      -----------
                                  $(3,056,055)     $ 2,411,857      $(5,856,902)
                                  ===========      ===========      ===========

      As of December 31, 2006,  the Company had U.S.  Federal net operating loss
carryforwards of approximately  $21,825,800 which expire from 2020 through 2025.
In August  2001,  the  Company  was a party to a  reverse  merger  with  Network
Peripherals,  Inc. ("NPI").  As of the date of the merger,  NPI had U.S. Federal
net  operating  loss  carryforwards  of  $93,268,500  that  start to  expire  in
December,  2012.  As of December 31, 2006,  the Company had state net  operating
loss  carryforwards of approximately  $13,657,200 which expire from 2007 through
2025.  As of December  31,  2006,  the Company  had foreign net  operating  loss
carryforwards  of approximately  $4,719,700.  At December 31, 2006 and 2005, the
Company  established a valuation  allowance to reduce its deferred tax assets to
an amount that is  more-likely-than-not  realizable  due to the Company's  prior
history of pre-tax  losses and  uncertainty  about the timing of and  ability to
generate  taxable  income in the future.  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 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,  $4,631,900  would be
allocated to paid-in-capital  with the remainder reducing income tax expense. Of
the amount allocable to paid-in-capital, $2,340,600 relates to the tax effect of
the  deductions  for  payments of  liabilities  of  discontinued  operations  in
connection  with the reverse  merger and the remainder of $2,291,300  relates to
the tax effects of excess compensation deductions from exercises of employee and
consultant  stock  options.  In  determining  the  period in which  related  tax
benefits are realized for book purposes,  excess share-based  payment deductions
and deduction from discontinued  operations included in net operating losses are
realized after regular net operating losses are exhausted.

(7) STOCKHOLDERS' EQUITY

      In September, 2003 the Company entered into a worldwide OEM agreement with
a major technology company (the "OEM"), and granted the OEM warrants to purchase
750,000 shares of the Company's common stock with an exercise price of $6.18 per
share.  A  portion  of the  warrants  may vest  annually  subject  to the  OEM's
achievement  of pre-defined  and mutually  agreed upon sales  objectives  over a


                                       50


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.  Through  December 31,
2006,  the Company had not generated any revenues from this OEM and  accordingly
no warrants had vested.

(8) SHARE-BASED PAYMENT ARRANGEMENTS

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

      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 is  expensed  over the  periods  the  services  are
provided.  The related expense amounted to $32,860 and $87,023 in 2005 and 2004,
respectively. These services were completed as of December 31, 2005.

      On May 14, 2004, the Company  adopted the FalconStor  Software,  Inc. 2004
Outside  Directors  Stock  Option  Plan  (the  "2004  Plan").  The 2004  Plan is
administered  by the  Compensation  Committee  of the  Board  of  Directors  and
provides for the granting of options to non-employee directors of the Company to
purchase up to 300,000  shares of Company common stock.  Exercise  prices of the
options  must be equal to the fair market  value of the common stock on the date
of grant. Options granted have terms of ten years. All options granted under the
2004 Plan must be granted within three years of the adoption of the 2004 Plan.

      On May 17, 2006, the Company  adopted the FalconStor  Software,  Inc. 2006
Incentive  Stock Plan (the "2006 Plan").  The 2006 Plan is  administered  by the
Compensation  Committee of the Board of Directors  and provides for the grant of
incentive and nonqualified  stock options,  and restricted  stock, to employees,
officers, consultants and advisors of the Company. A maximum of 1,500,000 of the
authorized  but  unissued or treasury  shares of the common stock of the Company
may be issued upon the grant of restricted stock or upon the exercise of options
granted under the 2006 Plan. Exercise prices of the options must be equal to the
fair market value of the common stock on the date of grant. Options granted have
terms of not greater than ten years.  All options and shares of restricted stock
granted under the 2006 Plan must be granted  within ten years of the adoption of
the 2006 Plan.

      A summary of the Company's stock option activity for 2006 is as follows:


                                       51


                                                                                                          Weighted
                                                                                           Weighted       Average
                                                                                           Average        Remaining      Aggregate
                                                                         Number of        Exercise       Contractual     Intrinsic
                                                                          Options           Price        Life (Years)      Value
                                                                       ------------     ------------    ------------    ------------
Options Outstanding at December 31, 2005                                 10,062,745     $       5.29
                                                                       ============     ============
Granted                                                                   2,086,150     $       7.26
Exercised                                                                  (643,925)    $       3.88
Canceled                                                                   (668,995)    $       7.45
                                                                       ------------     ------------

Options Outstanding at December 31, 2006                                 10,835,975     $       5.62            6.55    $ 33,360,990
                                                                       ============     ============    ============    ============

Options Exercisable at December 31, 2006                                  7,530,233     $       4.89            5.62    $ 28,695,438
                                                                       ============     ============    ============    ============

Options Expected to Vest at December 31, 2006                             3,001,271     $       7.25            8.72    $  4,199,665
                                                                       ------------     ------------    ------------    ------------

      Stock option  exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the years ended December 31,
2006, 2005 and 2004 was $2,501,156, $1,942,540 and $2,031,903, respectively. The
total intrinsic value of stock options  exercised during the year ended December
31, 2006, was $2,697,850.

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

                                                                    Year Ended
                                                                    December 31,
                                                                        2006
                                                                     ----------
Cost of maintenance software services and other revenue              $1,342,970
Software development costs                                            4,331,902
Selling and marketing                                                 2,803,585
General and administrative                                              914,697
                                                                     ----------
                                                                     $9,393,154
                                                                     ==========

      The Company  recognized  $45,895 of tax  benefits  related to  share-based
payment compensation during the year ended December 31, 2006.

      In 2006,  the Company  granted  options to purchase an aggregate of 25,000
shares of common  stock to certain  non-employee  consultants  in  exchange  for
professional  services.  The aggregate fair value of these options as determined
using the  Black-Scholes  method,  $161,230 as of December  31,  2006,  is being
expensed  over the periods  the  services  are  provided.  The  related  expense
amounted to $17,914 during the year ended December 31, 2006.

      In 2006,  the Company  granted  225,000  shares of restricted  stock at an
average fair value per share at date of grant of $7.06 per share.  There were no
restricted  shares issued or outstanding as of December 31, 2005. As of December
31, 2006 no restricted shares have been vested or forfeited.

      For periods prior to January 1, 2006,  the Company  recorded  compensation
expense for employee stock options based upon their  intrinsic value on the date
of grant  pursuant  to  Accounting  Principles  Board  ("APB")  Opinion  No. 25,
ACCOUNTING  FOR STOCK ISSUED TO  EMPLOYEES.  Since the  exercise  price for such
options was equal to the fair market value of the Company's stock at the date of
grant,  the stock options had no intrinsic value upon grant and,  therefore,  no
expense was recorded in the consolidated statements of operations.


                                       52


      Had the  compensation  cost of the  Company's  share-based  payments  been
determined in  accordance  with SFAS No. 123, the Company's pro forma net income
and net income per share for the years  ended  December  31, 2005 and 2004 would
have been:

                                                                  Year Ended       Year Ended
                                                                  December 30,     December 31,
                                                                     2005             2004
                                                                 ------------     ------------
Net Income (loss) as reported                                    $  2,293,107     $ (5,888,847)
Add share-based payment compensation expense
included  in reported net income (loss), net of tax              $         --     $      7,969

Deduct total share-based payment compensation
expense determined under fair-value-based method,
net of tax                                                       $ (8,565,701)    $ (8,268,471)
                                                                 ------------     ------------

Net loss - pro forma                                             $ (6,272,594)    $(14,149,349)
                                                                 ============     ============
Basic and diluted net income (loss) per common
share-as  reported
                                                                 $       0.05     $      (0.13)

Basic and diluted net loss per common share-pro forma            $      (0.13)    $      (0.30)

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

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

      The per share weighted average fair value of share-based  payments granted
during the years ended  December  31, 2006,  2005 and 2004 was $4.32,  $4.52 and
$6.55,  respectively.  In addition to the  exercise and grant date prices of the
awards, certain weighted average assumptions that were used to estimate the fair
value of share-based  payment grants in the respective periods are listed in the
table below:

                                                 Year ended December 31,
                                              2006         2005          2004
                                              ----         ----          ----
Expected dividend yield                           0%            0%            0%
Expected volatility                         57 - 60%      61 - 65%    166 - 176%
Risk-free interest rate                   4.4 - 5.1%    3.7 - 4.6%          3.5%
Expected term (years)                             6             6             5
Discount for post-vesting                       N/A           N/A           N/A
   restrictions


                                       53


      Options  granted during fiscal 2006 have exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
a vesting  period of three years and an  estimated  forfeiture  rate of 23%. All
options granted through  December 31, 2005 had exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
generally a vesting  period of three years and an estimated  forfeiture  rate of
23%.

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

      As of December  31, 2006,  there was  approximately  $11,433,934  of total
unrecognized  compensation  cost related to the Company's  unvested  options and
restricted  shares  granted under the Company's  stock plans.  The  unrecognized
compensation cost is expected to be recognized over a weighted-average period of
2.23 years.

      As of December 31, 2006, the Company has 12,605,548 shares of common stock
reserved  for  issuance  upon the  exercise  of options,  restricted  shares and
warrants.

(9) LITIGATION SETTLEMENT CHARGES

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

      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.

(10) COMMITMENTS AND CONTINGENCIES

      The Company has an operating  lease covering its primary  office  facility
that expires in February,  2012. The Company also has several  operating  leases
related to offices in foreign  countries.  The expiration dates for these leases
range from 2007 through  2012.  The  following  is a schedule of future  minimum
lease payments for all operating leases as of December 31, 2006:

Year Ending December 31,

2007..............................................................    $1,875,673
2008..............................................................     1,372,384
2009..............................................................     1,365,163
2010..............................................................     1,331,877
2011..............................................................     1,367,538
Thereafter........................................................       708,120
                                                                      ----------
                                                                      $8,020,755
                                                                      ==========


                                       54


      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  $1,945,991,  $1,461,051,  and  $1,103,008  for the years ended December 31,
2006, 2005 and 2004, 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 9, through  December 31, 2006,  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.   The  Company   expenses   legal  costs  related  to
contingencies when incurred.

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

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

(11) EMPLOYEE BENEFIT PLANS

DEFINED CONTRIBUTION PLAN

      Effective  July 2002,  the Company  established  a  voluntary  savings and
defined  contribution  plan (the "Plan")  under  Section  401(k) of the Internal
Revenue Code. This Plan covers all U.S.  employees  meeting certain  eligibility
requirements  and allows  participants  to  contribute a portion of their annual
compensation.  Employees  are 100%  vested in their own  contributions.  For the
years  ended  December  31,  2006,  2005 and 2004,  the Company did not make any
contributions to the Plan.

DEFINED BENEFIT PLAN

      The Company has a defined  benefit plan covering  employees in Taiwan.  On
December 31, 2006, the Company adopted the provisions of FASB statement No. 158,
EMPLOYERS'  ACCOUNTING  FOR DEFINED  BENEFIT  PENSION  AND OTHER  POSTRETIREMENT
PLANS,  AN AMENDMENT OF FASB  STATEMENTS  NO. 87, 88, 106, AND 132(R) ("SFAS No.
158"),  which required the Company to recognize the funded status of its defined
benefit  plan in the  accompanying  consolidated  balance  sheet at December 31,
2006,  with the  corresponding  adjustment to  accumulated  other  comprehensive
income,  net of tax.  Therefore,  as a result of adopting the provisions of SFAS
No. 158, the Company  increased  other  non-current  liabilities and accumulated
other comprehensive income by $87,482 as of December 31, 2006. The adjustment to
accumulated  other  comprehensive   income  upon  adoption  represents  the  net
unrecognized  actuarial losses,  which were previously netted against the funded


                                       55


status  in the  Company's  consolidated  balance  sheet in  accordance  with the
provision of SFAS No. 87. These amounts will be recognized  subsequently  as net
periodic  pension  cost.  Actuarial  gains and losses  that arise in  subsequent
periods and are not recognized as net periodic  pension cost in the same periods
will be  recognized  as a component  of other  comprehensive  income and will be
recognized  subsequently as a component of net periodic pension cost on the same
basis as the amounts recognized in accumulated other  comprehensive  income upon
adoption of SFAS No. 158.

      Included in accumulated other  comprehensive loss at December 31, 2006 are
the  following  amounts,  net of tax,  that have not yet been  recognized in net
periodic  pension  cost:  unrecognized  transition  obligation  of $63,120,  and
unrecognized   actuarial  losses  of  $24,362.  The  transition  obligation  and
actuarial loss included in accumulated other  comprehensive loss and expected to
be recognized in net periodic pension cost for the year ended December 31, 2007,
is $5,260 and $740, respectively.

Pension information for the year ended December 31, 2006 is as follows:

Accumulated benefit obligation                                          $108,418
                                                                        ========

Changes in projected benefit obligation:
    Projected benefit obligation at beginning of year                    120,457
    Interest cost                                                          4,216
    Actuarial (gain)/loss                                                 31,320
    Benefits paid                                                             --
    Service cost                                                           1,129
                                                                        --------
    Projected benefit obligation at end of year                         $157,122
                                                                        ========

Changes in plan assets:
    Fair value of plan assets at beginning of year                         5,780
    Actual return on plan assets                                              28
    Benefits paid                                                             --
    Employer contributions                                                13,763
                                                                        --------
    Fair value of plan assets at end of year                            $ 19,571
                                                                        ========

Funded status                                                           $137,551
                                                                        ========

Components of net periodic pension cost:
    Interest cost                                                       $  4,253
    Expected return on plan assets                                           204
    Amortization of net loss                                               5,306
    Service cost                                                           1,139
                                                                        --------
    Net periodic pension cost                                           $ 10,902
                                                                        ========

      The company makes  contributions to the plan so that minimum  contribution
requirements, as determined by government regulations, are met. The Company does
not  anticipate  a  contribution  to this  plan in  2007.  Benefit  payments  of
approximately $58,000 are expected to be paid in 2012 through 2016.

(12) 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, 2006,
the  Company  purchased  315,600  shares  of its  common  stock  in open  market
purchases for a total cost of  $2,147,233.  As of December 31, 2006, the Company
had repurchased a total of 865,200 shares for $5,780,163.


                                       56


(13) SEGMENT REPORTING AND CONCENTRATIONS

      The Company is  organized  in a single  operating  segment for purposes of
making operating decisions and assessing  performance.  Revenues from the United
States to  customers  in the  following  geographical  areas for the years ended
December 31, 2006,  2005 and 2004,  and the location of long-lived  assets as of
December 31, 2006, 2005 and 2004, are summarized as follows:

                                                            2006           2005           2004
                                                        -----------------------------------------
Revenues:

United States                                           $37,461,247    $28,300,822    $18,140,465

Asia                                                      8,352,382      6,535,128      5,821,902

Other international                                       9,252,399      6,128,153      4,746,311
                                                        -----------    -----------    -----------
  Total Revenues                                        $55,066,028    $40,964,103    $28,708,678
                                                        ===========    ===========    ===========

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

United States                                           $10,113,633    $ 9,716,031    $ 9,929,214

Asia                                                      1,498,534      1,320,865        950,387

Other international                                         279,695        207,098        322,544
                                                        -----------    -----------    -----------
  Total long-lived assets                               $11,891,862    $11,243,994    $11,202,145
                                                        ===========    ===========    ===========

      For the year ended  December 31, 2006,  the Company had one customer  that
accounted for a total of 27% of revenues.  For the year ended December 31, 2005,
the Company had two  customers  that  together  accounted  for a total of 31% of
revenues.  For the year ended  December 31,  2004,  the Company had one customer
that accounted for 16% of revenues. As of December 31, 2006, the Company had two
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, 2005, the Company had two customers with accounts  receivable
balances  greater than 5% of gross accounts  receivable,  which in the aggregate
were 28% of the accounts receivable balance.

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

                         Balance at                                            Balance at
                        Beginning of    Additions charged                        End of
  Period ended             Period          To Expense        Deductions          Period
-----------------        ----------        ----------        ----------        ----------
December 31, 2006        $3,846,882        $4,765,148        $2,595,732        $6,016,298
December 31, 2005        $2,551,616        $4,340,102        $3,044,836        $3,846,882
December 31, 2004        $1,837,934        $3,296,275        $2,582,593        $2,551,616


                                       57


(15) QUARTERLY FINANCIAL DATA (UNAUDITED)

      The following is a summary of selected  quarterly  financial  data for the
years ended December 31, 2006 and 2005:

                                                     Fiscal Quarter

                                First            Second           Third           Fourth
------------------------    ------------     ------------     ------------     ------------
2006

Revenue                     $  9,208,320     $ 12,668,227     $ 12,966,111     $ 20,223,370
                            ============     ============     ============     ============
Net income (loss)           $ (3,636,886)    $ (1,304,795)    $ (1,258,371)    $  2,825,524
                            ============     ============     ============     ============
Basic net income
   (loss) per share         $      (0.08)    $      (0.03)    $      (0.03)    $       0.06
                            ============     ============     ============     ============
Diluted net income
  (loss) per share          $      (0.08)    $      (0.03)    $      (0.03)    $       0.06
                            ============     ============     ============     ============
Basic weighted average
   common shares
    outstanding               48,006,309       48,047,291       47,990,558       48,134,809
                            ============     ============     ============     ============
Diluted weighted average
   common shares
    outstanding               48,006,309       48,047,291       47,990,558       50,370,514
                            ============     ============     ============     ============
2005

Revenue                     $  8,392,036     $  9,495,587     $ 10,056,665     $ 13,019,815
                            ============     ============     ============     ============
Net income (loss) (a)       $   (133,829)    $    288,105     $    482,879     $  1,655,952
                            ============     ============     ============     ============
Basic net income
   (loss) per share         $      (0.00)    $       0.01     $       0.01     $       0.03
                            ============     ============     ============     ============
Diluted net income
  (loss) per share          $      (0.00)    $       0.01     $       0.01     $       0.03
                            ============     ============     ============     ============
Basic weighted average
   common shares
    outstanding               47,528,874       47,594,072       47,720,496       47,802,694
                            ============     ============     ============     ============
Diluted weighted average
   common shares
    outstanding               47,528,874       50,623,983       50,531,012       50,958,553
                            ============     ============     ============     ============

(a) Net income for the year ended December 31, 2005,  includes an  out-of-period
charge of approximately $0.2 million to recognize  investment losses realized in
prior years. Such charge was not considered material to any period.

      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.


                                       58


ITEM  9.  CHANGES  IN AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND
          FINANCIAL DISCLOSURE

          None.

ITEM 9A.  CONTROLS AND PROCEDURES

          DISCLOSURE CONTROLS AND PROCEDURES

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

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

          INTERNAL CONTROL OVER FINANCIAL REPORTING

          MANAGEMENT'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,
          2006,  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  consolidated  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 in
          May 2007, and is  incorporated  herein by reference.  The  information
          appears  in the  Proxy  Statement  under  the  captions  "Election  of
          Directors",  "Management",  "Executive Compensation",  "Section 16 (a)
          Beneficial  Ownership  Reporting  Compliance",  and "Committees of the
          Board of Directors." The Proxy Statement will be filed within 120 days
          of December 31, 2006, our year-end.


                                       59


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  2007,  and is  incorporated  herein  by
          reference.  The  information  appears in the Proxy Statement under the
          captions   "Executive    Compensation",    "Director    Compensation",
          "Compensation   Committee   Interlocks  and  Insider   Participation",
          Compensation  Committee  Report"  and  "Committees  of  the  Board  of
          Directors."  The  Proxy  Statement  will be filed  within  120 days of
          December 31, 2006, our year-end.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

          Information  regarding Securities Authorized for Issuance Under Equity
          Compensation Plans is included in Item 5 and is incorporated herein by
          reference. All other information called for by Part III, Item 12, will
          be included in our Proxy  Statement  relating to our annual meeting of
          stockholders  scheduled  to be held in May 2007,  and is  incorporated
          herein by reference.  The  information  appears in the Proxy Statement
          under  the  caption  "Beneficial   Ownership  of  Shares."  The  Proxy
          Statement  will be filed  within 120 days of December  31,  2006,  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 2007, 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,  2006,  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  2007,  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, 2006, our year-end.


                                       60


                                     PART IV

ITEM 15.  EXHIBITS AND 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,  incorporated
                  herein by reference to Exhibit 4.3 to the Registrant's  Annual
                  Report  on Form 10-K for the year  ended  December  31,  2004,
                  filed on March 16, 2005.

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

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

            4.6   2006 Incentive Stock Plan incorporated  herein by reference to
                  Exhibit 99.1 to the  Company's  quarterly  report on Form 10-Q
                  for the quarter ended June 30, 2006, filed on August 8, 2006.

            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.


                                       61


            10.2  Second  Amended  and  Restated  Employment  Agreement,   dated
                  November  7,  2005  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, 2005, filed on November 8, 2005.

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

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

            23.1  *Consent of KPMG LLP

            31.1  *Certification of the Chief Executive Officer

            31.2  *Certification of the Chief Financial Officer

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


                                       62


                                   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 15, 2006.

FALCONSTOR SOFTWARE, INC.


By: /S/ REIJANE HUAI                                        Date: March 14, 2007
    ---------------------------------------------
    ReiJane Huai, President, Chief  Executive
    Officer of FalconStor Software, Inc.

                                POWER OF ATTORNEY

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

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


By: /S/ Reijane Huai                                   March 14, 2007
    ---------------------------------------------      -------------------------
    Reijane Huai, President, Chief Executive           Date
    Officer and Chairman of the Board
    (Principal Executive Officer)


By: /S/ James Weber                                    March 14, 2007
    -------------------------------------------        -------------------------
    James Weber, Chief Financial Officer,              Date
    Vice President and Treasurer
    (Principal Financial Officer and
    Principal Accounting Officer)


By: /S/ Steven L. Bock                                 March 14, 2007
    -------------------------------------------        -------------------------
    Steven L. Bock, Director                           Date


By: /S/ Patrick B. Carney                              March 14, 2007
    -------------------------------------------        -------------------------
    Patrick B. Carney, Director                        Date


By: /S/ Lawrence S. Dolin                              March 14, 2007
    -------------------------------------------        -------------------------
    Lawrence S. Dolin, Director                        Date


By: /S/ Steven R. Fischer                              March 14, 2007
    -------------------------------------------        -------------------------
    Steven R. Fischer, Director                        Date


By: /S/ Alan W. Kaufman                                March 14, 2007
    -------------------------------------------        -------------------------
    Alan W. Kaufman, Director                          Date


                                       63`