`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, 2005.

                                       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. |_|

      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, 2005 was  $158,217,433  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, 2006 was
48,565,923 and 48,016,323, 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.


                                       1


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                         2005 ANNUAL REPORT ON FORM 10-K

                                TABLE OF CONTENTS

                                                                            Page

PART I.

Item 1.   Business........................................................    3
Item 1A.  Risk Factors....................................................    9
Item 1B.  Unresolved Staff Comments.......................................   17
Item 2.   Properties......................................................   17
Item 3.   Legal Proceedings...............................................   17
Item 4.   Submission of Matters to a Vote of Security Holders.............   17

PART II.

Item 5.   Market for Registrant's Common Equity and Related
          Stockholder Matters.............................................   18
Item 6.   Selected Consolidated Financial Data............................   19
Item 7.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations.......................................   22
Item 7A.  Qualitative and Quantitative Disclosures About Market Risk......   33
Item 8.   Financial Statements and Supplementary Data.....................   34
Item 9.   Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure.............................   56
Item 9A.  Controls and Procedures.........................................   56
Item 9B.  Other Information...............................................   56

PART III.

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

PART IV.

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

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


                                       2


                                     PART I

ITEM 1. BUSINESS

OVERVIEW

FalconStor Software, Inc. ("FalconStor") is a premier developer of adaptive 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
offerings  include   award-winning,   easy-to-deploy   storage   virtualization,
continuous  data  protection  (CDP),  virtual tape library  (VTL),  and disaster
recovery (DR) software solutions and related  implementation,  maintenance,  and
engineering services. In addition, FalconStor recently launched its PrimeVaultSM
offsite data protection  center,  which provides 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).

FalconStor  technology  empowers 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- and Fibre  Channel-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 and future environments obsolete.

Recognizing the strong value  proposition of FalconStor's  proven,  cutting-edge
technology,  multiple Tier-1 partners utilize  FalconStor's  innovative software
products - including IPStor(R), VirtualTape Library, and DiskSafe(TM) - to power
their special-purpose 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-3COM,  IBM, Intel,
LSI Logic, McData  Corporation,  Microsoft,  NEC, Network Appliance,  Novell, NS
Solutions  Corporation  (subsidiary  of The Nippon  Steel  Corporation,  Japan),
Oracle, QLogic, Quantum, Sony, SUN Microsystems, and VMware.

Further validation of the best-in-class status of Falconstor's solutions,  comes
from  the  agreements   Falconstor  has  with  many  Tier-1  original  equipment
manufacturers (OEMs) and others to integrate FalconStor's  technology with those
companies' products.


                                       3


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

PRODUCTS AND TECHNOLOGY

FalconStor's flexible product portfolio  facilitates the simple,  cost-effective
creation  of  customized  data  protection  solutions  that  adapt  to  changing
requirements during the entire data lifecycle.  FalconStor's innovative approach
goes beyond mere backup to address  additional  elements of the data  protection
workflow:  nearline storage; offsite storage;  archiving; and, most importantly,
recovery.  Because FalconStor's products are engineered from the ground up, they
are  extraordinarily  integrated and scalable;  businesses benefit from 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.

SOFTWARE PRODUCTS

IPSTOR(R)

FalconStor's  flagship  product,  IPStor  software - available in an  Enterprise
Edition, a Standard Edition,  and an Express Edition - provides advanced storage
networking  and  best-in-class  business   continuity/disaster  recovery  (BCDR)
functionality to all segments of the enterprise,  small and medium-size business
(SMB), and small office/home office (SOHO) markets. IPStor software 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.  IPStor software aggregates storage capacity,
provisioning,  and  services to  application  servers via all  industry-standard
protocols with speed, security, reliability, interoperability, and scalability.

      o     IPStor continuous data protection (CDP) solutions  maintain 24x7x365
            availability  and  usability  of data in the  event of an  unplanned
            hardware failure, deletion, or software error, or planned downtime.

      o     IPStor  disaster  recovery (DR) solutions  provide  rapid,  reliable
            recovery in the event of catastrophic site failure,  such as a fire,
            power outage, or flood in the main data center.

      o     IPStor  virtualization  solutions enable  enterprise data centers to
            consolidate  heterogeneous  storage environments and servers, and to
            centralize storage management under one simple interface.

VIRTUALTAPE LIBRARY (VTL)

FalconStor   VirtualTape   Library   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.

DISKSAFE(TM) AND FILESAFE(TM)

FalconStor  DiskSafe and FalconStor  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  their  entire  local  disks   (DiskSafe)  or  individual   files  and
directories  (FileSafe)  to  IPStor-managed  storage  for  automated  backup and
off-site  data  storage  and  rapid,  user-initiated  data  recovery.  Moreover,
DiskSafe  technology  captures  the  information  necessary  to easily  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,


                                       4


facilitating the transfer of replicated data over an IP or Fibre Channel network
to a  centralized  FalconStor  data  management  appliance  for  both  redundant
nearline storage and remote disaster recovery 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  (TTR).  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.

SOFTWARE APPLIANCE KITS (SAKS)

Addressing one of the fastest growing segments of the storage industry, SMBs and
the SOHO market,  FalconStor has entered into agreements with resellers and with
OEMs to develop  software  kits for storage  appliances  that  combine  specific
IPStor,  VirtualTape  Library,  and  DiskSafe  functionality  with  third  party
hardware to create  cost-effective,  turnkey storage  solutions that are easy to
deploy and maintain. Currently, FalconStor's resellers and/or OEM partners offer
the following storage appliances:

      o     VIRTUALTAPE LIBRARY  BACKUP|RECOVERY  APPLIANCES use disk to enhance
            the   reliability,   speed,   and   availability  of  backups  while
            consolidating  the management and provisioning of backup resources -
            without changing existing tape backup software and procedures.  With
            backup windows  shrinking and rapid data  restoration  more critical
            than ever,  VirtualTape  Library  appliances  allow users to utilize
            disk storage to emulate multiple tape libraries  concurrently and to
            accelerate  backup/restore  speed across  IP/iSCSI and Fibre Channel
            networks.

      o     ISCSI STORAGE/CDP  APPLIANCES leverage the  industry-standard  iSCSI
            protocol  and an existing IP network to create a reliable  networked
            storage solution for small or remote offices,  as well as small data
            centers,   at  an  affordable   price.   These  appliances  work  in
            conjunction  with  DiskSafe and FileSafe to aggregate  and provision
            storage  capacity and provide  services that deliver rapid recovery,
            continuous  data  protection,  and  disaster  recovery  capabilities
            across networked and direct-attached storage environments.

      o     REALTIME  DATA  MIGRATION  APPLIANCES  deliver   zero-downtime  data
            migration by  leveraging  an existing  storage  network to transport
            data between different vendors' storage subsystems without requiring
            reconfiguration or shutting down of production servers.

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 power to
protect  and to archive  their data at a secure  facility at an  affordable  and
predetermined  price  based on  individualized  needs.  By cutting  the costs of
deploying  and  maintaining  an  alternate  site  by  half  to   three-quarters,
PrimeVault makes alternate sites practical for most, if not all businesses.

PrimeVault offerings include:

o     Rapid  24x7x365 data recovery  with maximum  business  continuity/disaster
      recovery (BCDR) capability

o     Immediate BCDR solution deployment

      -     Cost-effective, flexible pricing

      -     Minimal up-front IT investment and operating overhead

      -     No need to build and staff a dedicated DR center

      -     No need to buy software and hardware for a DR center

o     Rapid compliance solution deployment while minimizing implementation costs


                                       5


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

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

      -     Closed-circuit video surveillance 24x7x365

      -     Encrypted, multi-point verified access to facility

PrimeVault also offers:

o     Managed  storage  with the benefit of advanced  IPStor  storage  services,
      including mirroring, continuous data replication and snapshots.

o     Co-location

BUSINESS STRATEGY

FalconStor  intends  to  maintain  its  position  as a leading  network  storage
software provider to enterprises worldwide and intends to continue its expansion
into the  non-enterprise  storage market by offering a diverse range of products
for use in the small/medium  business (SMB) and small office/home  office (SOHO)
markets.  FalconStor  intends to achieve these objectives  through the following
strategies:

o     MAINTAIN A LEADERSHIP  POSITION IN ENTERPRISE  NETWORK  STORAGE  SOFTWARE.
      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 network storage software
      market.  The network  storage  software market is defined by rapid change,
      and  FalconStor  plans to continue to focus its research  and  development
      efforts on continuing to invent innovative  solutions and bringing them to
      market quickly.

o     EXPAND PRODUCT  OFFERINGS.  In 2005,  FalconStor  offered  additional data
      protection options and enhancements for its software, including continuous
      data  protection for nonstop data  protection and immediate  granular data
      recovery;  Adaptive  Replication with  intelligent,  automated  throttling
      capabilities  to  maximize  efficient  usage of  bandwidth  during  remote
      replication  of data;  VTL  Encryption to safeguard data on physical tapes
      and in transit during  replication  of virtual  tapes;  and Automated Tape
      Caching for simple,  seamless  integration  with existing tape  libraries.
      FalconStor  intends to  continue  to expand its data  protection  solution
      offerings across all market segments.

o     INCREASE MARKET  PENETRATION AND BRAND  RECOGNITION.  FalconStor  believes
      that  establishing a strong brand  identity as a premier  provider of data
      protection solutions is important to its future success.  FalconStor plans
      to continue to promote  corporate  and product  awareness  by investing in
      activities which have been shown to deliver positive results, such as:

            o     Engaging an experienced, storage-focused PR agency;

            o     Advertising  in  strategic  storage  publications  and  online
                  media;

            o     Hosting  solution-focused  end user and  partner  seminars  in
                  partnership with industry trade groups and leading analysts;

            o     Forming strategic partnerships with leading industry players;

            o     Participating  in  industry-specific  events,  conferences and
                  trade shows; and

            o     Continuing targeted promotions and PR campaigns.


                                       6


o     ESTABLISH A GLOBAL PRESENCE.  Because FalconStor believes that significant
      market  share can be  achieved  in Europe  and Asia,  FalconStor  plans to
      continue  expansion  of  its  operational   capabilities  and  promotional
      activities  in these regions to build on current  successes.  In addition,
      FalconStor  believes that it is developing a strong business  presence and
      positive reputation in Europe and the Asia/Pacific Rim.

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

            o     Important enabling technology;

            o     Complementary applications;

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

            o     Key personnel.

o     SEEK OEM  RELATIONSHIPS  WITH  INDUSTRY  LEADERS.  FalconStor  intends  to
      continue to enter into 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.

o     OFFER  PRODUCTS AND SERVICES TO THE SMB AND SOHO  MARKETS.  FalconStor  is
      working with industry  partners to offer storage  solutions or services to
      the  SMB  and  SOHO  markets.   These   solutions  and  services   include
      special-purpose appliances and applications, as well as hosted storage and
      DR services via FalconStor's PrimeVault services.

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.

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

      o     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.

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

      o     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  amongst
customers, partners, analysts, and the media, and developing qualified leads for
the sales force.

FalconStor   Professional  Services  personnel  are  also  available  to  assist
customers and partners  throughout the product life cycle of FalconStor solution
deployments.   The  Professional  Services  team  includes  experienced  Storage
Architects


                                       7


(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 network-based  storage products and services  increases,  more
competitors  will enter this  high-growth  market  segment.  Although  there are
several  companies  attempting to offer unified storage  services to application
hosts  attached to iSCSI,  Fibre  Channel,  CIFS,  and NFS networks,  FalconStor
believes  it  is  the  only   software-based   solution   provider   capable  of
accommodating storage devices with industry-standard interfaces and provisioning
the  virtualized  resource  over  IP/iSCSI,  Fibre  Channel,  NFS, and CIFS with
comprehensive storage services and simple end-to-end manageability.

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 storage services  running on a standard  Linux-,  Windows- or
Solaris-based  appliance.  FalconStor  believes that the  principal  competitive
factors affecting its market include product features such as scalability,  data
availability,  ease of use, price,  reliability,  hardware/platform  neutrality,
customer service, and support.

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

INTELLECTUAL PROPERTY

FalconStor's  success  is  dependent  in part upon its  proprietary  technology.
Currently,  the  IPStor  software  suite  forms  the  core of  this  proprietary
technology.  FalconStor  currently  has one patent 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.


                                       8


MAJOR CUSTOMERS

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. For the year ended December
31, 2003,  FalconStor  did not have any customers that accounted for over 10% of
revenues.  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. As of December 31, 2004,
the Company had three customers with accounts  receivable  balances greater than
5% of gross accounts receivable, which in the aggregate were 33% of the accounts
receivable balance.

EMPLOYEES

As of December 31, 2005,  FalconStor had 279 full-time employees,  consisting of
139 in research and development,  74 in sales and marketing,  49 in service, and
17 in  general  administration.  FalconStor  is not  subject  to any  collective
bargaining agreements and believes its employee relations are good.

INTERNET ADDRESS AND AVAILABILITY OF FILINGS

FalconStor's internet address is WWW.FALCONSTOR.COM.  FalconStor makes available
free of charge, on or through its Internet website,  FalconStor's  Annual Report
on Form 10-K,  Quarterly Reports on Form 10-Q,  Current Reports on Form 8-K, and
amendments  to those reports  filed or furnished  pursuant to Sections  13(a) or
15(d) of the Securities  Exchange Act of 1934 as soon as reasonably  practicable
after  FalconStor  electronically  files such material with, or furnishes it to,
the SEC.  FalconStor complied with this policy for every Securities Exchange Act
of 1934 report filed during the year ended December 31, 2005.

ITEM 1A. RISK FACTORS

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.


                                       9


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.

WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM  BUSINESS AND SMALL OFFICE/HOME
OFFICE MARKETS.

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

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

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

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

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

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

      Our IPStor platform 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.


                                       10


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. 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.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR  RECEIVABLES  ARE
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, 2005, we
had two  customers  who together  accounted  for 31% of our  revenues.  While we
believe  that we will  continue  to  receive  revenue  from these  clients,  our
agreements with these clients do not have any minimum sales  requirements and we
cannot  guarantee  continued  revenue.  If our contracts with these partners are
terminated, or if the volume of sales from these clients significantly declines,
it would have a material adverse effect on our operating results.

      In addition,  as of December 31, 2005, two customers accounted for a total
of 28% of our  outstanding  receivables.  While we  currently  have no reason to
question  the  collectibility  of  these  receivables,  a  business  failure  or
reorganization  by 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 will thus be a delay before we learn whether  licensing revenue
from these OEMs has met,  exceeded,  or fallen  short of our  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 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.


                                       11


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 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 in  2005,  acquisitions  of two of our OEM
partners  had an  impact  on our  revenues.  If  additional  OEM  customers  are
acquired, the new parents 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.

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:


                                       12


o     retention of key management, marketing and technical personnel;

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

o     competitive  conditions  in the network  storage  infrastructure  software
      market.

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

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

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

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.

      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, 2005, the closing market price of our common stock as quoted on the
NASDAQ National  Market System  fluctuated  between $5.23 and $9.67.  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;


                                       13


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

      The Financial  Accounting  Standards Board ("FASB") has required companies
to recognize the fair value of stock options and other equity-based compensation
to employees as  compensation  expense in the statement of  operations.  We must
implement  this FASB standard  effective in the first quarter of 2006.  While we
are still  evaluating the impact of this  requirement,  there will be a negative
impact on our results of operations.

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

      Our Board of Directors has the  authority,  without  further action by the
stockholders,  to issue up to 2,000,000  shares of preferred stock on such terms
and  with  such  rights,  preferences  and  designations,   including,   without
limitation  restricting  dividends on our common  stock,  dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our  common  stock,  as  the  Board  may  determine  without  any  vote  of  the
stockholders.  Issuance  of such  preferred  stock,  depending  upon the rights,
preferences and designations thereof may have the effect of delaying,  deterring
or  preventing  a  change  in  control.  In  addition,  certain  "anti-takeover"
provisions of the Delaware  General  Corporation  Law,  among other things,  may
restrict  the  ability  of our  stockholders  to  authorize  a merger,  business
combination  or change of  control.  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 AND WARRANTS,  THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING  STOCKHOLDERS'  PERCENTAGE  OWNERSHIP OF
OUR COMMON STOCK.

      As of December  31,  2005,  we had  outstanding  options  and  warrants to
purchase an  aggregate  of  10,950,908  shares of our common stock at a weighted
average  exercise price of $5.29 per share. We also have 1,006,314 shares of our
common stock  reserved for issuance under our stock option plans with respect to
options that have not been granted.

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

OUR BUSINESS  COULD BE  MATERIALLY  AFFECTED AS A RESULT OF A NATURAL  DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS

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


                                       14


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

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

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

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


                                       15


      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.

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


                                       16


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 33,000
square feet in Le Chesnay, France;  Taichung,  Taiwan; Tokyo, Japan; Beijing and
Shanghai,  China; Munich,  Germany;  Seoul, Korea; 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


                                       17


                                     PART II

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

MARKET INFORMATION

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

                                           2005                      2004
                                    -------------------      -------------------
                                      High        Low          High         Low
                                      ----        ---          ----         ---
      Fourth Quarter                $  8.02     $  5.81      $  9.57     $  6.21
      Third Quarter                 $  6.87     $  5.66      $  7.85     $  5.13
      Second Quarter                $  7.43     $  5.23      $  8.35     $  6.15
      First Quarter                 $  9.67     $  5.78      $ 10.15     $  6.57

HOLDERS OF COMMON STOCK

      We had  approximately 182 holders of record of Common Stock as of February
      21, 2006. 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.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

      Shares of common stock  repurchased  during the quarter ended December 31,
      2005:

                                                            Total Number of         Maximum Number
                                                           Shares Purchased       of Shares that May
                    Total Number of     Average Price     as Part of Publicly      Yet Be Purchased
                   Shares Purchased    Paid per Share       Announced Plan          Under the Plan

November, 2005           8,000              $7.50                8,000                1,492,400

December, 2005          42,000              $7.49               42,000                1,450,400

     Total              50,000              $7.49               50,000                1,450,400


                                       18


      The Company's Board of Directors approved a program, effective October 24,
      2001,  to  repurchase  up to two million  shares of the  Company's  common
      stock. The program has no expiration date.

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."


                                       19


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,
                                              2005          2004           2003           2002           2001
                                          -----------------------------------------------------------------------
                                                           (In thousands, except per share data)

Revenues:
Software license revenue .............      $ 29,544      $ 21,488       $ 12,251       $  8,667       $  4,714
Maintenance revenue ..................         7,594         4,443          2,473          1,297             17
Software services and other revenue ..         3,826         2,778          2,220            665            861
                                            --------      --------       --------       --------       --------
                                              40,964        28,709         16,944         10,629          5,592
                                            --------      --------       --------       --------       --------
Operating expenses:
  Amortization of purchased
  and capitalized
  software ...........................           782         1,394          1,394            899            273
  Cost of maintenance,
  software services and
  other revenue ......................         6,114         4,150          2,580          1,309            897
  Software development
  costs ..............................        12,039         9,050          7,068          6,281          5,004
  Selling and marketing ..............        16,109        14,277         10,967          9,856          8,085
  General and administrative .........         4,213         5,109          2,878          2,592          2,732
  Litigation settlement ..............            --         1,300             --             --             --
  Lease abandonment charge ...........            --            --            550             --             --
  Impairment of prepaid royalty ......            --            --             --            483             --
                                            --------      --------       --------       --------       --------

                                              39,257        35,280         25,437         21,420         16,991
                                            --------      --------       --------       --------       --------
    Operating income (loss) ..........         1,707        (6,571)        (8,493)       (10,791)       (11,399)
                                            --------      --------       --------       --------       --------
Interest and other income ............           705           714          1,122          1,585          1,365

Impairment of long-lived assets ......            --            --             35         (2,300)            --
                                            --------      --------       --------       --------       --------

    Income (loss) before income ......         2,412        (5,857)        (7,336)       (11,506)       (10,034)

Provision for income taxes ...........           119            32             33             37             22
                                            --------      --------       --------       --------       --------

    Net income (loss) ................      $  2,293      $ (5,889)      $ (7,369)      $(11,543)      $(10,056)
                                            --------      --------       --------       --------       --------
Beneficial conversion feature
  attributable to convertible
  preferred stock ....................            --            --             --             --          3,896
                                            --------      --------       --------       --------       --------
Net income (loss) attributable to
  common shareholders ................      $  2,293      $ (5,889)      $ (7,369)      $(11,543)      $(13,952)
                                            ========      ========       ========       ========       ========

Basic net income (loss) per share
  attributable to common shareholders       $   0.05      $  (0.13)      $  (0.16)      $  (0.26)      $  (0.40)
                                            ========      ========       ========       ========       ========

Diluted net income (loss) per share
  attributable to common shareholders       $   0.05      $  (0.13)      $  (0.16)      $  (0.26)      $  (0.40)
                                            ========      ========       ========       ========       ========

Basic weighted average common
  shares outstanding .................        47,662        46,967         45,968         45,233         35,264
                                            ========      ========       ========       ========       ========

Diluted weighted average common
  shares outstanding .................        50,776        46,967         45,968         45,233         35,264
                                            ========      ========       ========       ========       ========


                                       20


CONSOLIDATED BALANCE SHEET DATA:

                                   December 31,   December 31,   December 31,   December 31,   December 31,
                                   2005           2004           2003           2002           2001
                                   ------------------------------------------------------------------------
                                                              (In thousands)

Cash and cash equivalents
  and marketable securities        $36,631        $33,973        $36,685        $51,102        $64,527

Working capital                     39,654         36,452         39,527         47,746         57,518

Total assets                        63,974         56,074         56,493         64,710         74,471

Long-term obligations                2,240          1,290            396             --            283

Stockholders' equity                48,658         46,364         50,556         55,901         63,562


                                       21


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

      Fiscal 2005 was a year of continued growth and profitability. Our revenues
for the full year  increased to $41.0 million from $28.7 million in 2004. We are
pleased that we were profitable for a full year for the first time.

      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 2005 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 2006 and
we anticipate that our research and development and sales and marketing expenses
will increase in 2006.

      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 for us to remain competitive and to continue our growth.

      It is important  to our success  that our  products  meet the needs of end
users  and  that  our  products  are - and  are  viewed  by the  market  to be -
innovative.  In 2005 our  products  continued to receive  recognition  for their
features, quality and innovation from several respected,  independent,  industry
publications  and  organizations.  This  recognition  helps  us gain  access  to
additional customers and assists us in closing sales.

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

      In the fourth  quarter of 2005, we announced the launch of our  PrimeVault
disaster recovery,  archiving and hosting 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.

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

      Our sales  "pipeline"  consists of inquiries  from end users and resellers
for possible  purchases of our  products.  Our overall sales  pipeline  steadily
increased for each quarter of 2005 compared with the same quarter in 2004.


                                       22


      OEM relationships are important to us for two main reasons.  First,  sales
by our OEM partners  contribute  to our  revenues.  Second,  having our products
selected  by  respected,  established  industry  leaders  signals to  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.

      Overall,  product  licenses  to OEMs  accounted  for  approximately  forty
percent of our revenues in 2005.  Two OEM customers  each accounted for over ten
percent of our  revenues.  We  anticipate  that OEMs will account for over forty
percent of our  revenues in 2006.  We expect that at least one OEM will  account
for at least ten percent of our revenues in 2006. Accordingly,  the loss of this
customer would have a material adverse effect on our business.

      In 2005,  we signed a new agreement for our VTL product with a Tier-1 OEM.
This OEM released a solution using our VTL in the fourth quarter of 2005. Due to
the timing of the royalty reports from this OEM, the revenue will be recorded on
a one quarter  lag.  As a result of this lag,  we did not have any revenue  from
this OEM in 2005, but we expect to start generating revenue in 2006. In 2005, we
signed a number of agreements with  international  OEMs for our IPStor,  VTL and
iSCSI  Storage  Server  products.  One of  these  agreements  is with a major IP
Networking  solution  provider based in Hangzhou,  China to offer turn-key iSCSI
solutions.  We also  renewed  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.

      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  complaining  about  the  level  of  support  they  are  receiving  from the
suppliers, the resellers will move quickly to offer different solutions to their
customers. Additional sales by resellers are therefore an important indicator of
our business  prospects.  We saw growth in the sales by most of our  significant
resellers  in 2005 and expect that this growth  will  continue in 2006.  We have
established strong relationships with many premier resellers. In 2005, 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 received  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 maintenance and support  services.  Our deferred  revenue  increased to
$9.6 million as of December 31, 2005,  compared with $5.4 million as of December
31, 2004. We expect deferred revenue to continue to grow in 2006.

      The level of re-orders  from existing end users of our products is another
measure of customer satisfaction. Information technology professionals will only
order  additional  products and services for their  companies if they  determine
that the products  have reduced total cost of ownership and have provided a good
return on  investment.  Re-orders are thus an  indication  that our products are
delivering as promised and that our support is meeting the end user's needs.  In
2005, many end users ordered  additional  copies of our products,  or additional
products or ordered additional  options. If re-orders decline, it would indicate


                                       23


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 had an adverse impact on our
revenues in 2005.  During 2005,  two of our OEM partners were purchased by other
companies. In one case, the uncertainty caused by the impending purchase and the
subsequent  consolidation  of the businesses  caused a loss of focus on sales by
the two  companies.  In the other  case,  after the  acquisition,  the  acquirer
undertook a lengthy review of which  solutions  would be offered by the combined
entity.  This review caused a near halt in sales of solutions  incorporating our
product.  We are pleased that both  acquirers  have decided to continue to offer
solutions incorporating our products.

      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 2006.

      We have new  initiatives  in the  small/medium  business  (SMB)  and small
office/home office (SOHO) markets.  We did not receive  significant revenue from
these  markets in 2005,  but we believe  that these  non-enterprise  markets are
another  growth  area for  storage  software.  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.  The launch is
scheduled  for the first  quarter of 2006.  It is too early to estimate  whether
revenues from these markets will be significant  contributors to our revenues in
2006.

      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 2006,  as our new OEM  continues  it sales  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.

      Market  acceptance  of IP-based  Storage Area  Networks,  primarily  using
iSCSI, continued in 2005. Previously, most SANs had been based on fibre-channel.
However,  this portion of the storage software market has not been a significant
contributor to our revenues.  Our expectations regarding the size of the revenue
contribution  from this market in 2005 were  impacted  negatively,  in part,  by
sales from our Tier 1 OEM partner  that were lower than we had  anticipated.  In
2006,  we plan to work with this  partner to enhance the product line to help to
grow sales. In addition,  we have signed agreements with  international  OEMs to
market these products. We plan to continue to tap into the growth in this market
through sales of our products by other strategic partners.

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

      Our gross margin  increased on a full year basis to 83% compared  with 81%
in 2004. We believe this  demonstrates that we were successful in our ability to
scale our business.

      We are pleased  with our  ability to contain  the  increase of expenses in
2005. 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 2005, and we anticipate that our quarterly
results for 2006 will show the effects of seasonality as well.


                                       24


      As described in note 1 to our consolidated financial statements, beginning
with the first  quarter of 2006,  we will be required by  Statement of Financial
Accounting  Standards No. 123(R), Share Based Payment, to expense the grant date
fair value of stock options and other equity based compensation to employees and
non-employees  in our  financial  statements.  We are currently  evaluating  the
impact  that  the  adoption  of this  statement  will  have on our  consolidated
financial  statements,  but there  will be a  negative  impact  on our  reported
results of operations.  Notwithstanding this change to our financial statements,
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
stock option 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 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,  and we have not provided any of our
customers  extended payment terms.  When a customer  licenses  software together
with  the  purchase  of  maintenance,  we  allocate  a  portion  of  the  fee to
maintenance for its fair value.

      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.

      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, 2005, 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, 2005  COMPARED TO THE
YEAR ENDED DECEMBER 31, 2004

      Revenues  for the year ended  December  31,  2005  increased  43% to $41.0
million  compared to $28.7  million for the year ended  December 31,  2004.  Our
operating  expenses increased 11% from $35.3 million in 2004 to $39.3 million in
2005. Net income for the year ended December 31, 2005 was $2.3 million  compared
with a net loss of $5.9  million  for the year  ended  December  31,  2004.  The


                                       25


increase in revenues was mainly due to an increase in (i) demand for our network
storage  solution  software  and  (ii)  sales  from  our 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, 2005.  Revenue
from resellers and  distributors  also increased in absolute  dollars.  Expenses
increased in cost of maintenance,  software services and other revenue, software
development, and selling and marketing to support our growth. For the year ended
December 31, 2005,  we increased the number of employees and continued to invest
in infrastructure by purchasing additional computers and equipment. We increased
the number of  employees  from 217  employees  as of  December  31,  2004 to 279
employees as of December  31,  2005.  Included in our results for the year ended
December 31, 2004 are a litigation  settlement  charge of $1.3 million and legal
fees of $1.0  million,  each  associated  with  litigation  relating  to  patent
infringement that was resolved in the third quarter of 2004.

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 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.  We expect  our  software  license  revenue to
continue to grow and the percentage of future  software  license revenue derived
from our OEM partners to increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Maintenance,  software  services  and  other  revenues  are  comprised  of
software  maintenance and technical  support,  professional  services  primarily
related to the implementation of our software,  engineering services,  and sales
of computer  hardware.  Revenue derived from  maintenance and technical  support
contracts is deferred and recognized  ratably over the  contractual  maintenance
term. Professional services revenue is recognized in the period that the related
services are performed.  Revenue from engineering  services is primarily related
to customizing  software  product masters for some of our OEM partners.  Revenue
from  engineering  services  is  recognized  in  the  period  the  services  are
completed. In 2005 and 2004, 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 fee 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  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.  We expect
maintenance, software services and other revenues to continue to increase.


                                       26


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, 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,  we recorded  $1.4 million of  amortization  related to these
purchased software  licenses.  We will continue to evaluate third party software
licenses and may make additional purchases, which would result in an increase in
amortization expense.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Cost  of  maintenance,  software  services  and  other  revenues  consists
primarily  of  personnel  and other costs  associated  with  providing  software
implementations,  technical support under maintenance  contracts,  and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware  purchased that was resold.  Cost of maintenance,  software services
and other revenues for the year ended December 31, 2005 increased by 47% to $6.1
million  compared to $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. 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, 2005 was $34.1 million or 83%
of  revenues  compared to $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  consist  primarily  of  personnel  costs for
product  development  personnel  and other  related  costs  associated  with the
development  of  new  products,   enhancements  to  existing  products,  quality
assurance and testing. Software development costs increased 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.  We intend to continue
recruiting and hiring product  development  personnel to support our development
process.

SELLING AND MARKETING

      Selling and marketing  expenses  consist  primarily of sales and marketing
personnel  and  related  costs,  travel,  public  relations  expense,  marketing
literature  and  promotions,  commissions,  trade show  expenses,  and the costs
associated  with our  foreign  sales  offices.  Selling and  marketing  expenses
increased  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.  We  believe  that to  continue  to grow  sales,  our sales and
marketing expenses will continue to increase.


                                       27


GENERAL AND ADMINISTRATIVE

      General and  administrative  expenses consist primarily of personnel costs
of general and administrative functions, public company related costs, directors
and officers insurance,  legal and professional fees and other general corporate
overhead  costs.  General  and  administrative  expenses  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

      We  invest  our  cash,  cash  equivalents  and  marketable  securities  in
government securities and other low risk investments.  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

      We did not  record  a tax  benefit  associated  with the  pre-tax  results
incurred from the period from inception (February 10, 2000) through December 31,
2005,  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 consists
of tax expenses related to alternative  minimum taxes and taxes from our foreign
subsidiaries.

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

REVENUES

SOFTWARE LICENSE REVENUE

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

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Maintenance,  software  services and other  revenue  increased 54% to $7.2
million in 2004 from $4.7 million in 2003. The major factor  contributing to the
increase in maintenance, software services and other revenue was the increase in
the number of maintenance and technical  support contracts we sold. As we are in
business longer, and as we license more software,  we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and


                                       28


support and most  customers  renew  their  maintenance  and support  after their
initial  contracts expire.  Maintenance  revenue increased from $2.5 million for
the year ended December 31, 2003 to $4.4 million for the year ended December 31,
2004.  Software  services and other revenue  increased to $2.8 million from $2.2
million in 2003. Growth in our professional  services  revenue,  which increased
from $0.9 million in 2003 to $1.3 million in 2004, partially  contributed to the
increase in software services and other revenues.  This increase in professional
services revenue was related to the increase in our software  license  customers
that elected to purchase professional services. Additionally, our hardware sales
increased  from $1.3 million in 2003 to $1.5 million in 2004.  This increase was
the result of an increase in demand from our customers for bundled solutions.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

      As of  December  31,  2004 and  2003,  we had $4.9  million  of  purchased
software licenses that are being amortized over three years. For the years ended
December 31, 2004 and 2003, we recorded $1.4 million of amortization  related to
these purchased  software  licenses.  Amortization  of capitalized  software was
$7,881 and $31,523 for the years ended December 31, 2004 and 2003, respectively.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

      Cost of  maintenance,  software  services and other  revenues for the year
ended  December  31,  2004  increased  by 61% to $4.2  million  compared to $2.6
million  for  the  year  ended  December  31,  2003.  The  increase  in  cost of
maintenance,  software  services  and other  revenue was  principally  due to an
increase in personnel.  As a result of our increased  sales of  maintenance  and
support  contracts  and  professional  services,  we required a higher number of
employees to provide technical support and to implement our software.

      Gross profit for the year ended December 31, 2004 was $23.2 million or 81%
of  revenues  compared to $13.0  million or 77% of  revenues  for the year ended
December  31,  2003.  The increase in gross profit and gross margin was directly
related to the increase in revenues relative to the increase in expenses. As our
software  license  revenues  increase,  the associated  costs as a percentage of
those  revenues  tend to decrease.  Additionally,  the  increased  percentage of
revenue  from our OEM  partners  in 2004  contributed  to the  increase in gross
margin since revenues from our OEM partners have higher gross margins.

SOFTWARE DEVELOPMENT COSTS

      Software development costs increased 28% to $9.1 million in 2004 from $7.1
million in 2003. The increase in software development costs was primarily due to
an increase  in  employees  required  to enhance  and test our  network  storage
software products, as well as to develop new innovative features and options. In
addition,  as we entered  into  agreements  with new OEM  partners,  we required
additional  employees to test and  integrate our software with our OEM partners'
products.  At the end of 2003, we also opened a  development  office in China to
assist in our development work.

SELLING AND MARKETING

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

GENERAL AND ADMINISTRATIVE

      General and administrative  expenses increased 77% to $5.1 million in 2004
from $2.9 million in 2003. The increase in general and  administrative  expenses
was partially due to a $1.0 million  increase in legal expense  attributable  to
litigation  relating  to  alleged  patent  infringement  with Dot  Hill  Systems
Corporation ("Dot Hill") and Crossroads  Systems (Texas),  Inc.  ("Crossroads").


                                       29


Expenses  of $0.8  million  for the year ended  December  31,  2004,  related to
compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and an increase in
the  number of  employees  also  contributed  to the  increase  in  general  and
administrative expenses.

INTEREST AND OTHER INCOME

      Interest and other income  decreased 36% to $0.7 million in 2004 from $1.1
million in 2003.  This  decrease  in interest  income was due to lower  interest
rates  and  lower  average  cash,  cash  equivalent  and  marketable  securities
balances.

INCOME TAXES

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

LEASE ABANDONMENT CHARGE

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

LIQUIDITY AND CAPITAL RESOURCES

      Our total cash and cash equivalents and marketable  securities  balance as
of December 31, 2005  increased  by $2.7 million  compared to December 31, 2004.
Our cash and cash  equivalents  totaled $18.8 million and marketable  securities
totaled  $17.8  million at December  31, 2005.  As of December 31, 2004,  we had
$15.5  million in cash and cash  equivalents  and $18.5  million  in  marketable
securities.

      In  2005,  we  made  investments  in our  infrastructure  to  support  our
long-term  growth.  We increased  the total number of employees in 2005 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.  We believe we have no
further payment obligations.

      In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding  common stock. Since October 2001, 549,600
shares have been  repurchased  at an  aggregate  purchase  price of $3.6 million
including 272,500 shares  repurchased in 2005 at an aggregate  purchase price of
$1.9 million.

      Net cash  provided by  operating  activities  totaled $6.5 million for the
year  ended  December  31,  2005,  compared  with  net  cash  used in  operating
activities of $1.1 million for the year ended December 31, 2004 and $5.9 million
for the year ended December 31, 2003. The positive trend in our cash provided by
operating  activities is mainly due to the  improvement in our net results which
resulted in net income of $2.3  million for the year ended  December  31,  2005,


                                       30


compared  with a net loss of $5.9  million for the year ended  December 31, 2004
and $7.4 million for the year ended  December  31, 2003.  In addition to our net
income for 2005 and our  decrease  in net loss for 2004 and 2003,  our  deferred
revenues  increased by $4.2 million in 2005 compared to $2.8 million in 2004 and
$0.4 million in 2003.  The increase in our deferred  revenue is the result of an
increase in our  maintenance  contracts,  which are deferred and  recognized  as
revenue ratably over the term of the contract.  This amount was partially offset
by increases in our net  accounts  receivable  balances of $4.9 million in 2005,
$3.2  million in 2004 and $2.8  million in 2003.  The  increases in our accounts
receivable  balances are due to our revenue  growth.  We expect cash provided by
operating  activities  to continue to increase as we  anticipate  our net income
will increase.

      Net cash used in investing activities was $2.8 million in 2005 compared to
net cash  provided  by  investing  activities  of $6.3  million in 2004 and $2.5
million in 2003.  Included in investing  activities  for each year are the sales
and  purchases  of  our  marketable  securities.   These  represent  the  sales,
maturities and reinvesting of our marketable  securities.  The net cash provided
by investing  activities from the net sale of securities was $0.6 million,  $9.5
million and $8.5 million in 2005,  2004 and 2003,  respectively.  These  amounts
will  fluctuate  from  year to  year  depending  on the  maturity  dates  of our
marketable securities. The cash used to purchase property and equipment was $3.2
million, $2.8 million and $3.0 million in 2005, 2004 and 2003, respectively. The
cash used to purchase  software  licenses  was $0.1 million in 2005 and 2004 and
$1.8 million in 2003. 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  $24,385 in 2005,  $1.8
million in 2004 and $0.9 million in 2003. We received proceeds from the exercise
of stock options of $1.9 million in 2005,  $2.0 million in 2004 and $0.9 million
in 2003.  We made  payments of $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 2006 through  2012.  The  following is a schedule of future  minimum  lease
payments for all operating leases as of December 31, 2005:

      Year ending December 31
      -----------------------

      2006......................................................     $ 1,915,879
      2007......................................................       1,433,153
      2008......................................................       1,220,435
      2009......................................................       1,254,067
      2010......................................................       1,288,708
      Thereafter................................................       1,699,218
                                                                     -----------
                                                                     $ 8,811,460
                                                                     ===========

      We  believe  that our  current  balance  of  cash,  cash  equivalents  and
marketable  securities,   and  expected  cash  flows  from  operations  will  be
sufficient to meet our cash requirements for at least the next twelve months.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based
Payment ("SFAS 123R"),  which revises SFAS 123. SFAS 123R also supersedes APB 25
and amends  SFAS No. 95,  Statement  of Cash  Flows.  SFAS 123R  eliminates  the
alternative  to account for employee stock options under APB 25 and requires the
fair value of all share-based payments to employees (including stock options) be
recognized in the income statement,  generally over the vesting period. In March
2005, the Securities and Exchange  Commission  issued Staff Accounting  Bulletin
("SAB") No. 107,  which  provides  additional  implementation  guidance for SFAS
123R.  Among other  things,  SAB 107 provides  guidance on  share-based  payment
valuations, income statement classification and presentation,  capitalization of
costs and related income tax accounting.


                                       31


      SFAS 123R provides for adoption  using either the modified  prospective or
modified retrospective  transition method. We will adopt SFAS 123R on January 1,
2006, using the modified  prospective  transition  method in which  compensation
cost is  recognized  beginning  January  1,  2006 for all  share-based  payments
granted on or after that date and for all awards  granted to employees  prior to
January 1, 2006 that remain  unvested on that date. We expect to continue to use
the  Black-Scholes-Merton  option  pricing  model to determine the fair value of
stock option awards.

      Adoption  of SFAS  123R's  fair  value  method  will have an effect on our
results of  operations.  The future  impact of SFAS 123R cannot be  predicted at
this time  because it will  depend on levels of  share-based  payments  granted.
However,  had SFAS 123R been  adopted in prior  periods,  the effect  would have
approximated  the SFAS 123 pro forma  amounts  disclosed in footnote 1(j) to our
accompanying consolidated financial statements.

      SFAS  123R also  requires  the  benefits  of tax  deductions  in excess of
recognized  compensation  cost to be reported as a financing  cash flow,  rather
than as an operating cash flow as currently  required.  We have historically not
realized significant tax benefits associated with tax deductions for stock-based
compensation.  Further,  those amounts  cannot be estimated  for future  periods
(because they depend on, among other things,  when  employees  will exercise the
stock options and the market price of the Corporation's common stock at the time
of exercise).

      In June 2005, the FASB issued SFAS No. 154,  ACCOUNTING  CHANGES AND ERROR
CORRECTIONS  - a  replacement  of APB  Opinion No. 20 and FASB  Statement  No. 3
("SFAS  154").  SFAS 154 replaces APB Opinion No. 20,  ACCOUNTING  CHANGES ("APB
20"),  and SFAS  No.  3,  REPORTING  ACCOUNTING  CHANGES  IN  INTERIM  FINANCIAL
STATEMENTS.  SFAS 154  requires  retrospective  application  to  prior  periods'
financial  statements of a voluntary change in accounting principle unless it is
impracticable to determine either the period-specific  effects or the cumulative
effects of the change. APB 20 previously required that most voluntary changes in
accounting  principle be  recognized by including in net income in the period of
the change the cumulative  effect of changing to the new  accounting  principle.
This  standard  generally  will not apply with  respect to the  adoption  of new
accounting  standards,  as new accounting  standards  usually  include  specific
transition provisions,  and will not override transition provisions contained in
new or existing  accounting  literature.  SFAS 154 is effective for fiscal years
beginning  after  December  15,  2005,  and  early  adoption  is  permitted  for
accounting  changes and error corrections made in years beginning after the date
that SFAS 154 was issued.  The Company does not expect that the adoption of SFAS
154 on  January  1,  2006  will  have a  significant  effect  on its  financials
condition or results of operations.

      On December 21, 2004, the Financial  Accounting  Standards  Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING  FOR INCOME  TAXES,  TO THE TAX  DEDUCTION  ON  QUALIFIED  PRODUCTION
ACTIVITIES  PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2,  ACCOUNTING  AND DISCLOSURE  GUIDANCE FOR
THE FOREIGN  EARNINGS  REPATRIATION  PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how  companies  should  account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22,  2004.  FSP No. 109-1 states
that  the  tax  deduction  for  domestic  manufacturing   activities  from  this
legislation  should be  accounted  for as a "special  deduction"  and reduce tax
expense in the period(s) the amounts are deductible on the tax return, not as an
adjustment of recorded deferred tax assets and liabilities.  FSP No. 109-2 gives
a company additional time to evaluate the effects of the legislation on any plan
for  reinvestment or  repatriation of foreign  earnings for purposes of applying
FASB Statement No. 109. The Company has  determined  that it will not repatriate
any undistributed foreign earnings under the new tax legislation and, therefore,
the legislation as it relates to undistributed foreign earnings will not have an
affect on the Company's consolidated financial statements.


                                       32


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 $36.6 million as of December 31, 2005,
is subject to interest  rate risks.  We  regularly  assess  these risks and have
established  policies  and  business  practices to manage the market risk of our
marketable securities.

FOREIGN  CURRENCY  RISK.  We have  several  offices  outside the United  States.
Accordingly,  we are  subject to  exposure  from  adverse  movements  in foreign
currency   exchange  rates.  The  effect  of  foreign  currency   exchange  rate
fluctuations  have  not  been  material  since  our  inception.  We do  not  use
derivative financial instruments to limit our foreign currency risk exposure.

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


                                       33


ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   Index to Consolidated Financial Statements                               Page

       Reports of Independent Registered Public Accounting Firm ...........  35

       Consolidated Balance Sheets as of December 31, 2005 and 2004 .......  37

       Consolidated Statements of Operations for the years ended
         December 31, 2005, 2004 and 2003 .................................  38

       Consolidated Statements of Stockholders' Equity and Comprehensive
         Loss for the years ended December 31, 2005, 2004 and 2003 ........  39

       Consolidated Statements of Cash Flows for the years ended
         December 31, 2005, 2004 and 2003 .................................  40

       Notes to Consolidated Financial Statements .........................  41


                                       34


             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,  2005 and 2004,  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,  2005.  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,  2005 and 2004,  and the
results  of their  operations  and their cash flows for each of the years in the
three-year  period ended  December 31, 2005, in conformity  with U.S.  generally
accepted accounting principles.

      We also have  audited,  in  accordance  with the  standards  of the Public
Company  Accounting  Oversight  Board  (United  States),  the  effectiveness  of
FalconStor  Software,  Inc.'s  internal  control over financial  reporting as of
December  31,  2005,  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 15, 2006,  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 15, 2006


                                       35


             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, 2005,  based on
criteria  established in Internal  Control--Integrated  Framework  issued by the
Committee of Sponsoring  Organizations of the Treadway  Commission  (COSO).  The
Company's  management is responsible for maintaining  effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's  assessment  and an opinion on the  effectiveness  of the Company's
internal control over financial reporting based on our audit.

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

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

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

      In our  opinion,  management's  assessment  that  the  Company  maintained
effective internal control over financial  reporting as of December 31, 2005, 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, 2005,  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,  2005 and  2004,  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, 2005,  and our report  dated,  March 15, 2006,  expressed an
unqualified opinion on those consolidated financial statements.


                                                 /s/  KPMG LLP

Melville, New York
March 15, 2006


                                       36


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS

                                                                                         December 31,
                                                                                         ------------
                                                                                      2005             2004
                                                                                 ------------     ------------

                                     ASSETS
Current assets:
   Cash and cash equivalents ................................................    $ 18,796,973     $ 15,484,573
   Marketable securities ....................................................      17,833,683       18,488,616
   Accounts receivable, net of allowances of $3,846,882 and
     $2,551,616, respectively ...............................................      15,187,408       10,269,822
   Prepaid expenses and other current assets ................................         911,715          629,036
                                                                                 ------------     ------------

         Total current assets ...............................................      52,729,779       44,872,047

Property and equipment, net of accumulated depreciation of
  $7,150,762 and $4,698,025, respectively ...................................       5,277,609        4,662,269
Goodwill ....................................................................       3,512,796        3,512,796
Other intangible assets, net ................................................         216,864          307,620
Other assets, net ...........................................................       2,236,725        2,719,460
                                                                                 ------------     ------------

         Total assets .......................................................    $ 63,973,773     $ 56,074,192
                                                                                 ============     ============

                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable ..........................................................    $  1,152,228     $    821,433
  Accrued expenses ..........................................................       4,522,212        3,501,034
  Deferred revenue ..........................................................       7,401,018        4,097,279
                                                                                 ------------     ------------

         Total current liabilities ..........................................      13,075,458        8,419,746

Deferred revenue ............................................................       2,240,208        1,290,496
                                                                                 ------------     ------------

         Total liabilities ..................................................      15,315,666        9,710,242
                                                                                 ------------     ------------

 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,
      48,441,614 and 47,768,755 shares issued, respectively and 47,892,014
      and 47,491,655 shares outstanding, respectively .......................          48,442           47,769
  Additional paid-in capital ................................................      87,342,747       85,400,740
  Accumulated deficit .......................................................     (34,659,329)     (36,952,436)
  Common stock held in treasury, at cost (549,600 and 277,100 shares,
     respectively) ..........................................................      (3,632,930)      (1,714,775)
  Accumulated other comprehensive loss, net .................................        (440,823)        (417,348)
                                                                                 ------------     ------------

         Total stockholders' equity .........................................      48,658,107       46,363,950
                                                                                 ------------     ------------
         Total liabilities and stockholders' equity .........................    $ 63,973,773     $ 56,074,192
                                                                                 ============     ============

          See accompanying notes to consolidated financial statements.


                                       37


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                         Years Ended December 31,

                                                   2005            2004             2003
                                               ------------    ------------     ------------

Revenues:
  Software license revenue ................    $ 29,544,467    $ 21,487,866     $ 12,250,616
  Maintenance revenue .....................       7,593,804       4,442,724        2,473,504
  Software services and other revenue .....       3,825,832       2,778,088        2,220,015
                                               ------------    ------------     ------------
                                                 40,964,103      28,708,678       16,944,135
                                               ------------    ------------     ------------

Operating expenses:
  Amortization of purchased and capitalized
     software .............................         781,500       1,393,908        1,394,301
  Cost of maintenance, software services
     and other revenue ....................       6,114,112       4,150,309        2,580,141
  Software development costs ..............      12,039,488       9,050,092        7,067,605
  Selling and marketing ...................      16,109,440      14,277,167       10,966,548
  General and administrative ..............       4,212,769       5,108,516        2,878,192
  Litigation settlement ...................              --       1,300,000               --
  Lease abandonment charge ................              --              --          550,162
                                               ------------    ------------     ------------
                                                 39,257,309      35,279,992       25,436,949
                                               ------------    ------------     ------------
       Operating income (loss) ............       1,706,794      (6,571,314)      (8,492,814)
                                               ------------    ------------     ------------

Interest and other income, net ............         705,063         714,412        1,121,391
Other .....................................              --              --           35,000
                                               ------------    ------------     ------------

       Income (loss) before income taxes ..       2,411,857      (5,856,902)      (7,336,423)

 Provision for income taxes ...............         118,750          31,945           32,532
                                               ------------    ------------     ------------

       Net income (loss) ..................    $  2,293,107    $ (5,888,847)    $ (7,368,955)
                                               ------------    ------------     ------------

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

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

 Basic weighted average common shares
  outstanding .............................      47,662,446      46,967,422       45,967,830
                                               ============    ============     ============

 Diluted weighted average common shares
  outstanding .............................      50,776,396      46,967,422       45,967,830
                                               ============    ============     ============

          See accompanying notes to consolidated financial statements.


                                       38


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

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

                                                  Additional
                                    Common         paid-in          Deferred        Accumulated
                                    stock          capital        compensation        deficit
                                 ------------    ------------     ------------     ------------

Balance, December 31, 2002 ..    $     45,528    $ 81,423,661     $   (471,445)    $(23,694,634)

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

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

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

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

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

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

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

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 loss 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               --               --

Amortization of deferred
  compensation ..............              --              --               --               --

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

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

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

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

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

                                                  Accumulated
                                                     other
                                                 comprehensive        Total        Comprehensive
                                   Treasury          income        stockholders'       income
                                     stock           (loss)           equity           (loss)
                                 ------------    -------------     -------------   -------------

Balance, December 31, 2002 ..    $ (1,435,130)    $     33,073     $ 55,901,053

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

Exercise of stock options ...              --               --          851,817               --

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

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

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

Change in unrealized loss on
  marketable securities, net               --         (214,394)        (214,394)        (214,394)

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

Balance, December 31, 2003 ..    $ (1,435,130)    $   (262,489)    $ 50,555,549     $ (7,664,517)
                                                                                    ============

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

Exercise of stock options ...              --               --        2,036,760               --

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

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

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

Change in unrealized loss 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               --

Amortization of deferred
  compensation ..............              --               --               --               --

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

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

Change in unrealized loss 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
                                 ------------     ------------     ------------     ------------

          See accompanying notes to consolidated financial statements.


                                       39


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

                                                                   Years Ended December 31,

                                                             2005             2004             2003
                                                         ----------------------------------------------

Cash flows from operating activities:
   Net income (loss) ................................    $  2,293,107     $ (5,888,847)    $ (7,368,955)
     Adjustments to reconcile net loss to net cash
       used in operating activities:
       Depreciation and amortization ................       3,505,562        3,656,212        2,759,030
       Non-cash professional services expenses ......         (32,860)          87,023           86,875
       Realized loss on marketable securities .......         270,026           17,795               --
       Tax benefit from stock option exercise .......          33,000               --               --
       Equity-based compensation expense ............              --            7,969          463,476
       Provision for returns and doubtful accounts ..       4,340,102        3,296,275        1,700,100
     Changes in operating assets and liabilities:
       Accounts receivable ..........................      (9,274,971)      (6,456,175)      (4,524,130)
       Prepaid expenses and other current assets ....        (291,693)         636,208         (137,115)
       Other assets .................................         (50,401)        (251,038)        (227,711)
       Accounts payable .............................         354,471          259,128          125,217
       Accrued expenses .............................       1,104,416          791,498          761,827
       Deferred revenue .............................       4,234,918        2,789,987          415,059
                                                         ------------     ------------     ------------
         Net cash provided by (used in) operating
           activities ...............................       6,485,677       (1,053,965)      (5,946,327)
                                                         ------------     ------------     ------------
Cash flows from investing activities:
   Purchase of marketable securities ................     (61,264,424)     (33,897,295)      (8,537,284)
   Sale of marketable securities ....................      61,867,854       43,441,277       17,034,096
   Purchase of investments ..........................              --               --         (137,710)
   Purchase of property and equipment ...............      (3,161,383)      (2,842,792)      (2,998,908)
   Purchase of software licenses ....................        (108,000)         (50,000)      (1,821,000)
   Purchase of intangible assets ....................        (126,241)        (131,392)        (246,697)
   Net cash paid for acquisition of IP Metrics ......              --         (214,009)        (287,130)
   Security deposits ................................              --           (4,500)        (500,000)
                                                         ------------     ------------     ------------
     Net cash provided by (used in) investing
       activities ...................................      (2,792,194)       6,301,289        2,505,367
                                                         ------------     ------------     ------------
Cash flows from financing activities:
   Proceeds from exercise of stock options ..........       1,942,540        2,036,760          851,817
   Payments to acquire treasury stock ...............      (1,918,155)        (279,645)              --
                                                         ------------     ------------     ------------

     Net cash provided by financing activities ......          24,385        1,757,115          851,817
                                                         ------------     ------------     ------------

Cash flows from discontinued operations (all
  operating activities in 2003):
     Payments of liabilities of discontinued
       operations ...................................              --               --       (3,034,620)
                                                         ------------     ------------     ------------

Effect of exchange rate changes .....................        (405,468)          (6,010)         (81,168)
                                                         ------------     ------------     ------------

Net increase (decrease) in cash and cash equivalents        3,312,400        6,998,429       (5,704,931)

Cash and cash equivalents, beginning of year ........      15,484,573        8,486,144       14,191,075
                                                         ------------     ------------     ------------

Cash and cash equivalents, end of year ..............    $ 18,796,973     $ 15,484,573     $  8,486,144
                                                         ============     ============     ============

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

Cash paid for income taxes ..........................    $     21,583     $     24,554     $     48,351
                                                         ============     ============     ============

      The  Company  did not pay any  interest  expense for the three years ended
December 31, 2005.

          See accompanying notes to consolidated financial statements.


                                       40


                   FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 2005

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(A) THE COMPANY AND NATURE OF OPERATIONS

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

(B) PRINCIPLES OF CONSOLIDATION

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

(C) CASH EQUIVALENTS AND MARKETABLE SECURITIES

      The Company  considers  all highly liquid  investments  with a maturity of
three months or less when purchased to be cash  equivalents.  Cash  equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$12.4  million and $10.9  million at December  31, 2005 and 2004,  respectively.
Marketable  securities  at December 31, 2005 and 2004  amounted to $17.8 million
and $18.5 million, respectively, and consisted of corporate bonds and government
securities,  which  are  classified  as  available  for sale,  and  accordingly,
unrealized  gains  and  losses  on  marketable  securities  are  reflected  as a
component of accumulated other comprehensive loss in stockholders' equity.

(D) REVENUE RECOGNITION

      The Company  recognizes  revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE  RECOGNITION.  Accordingly,
revenue for  software  licenses is  recognized  when  persuasive  evidence of an
arrangement exists, the fee is fixed and determinable, the software is delivered
and  collection  of  the  resulting  receivable  is  deemed  probable.  Software
delivered to a customer on a trial basis is not  recognized  as revenue  until a
permanent key is delivered to the customer.  Reseller  customers  typically send
the Company a purchase order only when they have an end user identified.  When a
customer  licenses  software  together  with the  purchase of  maintenance,  the
Company  allocates  a  portion  of the fee to  maintenance  for its fair  value.
Software  maintenance  fees are deferred and recognized as revenue  ratably over
the term of the arrangement.  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.

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


                                       41


      For the years ended  December 31, 2005 and 2004, 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).

(E) 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
(generally  between 3 to 7 years).  Leasehold  improvements  are  amortized on a
straight-line  basis  over  the  term of the  respective  leases  or over  their
estimated useful lives, whichever is shorter.

(F) GOODWILL AND OTHER INTANGIBLE ASSETS

      Goodwill  represents  the excess of the purchase  price over the estimated
fair value of net  tangible  and  identifiable  intangible  assets  acquired  in
business  combinations.   Consistent  with  Statement  of  Financial  Accounting
Standards  ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE  ASSETS,  the Company has
not amortized  goodwill related to its acquisitions,  but has instead tested the
balance for impairment.  The Company's annual impairment assessment is performed
on  December  31st of each  year,  and  additionally  if  events or  changes  in
circumstances  indicate  that it is more  likely  than  not  that  the  asset is
impaired.  Identifiable intangible assets are amortized over a three-year period
using the straight-line method.  Amortization expense was $216,997, $220,712 and
$159,248 for 2005,  2004 and 2003,  respectively.  The gross carrying amount and
accumulated  amortization of other intangible assets as of December 31, 2005 and
December 31, 2004 are as follows:

                                                         December 31,  December 31,
                                                             2005          2004
                                                         ------------  ------------

      Customer relationships and purchased technology:

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

        Net carrying amount ..........................    $      --     $  36,142
                                                          =========     =========

      Patents:
      Gross carrying amount ..........................    $ 649,864     $ 523,623
      Accumulated amortization .......................     (433,000)     (252,145)
                                                          ---------     ---------

        Net carrying amount ..........................    $ 216,864     $ 271,478
                                                          =========     =========

(G) SOFTWARE DEVELOPMENT COSTS AND PURCHASED SOFTWARE TECHNOLOGY

      Costs  associated  with  the  development  of new  software  products  and
enhancements  to existing  software  products  are  expensed  as incurred  until
technological  feasibility  of the  product has been  established.  Based on the
Company's product development process,  technological feasibility is established
upon completion of a working model.  The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released,  the Company capitalized
$94,570 of software development costs, of which $7,881 and $31,523 was amortized
for  the  years  ended  December  31,  2004  and  2003,  respectively.  Software
development  costs  were  fully  amortized  as of the  first  quarter  of  2004.
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.


                                       42


      Purchased  software   technology  of  $372,306  and  $1,045,806,   net  of
accumulated  amortization  of $4,646,694  and  $3,865,194,  is included in other
assets in the balance  sheets as of December  31, 2005 and  December  31,  2004,
respectively.  Amortization  expense was $781,500,  $1,386,027 and 1,362,778 for
the years ended December 31, 2005, 2004 and 2003, 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,  2005,  amortization  expense on existing  identifiable
intangible assets and purchased software technology will be $443,457,  $104,451,
and $41,262 for the years ended December 31, 2006, 2007 and 2008,  respectively.
Such assets will be fully amortized at December 31, 2008.

(H) INCOME TAXES

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

(I) LONG-LIVED ASSETS

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

(J) ACCOUNTING FOR STOCK-BASED COMPENSATION

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

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

                                                              2005             2004             2003
                                                          ------------     ------------     ------------

Net income (loss) as reported ........................    $  2,293,107     $ (5,888,847)    $ (7,368,955)

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

Deduct total stock-based employee compensation expense
      determined under fair-value-based method for all
      awards, net of tax .............................      (8,565,701)      (8,268,471)      (4,930,656)
                                                          ------------     ------------     ------------
Net loss - pro forma .................................    $ (6,272,594)    $(14,149,349)    $(11,836,135)
                                                          ============     ============     ============

Diluted net income (loss) per common share-as reported    $       0.05     $      (0.13)    $      (0.16)

Diluted net loss per common share-pro forma ..........    $      (0.13)    $      (0.30)    $      (0.26)


                                       43


The per share weighted  average fair value of stock options granted during 2005,
2004 and 2003 was  $4.52,  $6.55 and $5.60,  respectively,  on the date of grant
using  the  Black-Scholes  option-pricing  method  with the  following  weighted
average  assumptions:  2005 - expected  dividend yield of 0%, risk free interest
rate ranging from 3.7% to 4.6%,  expected stock  volatility  ranging from 61% to
65% and an expected option life of six years for options granted to employees of
the  Company,   and  an  option  life  of  ten  years  for  options  granted  to
non-employees;

2004 - expected dividend yield of 0%, risk free interest rate of 3.5%,  expected
stock  volatility  ranging from 166% to 176% and an expected option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees;

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

(K) FINANCIAL INSTRUMENTS

      As of  December  31,  2005  and  2004,  the fair  value  of the  Company's
financial instruments including cash and cash equivalents,  accounts receivable,
accounts payable and accrued expenses,  approximates book value due to the short
maturity of these instruments.

(L) FOREIGN CURRENCY

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

(M) EARNINGS PER SHARE (EPS)

      Basic EPS is computed  based on the weighted  average  number of shares of
common stock outstanding.  Diluted EPS is computed based on the weighted average
number  of  common  shares  outstanding   increased  by  dilutive  common  stock
equivalents.  Due to net losses for the years ended  December 31, 2004 and 2003,
all common stock  equivalents  for these  periods were excluded from diluted net
loss per share.  As of December 31, 2005,  2004 and 2003,  potentially  dilutive
common stock  equivalents  included  10,200,908,  8,973,358 and 9,860,425  stock
options  outstanding,  respectively.  As of December  31,  2005,  2004 and 2003,
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:


                                       44


                          Twelve Months Ended December 31, 2005        Twelve Months Ended December 31, 2004

                        Net Income       Shares       Per Share     Net Income         Shares        Per Share
                       (Numerator)   (Denominator)      Amount      (Numerator)    (Denominator)      Amount
                       -----------   -------------   -----------    -----------    -------------   ------------

Basic EPS .........    $ 2,293,107     47,662,446    $      0.05    $(5,888,847)     46,967,422    $      (0.13)
                       -----------    -----------    -----------    -----------     -----------    ------------

Effect of dilutive
securities:
     Stock Options                      3,113,950                                            --

Diluted EPS            $ 2,293,107     50,776,396    $      0.05    $(5,888,847)     46,967,422    $      (0.13)
                       ===========    ===========    ===========    ===========     ===========    ============

                         Twelve Months Ended December 31, 2003

                       Net Income       Shares        Per Share
                       (Numerator)   (Denominator)      Amount
                       -----------   -------------   -----------

Basic EPS .........    $(7,368,955)    45,967,830    $     (0.16)
                       -----------    -----------    -----------

Effect of dilutive
securities:
     Stock Options                             --

Diluted EPS            $(7,368,955)    45,967,830    $     (0.16)
                       ===========    ===========    ===========

(N) COMPREHENSIVE INCOME (LOSS)

      Comprehensive  income (loss)  includes the  Company's  net income  (loss),
foreign  currency  translation  adjustments and unrealized  losses on marketable
securities.  Components of comprehensive income (loss) were comprised of foreign
currency  translation  adjustment losses of $391,540 and $149,542 as of December
31, 2005 and 2004,  respectively and unrealized losses on marketable  securities
of $49,283 and $267,806 as of December 31, 2005 and 2004, respectively.

(O) USE OF ESTIMATES

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

(P) NEW ACCOUNTING PRONOUNCEMENTS

      In December 2004, the FASB issued SFAS No. 123 (Revised 2004), SHARE-BASED
PAYMENT ("SFAS 123R"),  which revises SFAS 123. SFAS 123R also supersedes APB 25
and amends  SFAS No. 95,  STATEMENT  OF CASH  FLOWS.  SFAS 123R  eliminates  the
alternative  to account for employee stock options under APB 25 and requires the
fair value of all share-based payments to employees (including stock options) be
recognized in the income statement,  generally over the vesting period. In March
2005, the Securities and Exchange  Commission  issued Staff Accounting  Bulletin
("SAB") No. 107,  which  provides  additional  implementation  guidance for SFAS
123R.  Among other  things,  SAB 107 provides  guidance on  share-based  payment
valuations, income statement classification and presentation,  capitalization of
costs and related income tax accounting.

      SFAS 123R provides for adoption  using either the modified  prospective or
modified  retrospective  transition  method. The Company will adopt SFAS 123R on
January 1,  2006,  using the  modified  prospective  transition  method in which
compensation  cost is recognized  beginning  January 1, 2006 for all share-based
payments  granted on or after that date and for all awards  granted to employees
prior to January 1, 2006 that remain unvested on that date.

      Adoption  of SFAS  123R's  fair  value  method  will have an effect on the
Company's  results  of  operations.  The  future  impact of SFAS 123R  cannot be
predicted at this time because it will depend on levels of share-based  payments
granted.  However, had SFAS 123R been adopted in prior periods, the effect would
have approximated the SFAS 123 pro forma amounts disclosed in footnote 1(j).

      SFAS  123R also  requires  the  benefits  of tax  deductions  in excess of
recognized  compensation  cost to be reported as a financing  cash flow,  rather
than  as  an  operating  cash  flow  as  currently  required.  The  Company  has
historically not realized  significant  benefits  associated with tax deductions
for  stock-based  compensation.  Further,  those amounts cannot be estimated for
future periods (because they depend on, among other things,  when employees will
exercise the stock options and the market price of the Company's common stock at
the time of exercise).

      In June 2005, the FASB issued SFAS No. 154,  ACCOUNTING  CHANGES AND ERROR
CORRECTIONS  - a  replacement  of APB  Opinion No. 20 and FASB  Statement  No. 3
("SFAS  154").  SFAS 154 replaces APB Opinion No. 20,  ACCOUNTING  CHANGES ("APB
20"),  and SFAS  No.  3,  REPORTING  ACCOUNTING  CHANGES  IN  INTERIM  FINANCIAL


                                       45


STATEMENTS.  SFAS 154  requires  retrospective  application  to  prior  periods'
financial  statements of a voluntary change in accounting principle unless it is
impracticable to determine either the period-specific  effects or the cumulative
effects of the change. APB 20 previously required that most voluntary changes in
accounting  principle be  recognized by including in net income in the period of
the change the cumulative  effect of changing to the new  accounting  principle.
This  standard  generally  will not apply with  respect to the  adoption  of new
accounting  standards,  as new accounting  standards  usually  include  specific
transition provisions,  and will not override transition provisions contained in
new or existing  accounting  literature.  SFAS 154 is effective for fiscal years
beginning  after  December  15,  2005,  and  early  adoption  is  permitted  for
accounting  changes and error corrections made in years beginning after the date
that SFAS 154 was issued.  The Company does not expect that the adoption of SFAS
154 on January 1, 2006 will have a significant effect on its financial condition
or results of operations.

      On December 21, 2004, the Financial  Accounting  Standards  Board ("FASB")
issued FASB Staff Position No. FAS 109-1, APPLICATION OF FASB STATEMENT NO. 109,
ACCOUNTING  FOR INCOME  TAXES,  TO THE TAX  DEDUCTION  ON  QUALIFIED  PRODUCTION
ACTIVITIES  PROVIDED BY THE AMERICAN JOBS CREATION ACT OF 2004 ("FSP No. 109-1")
and FASB Staff Position No. FAS 109-2,  ACCOUNTING  AND DISCLOSURE  GUIDANCE FOR
THE FOREIGN  EARNINGS  REPATRIATION  PROVISION WITHIN THE AMERICAN JOBS CREATION
ACT OF 2004 ("FSP No. 109-2"). These staff positions provide accounting guidance
on how  companies  should  account for the effects of the American Jobs Creation
Act of 2004 that was signed into law on October 22,  2004.  FSP No. 109-1 states
that  the  tax  deduction  for  domestic  manufacturing   activities  from  this
legislation  should be  accounted  for as a "special  deduction"  and reduce tax
expense in the period(s) the amounts are deductible on the tax return, not as an
adjustment of recorded deferred tax assets and liabilities.  FSP No. 109-2 gives
a company additional time to evaluate the effects of the legislation on any plan
for  reinvestment or  repatriation of foreign  earnings for purposes of applying
FASB Statement No. 109. The Company has  determined  that it will not repatriate
any undistributed foreign earnings under the new tax legislation and, therefore,
the legislation as it relates to undistributed foreign earnings will not have an
affect 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) ACQUISITIONS

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

      The fair value of the net tangible  liabilities of IP Metrics  assumed was
$898,305, including $289,942 of accrued contingent consideration recorded at the
time of acquisition.  The Company purchased certain intangible assets, including
customer  relationships and purchased  technology with a fair value of $216,850.
These intangible assets are being amortized under the straight-line  method over
an  estimated  useful  life of 3 years,  the  expected  period of  benefit.  The
purchase  price in excess of the fair value of the net tangible  and  intangible
assets  acquired and liabilities  assumed by the Company  amounted to $3,325,071
and has been recorded as goodwill.

      On August  22,  2001,  pursuant  to an  Agreement  and Plan of Merger  and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged
with Network Peripherals,  Inc. ("NPI"), with NPI as the surviving  corporation.
Although NPI acquired  FalconStor,  as a result of the  transaction,  FalconStor
stockholders held a majority of the voting interests in the combined  enterprise


                                       46


after the merger.  Accordingly,  for accounting purposes,  the acquisition was a
"reverse  acquisition"  and  FalconStor  was  the  "accounting   acquirer."  The
transaction was accounted for as a  recapitalization  of FalconStor and recorded
based on the fair value of NPI's net  tangible  assets  acquired by  FalconStor,
with no goodwill or other intangible assets being recognized. At the time of the
merger, NPI had no continuing operations and, thus, any post-merger transactions
related to NPI have been  classified as discontinued  operations.  In connection
with the merger, the name of NPI was changed to FalconStor Software, Inc.

(3) PROPERTY AND EQUIPMENT

      Property and equipment consist of the following:

                                            December 31,     December 31,
                                                2005             2004
                                            ------------     ------------

      Computer hardware and software        $ 11,410,607     $  8,542,374

      Furniture and equipment                    501,861          503,819

      Leasehold improvements                     502,895          314,101

      Automobile                                  13,008               --
                                            ------------     ------------

                                              12,428,371        9,360,294

      Less accumulated depreciation           (7,150,762)      (4,698,025)
                                            ------------     ------------

                                            $  5,277,609     $  4,662,269
                                            ============     ============

      Depreciation expense was $2,452,737,  $2,041,592,  and $1,205,839 in 2005,
2004, and 2003, respectively.

(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 other
income. The cost of available-for-sale securities sold are based on the specific
identification  method and  interest  earned is included  in interest  and other
income.

      The cost and fair values of the  Company's  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
                                 ===========    ===========    ===========    ===========

      As of  December  31,  2005 there are 3  corporate  bonds and 2  government
securities which 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.


                                       47


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

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

      Auction rate securities    $ 8,960,511    $ 8,960,511    $        --    $        --

      Government securities        6,901,663      6,920,615             --         18,952

      Corporate bonds              2,626,442      2,875,296             --        248,854
                                 -----------    -----------    -----------    -----------

                                 $18,488,616    $18,756,422    $        --    $   267,806
                                 ===========    ===========    ===========    ===========

      The  cost  basis  and  fair  value  of  available-for-sale  securities  by
contractual maturity as of December 31, 2005, were as follows:

                                                                  Fair
                                                  Cost            Value
                                              -----------      -----------

      Due within one year                     $15,866,571      $15,838,499

      Due between one and two years             2,016,395        1,995,184
                                              -----------      -----------

                                              $17,882,966      $17,833,683
                                              ===========      ===========

(5) ACCRUED EXPENSES

      Accrued expenses are comprised of the following:

                                                 December 31,  December 31,
                                                     2005          2004
                                                 ------------  ------------

      Accrued compensation                        $1,517,115    $1,088,656

      Accrued consulting and professional fees       598,674       899,678

      Accrued marketing and promotion                229,675       193,592

      Other accrued expenses                       1,640,645       770,821

      Accrued hardware purchases                      38,946        73,252

      Accrued and deferred rent                      497,157       475,035
                                                  ----------    ----------

                                                  $4,522,212    $3,501,034
                                                  ==========    ==========

6) INCOME TAXES

      The  provision  for income  taxes for the year ended  December 31, 2005 is
comprised of Federal  Alternative  Minimum  Tax,  state income taxes and foreign
income taxes.  The  provision  for income taxes for the year ended  December 31,
2004 is comprised  solely of foreign income taxes.  The tax effects of temporary
differences that give rise to the Company's deferred tax assets (liabilities) as
of December 31, 2005 and 2004 are as follows:


                                       48


                                                                         2005             2004
                                                                    ------------     ------------

      U.S. Federal net operating loss carryforwards (FalconStor)    $ 11,123,022     $ 11,664,300
      U.S. Federal net operating loss carryforwards (NPI)             31,711,302       31,711,100
      Foreign net operating loss carryforwards                           941,369          335,100
      State net operating loss carryforwards                           1,065,636        1,715,300
      Start-up costs not currently deductible for taxes                   90,100          271,300
      Depreciation                                                      (358,207)        (584,300)
      Compensation                                                       348,562          361,300
      Tax credit carryforwards                                         1,889,255        1,433,200
      Deferred revenue                                                   650,555        1,977,400
      Capital loss carryforward                                          847,901          883,400
      Lease abandonment charge                                            77,327          111,800
      Allowance for receivables                                        1,440,036          995,100
      Patent                                                              99,194          113,500
      Other                                                               11,636            8,100
                                                                    ------------     ------------
                                                                      49,937,688       50,996,600
           Valuation allowance                                       (49,937,688)     (50,996,600)
                                                                    ------------     ------------
                                                                    $         --     $         --
                                                                    ============     ============

      The  difference  between the  provision  for income taxes  computed at the
Federal  statutory rate and the reported  amount of tax expense  attributable to
loss before income taxes for the years ended  December 31, 2005,  2004 and 2003,
are as follows:

                                                                          2005            2004            2003
                                                                      -----------     -----------     -----------

      Tax recovery at Federal statutory rate                          $   820,031     $(1,991,300)    $(2,494,400)
      Increase (reduction) in income taxes resulting from:
          State and local taxes, net of Federal income tax benefit        885,733         809,300        (318,000)
          Non-deductible expenses                                         302,207          47,600          41,900
          Compensation                                                         --           2,700         157,600
          Foreign tax credit                                                   --          (6,100)        (90,000)
          Net effect of foreign operations                                128,150         164,800            (900)
          Research and development credit                                (433,013)       (360,100)       (272,200)
          Increase (decrease) in valuation allowance                   (1,584,358)      1,365,000       3,008,600
                                                                      -----------     -----------     -----------

                                                                      $   118,750     $    31,900     $    32,600
                                                                      ===========     ===========     ===========

      The components of the Company's current income tax provision for the years
ended December 31, 2005, 2004 and 2003 are as follows:

                                      2005           2004           2003
                                    --------       --------       --------

      Federal                       $ 55,887       $     --       $     --
      State and local                  1,113             --             --
      Foreign                         61,750         31,900         32,600
                                    --------       --------       --------
                                    $118,750       $ 31,900       $ 32,600
                                    ========       ========       ========

      Income  (loss)  before  provision  for  income  taxes for the years  ended
December 31, 2005, 2004 and 2003 are as follows:

                                    2005            2004            2003
                                -----------     -----------     -----------

      Domestic income (loss)    $ 4,390,212     $(5,466,000)    $(7,434,000)
      Foreign income (loss)      (1,978,355)       (391,000)         98,000
                                -----------     -----------     -----------
                                $ 2,411,857     $(5,857,000)    $(7,336,000)
                                ===========     ===========     ===========


                                       49


      As of December 31, 2005,  the Company had U.S.  Federal net operating loss
carryforwards of approximately  $32,714,800 which expire from 2020 through 2025.
In  addition,  as of the date of the  merger  described  in Note 2, NPI had U.S.
Federal net operating loss carryforwards of $93,268,500 that starts to expire in
December,  2012.  As of December 31, 2005,  the Company had state net  operating
loss  carryforwards of approximately  $20,682,000  which expire starting in 2007
through  2025.  As of December 31, 2005,  the Company had foreign net  operating
loss carryforwards of approximately  $3,083,600.  At December 31, 2005 and 2004,
the Company established a valuation allowance against 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,   $4,628,100   would  be   allocated  to
paid-in-capital  with the remainder  reducing income tax expense.  Of the amount
allocable  to  paid-in-capital,  $2,336,800  related  to the tax  effect  of the
deductions for payments of the  liabilities of  discontinued  operations and the
balance of $2,291,300 related to the tax effect of compensation  deductions from
exercises of employee and consultant stock options.

(7) STOCKHOLDERS' EQUITY

      In  September,  2003,  the Company  entered into a worldwide OEM agreement
with a major technology  company (the "OEM"), and granted to 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 three-year  period  beginning  June 1, 2004. If the OEM  generates  cumulative
revenues to the Company in the mid-eight  figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the  three-year  period  will  expire.  If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants  earned will be recorded as a reduction  of revenue.  Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. As of December 31, 2005,
the Company had not  generated  any revenues  from this OEM and  accordingly  no
warrants had vested.

(8) STOCK OPTION PLANS

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

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

      The Company  granted  options to purchase an aggregate of 50,000 shares of
common stock to certain  non-employee  consultants in exchange for  professional
services  during 2002.  The aggregate  fair value of these options as determined
using the fair value  method  under SFAS No.  123,  is being  expensed  over the
periods the  services are  provided.  The related  expense  amounted to $32,860,
$87,023 and $86,875 in 2005,  2004 and 2003,  respectively.  These services have
been completed as of December 31, 2005.

      On May 14, 2004 the Company adopted a 2004 Outside  Directors Stock Option
Plan (the "2004 Plan").  The 2004 Plan is administered by the Board of Directors
and  provides  for the  granting  of options to  non-employee  directors  of the


                                       50


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.

      Stock option activity for the periods indicated is as follows:

                                                                            Weighted
                                                                             average
                                                             Number of      exercise
                                                              Options         Price
                                                            -----------     --------

      Outstanding at December 31, 2002 ...................   9,387,579       $ 3.55
      Granted ............................................   2,678,300       $ 7.01
      Exercised ..........................................  (1,224,833)      $  .70
      Canceled ...........................................    (980,621)      $ 9.19
                                                            ----------
      Outstanding at December 31, 2003 ...................   9,860,425       $ 4.29
                                                            ----------
      Granted ............................................   1,227,000       $ 6.91
      Exercised ..........................................  (1,023,425)      $ 1.99
      Canceled ...........................................  (1,090,642)      $ 6.01
                                                            ----------
      Outstanding at December 31, 2004 ...................   8,973,358       $ 4.71
                                                            ----------
      Granted ............................................   2,226,500       $ 7.31
      Exercised ..........................................    (465,110)      $ 4.02
      Canceled ...........................................    (533,840)      $ 6.38
                                                            ----------
      Outstanding at December 31, 2005 ...................  10,200,908       $ 5.22
                                                            ==========

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

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

      Vested at December 31, 2005 ........................   6,735,403       $ 4.19
                                                            ==========

      Options available for grant at December 31, 2005 ...   1,006,314
                                                            ==========

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

      The following table summarizes information about stock options outstanding
at December 31, 2005:

                                       Options Outstanding                                   Options Exercisable
                       -------------------------------------------------------       -----------------------------------

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

$0.35 - $1.01            2,208,913             4.53               $  0.35              2,208,913            $  0.35
$3.95 - $4.04            1,124,610             6.85               $  4.03              1,097,750            $  4.04
$5.07 - $5.86            1,775,341             6.87               $  5.27              1,432,252            $  5.20
$6.01 - $6.90            1,956,570             8.08               $  6.35                763,307            $  6.25
$7.35 - $8.43            2,673,200             8.51               $  8.11                839,587            $  8.24
$8.74 - $9.72              318,624             6.99               $  9.09                249,944            $  9.18
   $10.95                  143,650             4.31               $ 10.95                143,650            $ 10.95
                       -----------                                                   -----------

                        10,200,908             6.99               $  5.22              6,735,403            $  4.19
                       -----------                                                   -----------


                                       51


(9) LEASE ABANDONMENT CHARGE

      In November  2003,  the Company  relocated  its  headquarters  to a larger
facility.  As a result of this  relocation,  the Company  vacated  its  previous
office  space  and  recorded  a lease  abandonment  charge of  $550,162  for the
estimated loss expected to be incurred on the remaining lease obligation through
July 2007. The charge included the remaining lease rental obligation  reduced by
cash flows the Company  expects to generate  from an agreement to sub-lease  the
facility,  as well as the write-off of leasehold  improvements  at the Company's
previous  facility.  As of  December  31,  2005,  the  remaining  amounts due of
$137,429 associated with this charge were included in accrued expenses.

(10) LITIGATION SETTLEMENT CHARGE

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

(11) LIABILITIES OF DISCONTINUED OPERATIONS

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

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

(12) 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 2005 through  2012.  The  following  is a schedule of future  minimum
lease payments for all operating leases as of December 31, 2005:

      Year ending December 31,
      ------------------------

      2006......................................................     $ 1,915,879
      2007......................................................       1,433,153
      2008......................................................       1,220,435
      2009......................................................       1,254,067
      2010......................................................       1,288,708
      Thereafter................................................       1,699,218
                                                                     -----------

                                                                     $ 8,811,460
                                                                     ===========


                                       52


      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 $1,461,051,  $1,103,008, and $673,949 for the years ended December 31, 2005,
2004 and 2003, 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 10, through  December 31, 2005, 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.

      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  Executive  Officer,  Chief  Financial
Officer  and  certain  other key  executives  are  entitled  to receive  certain
contingent  benefits,  as set forth in the Severance  Plan,  including  lump sum
payments   and   acceleration   of  stock  option   vesting,   each  in  certain
circumstances.

(13) EMPLOYEE BENEFIT 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,  2005,  2004 and 2003,  the Company did not make any
contributions to the Plan.

(14) STOCK REPURCHASE PROGRAM

      On October 25,  2001,  the Company  announced  that its Board of Directors
authorized  the  repurchase  of  up to  two  million  shares  of  the  Company's
outstanding  common stock. The repurchases may be made from time to time in open
market  transactions  in such amounts as  determined  at the  discretion  of the
Company's  management.  The terms of the stock repurchases will be determined by
management based on market conditions.  During the year ended December 31, 2005,
the  Company  purchased  272,500  shares  of its  common  stock  in open  market
purchases for a total cost of  $1,918,155.  As of December 31, 2005, the Company
had repurchased a total of 549,600 shares for $3,632,930.


                                       53


(15) SEGMENT REPORTING

      The Company is  organized  in a single  operating  segment for purposes of
making operating decisions and assessing  performance.  Revenues from the United
States to  customers  in the  following  geographical  areas for the years ended
December 31, 2005,  2004 and 2003 and the  location of  long-lived  assets as of
December 31, 2005, 2004 and 2003 are summarized as follows:

                                                            2005           2004           2003
                                                        -----------    -----------    -----------

Revenues:
United States                                           $28,300,822    $18,140,465    $ 9,834,526
Asia                                                      6,535,128      5,821,902      3,580,741
Other international                                       6,128,153      4,746,311      3,528,868
                                                        -----------    -----------    -----------
  Total Revenues                                        $40,964,103    $28,708,678    $16,944,135
                                                        ===========    ===========    ===========

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

United States                                           $ 9,716,031    $ 9,929,214    $10,329,876
Asia                                                      1,320,865        950,387        760,148
Other international                                         207,098        322,544        334,576
                                                        -----------    -----------    -----------
  Total long-lived assets                               $11,243,994    $11,202,145    $11,424,600
                                                        ===========    ===========    ===========

      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.  For
the year ended  December 31, 2003,  the Company did not have any customers  that
accounted for over 10% of revenues. 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.
As of  December  31,  2004,  the  Company  had  three  customers  with  accounts
receivable balances greater than 5% of gross accounts  receivable,  which in the
aggregate were 33% of the accounts receivable balance.

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

                       Balance at     Additions                     Balance at
                      Beginning of     Charged                        End of
  Period Ended,          Period       to Expense     Deductions       Period
-----------------    -------------  -------------  -------------  -------------
December 31, 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
December 31, 2003    $     813,645  $   1,700,100  $     675,811  $   1,837,934

(17) QUARTERLY FINANCIAL DATA (UNAUDITED)

      The following is a summary of selected  quarterly  financial  data for the
years ended December 31, 2005 and 2004:


                                       54


                                                     Fiscal Quarter

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

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.

2004

Revenue                     $  5,258,798     $  6,483,137     $  7,469,999     $  9,496,744
                            ============     ============     ============     ============
Net income (loss)           $ (2,221,507)    $ (1,713,091)    $ (2,293,083)    $    338,834
                            ============     ============     ============     ============
Basic net income
   (loss) per share         $      (0.05)    $      (0.04)    $      (0.05)    $       0.01
                            ============     ============     ============     ============
Diluted net income
  (loss) per share          $      (0.05)    $      (0.04)    $      (0.05)    $       0.01
                            ============     ============     ============     ============
Basic weighted average
   common shares
    outstanding               46,638,740       46,859,326       47,054,294       47,307,612
                            ============     ============     ============     ============
Diluted weighted average
   common shares
    outstanding               46,638,740       46,859,326       47,054,294       51,249,985
                            ============     ============     ============     ============

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


                                       55


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

      None.

ITEM 9A. CONTROLS AND PROCEDURES.

      DISCLOSURE CONTROLS AND PROCEDURES

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

      The Company's Chief Executive  Officer (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, 2005, 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  2006,  and  is
      incorporated  herein by reference.  The  information  appears in the Proxy
      Statement under the captions


                                       56


      "Election of  Directors",  "Management"  and  "Committees  of the Board of
      Directors."  The Proxy Statement will be filed within 120 days of December
      31, 2005, our year-end.

ITEM 11. EXECUTIVE COMPENSATION

      Information called for by Part III, Item 11, will be included in our Proxy
      Statement  relating to our annual meeting of stockholders  scheduled to be
      held in May 2006, and is incorporated herein by reference. The information
      appears in the Proxy Statement under the caption "Executive Compensation."
      The Proxy  Statement  will be filed  within 120 days of December 31, 2005,
      our year-end.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      Information called for by Part III, Item 12, will be included in our Proxy
      Statement  relating to our annual meeting of stockholders  scheduled to be
      held in May 2006, and is incorporated herein by reference. The information
      appears in the Proxy Statement under the captions "Beneficial Ownership of
      Shares" and "Equity  Compensation  Plan  Information." The Proxy Statement
      will be filed within 120 days of December 31, 2005, 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 2006,  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,  2005,  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 2006, 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, 2005, our year-end.


                                       57


                                     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.

            10.1  Agreement of lease between  Huntington  Quadrangle 2, LLC, and
                  FalconStor Software,  Inc., dated August,  2003,  incorporated
                  herein  by  reference  to  Exhibit  99.1  to the  Registrant's
                  quarterly  report on Form 10-Q for the period ended  September
                  30, 2003, filed on November 14, 2003.

            10.2  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


                                       58


                  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.

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

            23.1  *Consent of KPMG LLP.

            31.1  *Certification of the Chief Executive Officer

            31.2  *Certification of the Chief Financial Officer

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

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

                  *- filed herewith.


                                       59


                                   SIGNATURES

      Pursuant  to the  requirements  of Section  13 or 15(d) of the  Securities
Exchange Act of 1934, the registrant has signed this report by the  undersigned,
thereunto duly authorized in Melville, State of New York on March 15, 2006.

FALCONSTOR SOFTWARE, INC.


By: /s/ Reijane Huai                                        Date: March 15, 2006
    ---------------------------------------------
    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 15, 2006
    ----------------------------------------------------          --------------
    Reijane Huai, President, Chief Executive Officer and          Date
    Chairman of the Board
    (Principal Executive Officer)


By: /s/ James Weber                                               March 15, 2006
    ----------------------------------------------------          --------------
    James Weber, Chief Financial Officer,                         Date
    Vice President and Treasurer
    (Principal Financial Officer and Principal
    Accounting Officer)


By: /s/ Steven L. Bock                                            March 15, 2006
    ----------------------------------------------------          --------------
    Steven L. Bock, Director                                      Date


By: /s/ Patrick B. Carney                                         March 15, 2006
    ----------------------------------------------------          --------------
    Patrick B. Carney, Director                                   Date


By: /s/ Lawrence S. Dolin                                         March 15, 2006
    ----------------------------------------------------          --------------
    Lawrence S. Dolin, Director                                   Date


By: /s/ Steven R. Fischer                                         March 15, 2006
    ----------------------------------------------------          --------------
    Steven R. Fischer, Director                                   Date


By: /s/ Alan W. Kaufman                                           March 15, 2006
    ----------------------------------------------------          --------------
    Alan W. Kaufman, Director                                     Date


                                       60`