SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549


FORM
10-K





ý
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For the
fiscal year ended December 31, 2009.





OR





 ̈
            TRANSITION REPORT TO SECTION 13
      OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
  1934


For the
transition period from __________ to __________





Commission
file number 0-23970





FALCONSTOR
SOFTWARE, INC.


(Exact
name of registrant as specified in its charter)





DELAWARE
            
            77-0216135(State
      or other jurisdiction of
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      No.)2
      Huntington Quadrangle, Suite 2S01
              Melville,
      New York
            
            11747(Address
      of principal executive offices)
            
            (Zip
      code)





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





Securities registered pursuant to
Section 12(b) of the Act:


Name
      of Each Exchange on WhichTitle of Each Class
              the Securities are
    RegisteredCommon
      Stock, $.001 par value
              NASDAQ
      Global Market


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




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes  ̈   No
ý
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes  ̈   No
ý
 
 Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the Registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days.  Yes ý   No
 ̈
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes No
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. ý
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer”, “accelerated filer”, and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
  Large
Accelerated Filer  ̈                                                               Accelerated
Filer ý
 Non-Accelerated
Filer  ̈                                                               Smaller
Reporting Company  ̈
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes
 ̈   No
ý
 
 The
aggregate market value of Common Stock held by non-affiliates of the Registrant
as of June 30, 2009 was $165,268,631 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 26, 2010 was 52,521,836 and
44,516,601, 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.
  Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
  2009
ANNUAL REPORT ON FORM 10-K
  TABLEOF CONTENTS


PagePART I.Item 1.
              Business
              4Item 1A.
              Risk Factors
              12Item 1B.
              Unresolved Staff Comments
              23Item 2.
              Properties
              23Item 3.
              Legal Proceedings
              24Item 4.
              “Reserved”
              24PART II.Item 5.
              Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
              24Item 6.
              Selected Financial Data
              27Item 7.
              Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
              29Item 7A.
              Quantitative and Qualitative Disclosures About Market
      Risk
              45Item 8.
              Financial Statements and Supplementary
    Data
              46Item 9.
              Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
              77Item 9A.
              Controls and Procedures
              77Item 9B.
              Other Information
              77PART III.Item 10.
              Directors, Executive Officers and Corporate
      Governance
              78Item 11.
              Executive Compensation
              78Item 12.
              Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
              78Item 13.
              Certain Relationships and Related Transactions, and
      Director Independence
              78Item 14.
              Principal Accountant Fees and Services
              78PART IV.Item 15.
              Exhibits and Financial Statement Schedules
              79SIGNATURES
              
              81
 
  2
 Table of Contents




PART I
  Item1.  Business
  OVERVIEW
 
 FalconStor
Software, Inc. (“FalconStor”, the “Company”, “we”, “our” or “us”) is the market
leader in disk-based data protection.  We deliver proven,
comprehensive, data protection solutions that facilitate the continuous
availability of business-critical data with speed, integrity, and simplicity.
Our TOTALLY OpenTM data protection solutions, built upon the award-winning
IPStor®virtualization platform, include the industry leading Virtual Tape
Library (VTL) with data deduplication for backup optimization, Continuous Data
Protector (CDP) for fast data recovery, Network Storage Server
(NSS)  for storage virtualization and provisioning, and File-interface
Deduplication System (FDS) for capacity optimized storage solutions. All of our
solutions are enabled with WAN-optimized replication technology for
cost-effective disaster recovery and remote office protection.  From
the Fortune 1000 to small and medium-size businesses, customers across a vast
range of industries worldwide have implemented FalconStor solutions in their
production IT environments in order to meet their recovery time objectives (RTO)
and recovery point objectives (RPO), as well as to manage their storage
infrastructures with minimal total cost of ownership (TCO) and with optimal
return on investment (ROI).
 
 The
FalconStor storage virtualization and data protection solutions are designed to
empower IT administrators and end users to recover data easily to any point in
time in the event of hardware failure, data corruption, deletion, or
catastrophic site-level disaster, allowing rollback or failover to a known,
good, immediately useable state to ensure that businesses maintain reliable
access to their vital applications, and to facilitate accurate data restoration
while concurrently minimizing downtime. FalconStor solutions are engineered to
integrate and to work seamlessly with database, email and file systems, and with
business applications. The application level integration allows for maintaining
space-efficient redundant sets of active data that are generated with complete
transactional and point-in-time integrity.  FalconStor solutions
enhance business productivity by eliminating the need for the time-consuming
consistency checks and data rebuilds that traditionally create long periods of
downtime during a recovery process.
 
 Designed
to contain escalating costs, FalconStor solutions enable companies to aggregate
heterogeneous, distributed storage capacity and to centralize administration of
both storage resources and business-critical data services such as backup,
snapshot, replication, and data migration. Companies benefit from lower
administrative overhead, elimination of storage over-provisioning, massive
scalability, and the ability to make cost-effective storage allocation and
purchasing decisions. Moreover, FalconStor’s commitment to a TOTALLY Open
software-based approach to storage networking entails any-to-any
connectivity  via native support for industry standards (including
Fibre Channel,  iSCSI,
SCSI,  SAS,  SATA  and  emerging  standards  such  as
InfiniBand and Fibre Channel over Ethernet) and
delivers  unified  support  for  multiple  storage
architectures.  As a result, FalconStor solutions provide companies of
any size and complexity with the freedom to leverage IP/iSCSI-, Fibre Channel-,
or InfiniBand-based networks and to implement their choice of state-of-the-art
equipment based on any standard protocol from any storage manufacturer, without
rendering their existing or future investments obsolete.
 
 Recognizing
the value propositions of FalconStor’s proven, cutting-edge technology, multiple
partners utilize FalconStor’s innovative software products – including CDP, FDS,
NSS, and VTL to power their storage appliances and their bundled solutions.
FalconStor’s products have been certified by such industry leaders as 3COM,
3Par, Acer, Adaptec, Brocade, Bus-Tech, Cisco, Citrix, Compellent, Dell, Dynamic
Solutions International, EMC, Hitachi Data Systems, HP, IBM, Intel, Lanchao, LSI
Logic, Microsoft, NEC, Nexsan, Oracle, Pillar Data Systems, Promise, QLogic,
SeaChange, Spectra Logic, Symantec, Violin Memory, Voltaire, VMware, and
Xiotech.
 
 Further
validation of FalconStor solutions comes from the agreements FalconStor has with
many Tier-1 original equipment manufacturers (OEMs) and others to integrate
FalconStor technology with those companies’ products.  In the past
year, OEM partners have released new solutions powered by FalconStor products
and have pursued visible market presence with FalconStor, leveraging both brands
for market presence.
 
 FalconStor
was incorporated in Delaware as Network Peripherals, Inc., in
1994.  Pursuant to a merger with FalconStor Inc., in 2001, the former
business of Network Peripherals, Inc., was discontinued, and newly re-named
FalconStor Software, Inc., continued the storage software business started in
2000 by FalconStor, Inc.  FalconStor’s headquarters are located at 2
Huntington Quadrangle, Suite 2S01, Melville, NY 11747. The Company also
maintains offices in California and Massachusetts and throughout Europe, Asia
and Australia.
  3
 Table of Contents
 
 PRODUCTS
AND TECHNOLOGY
 
 FalconStor’s
products and solutions are built on the IPStor common network infrastructure
software platform that provides the most reliable and complete disk-based data
protection and storage virtualization solutions. FalconStor data protection
solutions accelerate or eliminate the backup window, which allows users to
recover data in minutes, anytime, anywhere, with 100% data integrity. FalconStor
offers the following core products: VTL with deduplication, CDP, NSS and FDS.
All FalconStor products are enabled with WAN-optimized replication technology
for cost-effective disaster recovery and remote/branch office protection.
FalconStor solutions share several key technologies that foster seamless
integration and offer a competitive edge.
 
 One independent, TOTALLY Open data
protection platform - FalconStor solutions provide complete independence
to choose any storage or connectivity, delivering comprehensive data protection
across the enterprise, and scaling from the data center to the remote office or
single user desktop.
 
 Integrated - FalconStor
solutions are built on a common storage virtualization platform, eliminating the
compatibility and integration issues typically found with “bolted together”
solutions created from disparate products with different development
histories.  In addition, FalconStor solutions are built to seamlessly
integrate within customers’ environments to provide a high level of data
services and protection to business applications.
 
 Optimized - FalconStor
solutions are designed to optimize performance and capacity utilization, making
use of the latest advances in storage networking speed and technologies such as
thin provisioning and deduplication. Application-specific tools optimize
protection of key enterprise applications. Protection is enhanced even as costs
are reduced.
 
 Available - FalconStor
solutions are built to provide the best in data protection, recovery, and
persistent data accessibility.  FalconStor delivers data protection
with complete transactional integrity for fast and reliable
recovery.  FalconStor solutions are deployed in high availability
models, with built-in failover capabilities.
 
 FalconStor’s
data protection solutions address the full spectrum of data protection business
challenges, from the need to accelerate backup to the need to recover data after
a disaster.  Customers today are facing massive data
growth.  Gartner analyst David Cappuccio estimates enterprise data
growth over the next 5 years to be 650% and that 80% of this will be
unstructured data. Backup windows have not only shrunk; for many organizations
they have disappeared altogether.  Traditional backup has also been
plagued with media and hardware failures. These are some of the issues addressed
by FalconStor VTL or FalconStor FDS, depending on the customers’ environments.
In addition, the time to recover is also shrinking, so companies need more
recovery points and times, rather than the once-a-day recovery point offered by
daily backup. For this they turn to the FalconStor CDP solution to provide them
with instant data availability and with many granular points of recovery. To
improve the day-to-day management issues that arise from explosive storage
growth, customers use the FalconStor NSS solution to virtualize, to provision,
and to protect their data.  And for protecting remote office data from
disasters, FalconStor has built a highly efficient replication solution that
integrates with all of its product lines - VTL, CDP, NSS, and FDS. Because all
of these solutions are built from a single technology platform, deployment is
simplified and businesses benefit from the peace of mind knowing that FalconStor
solutions work together in an easily managed and a highly efficient fashion,
with high data availability and rapid recovery always paramount.
 
 Deployment
options
 
 FalconStor
sells its solutions as standalone software, as software pre-installed on
FalconStor-supplied hardware appliances, or as virtual appliances.
 
 Solutions
 
 FalconStor
offers a wide range of data protection and storage virtualization
solutions:
 
 ·
              Storage
      Virtualization, Provisioning, and Management – FalconStor
    NSS
 
 ·
              Tape
      Backup Optimization – FalconStor
VTL
  4
 Table of Contents
 
 ·
              Unified
      Backup and Disaster Recovery – FalconStor
CDP
 
 ·
              Storage
      Capacity Optimization – FalconStor
FDS
  FalconStor
provides data protection services at all levels from operating systems and
application software, to files, databases, and messaging data, across the entire
organization.  Our products are scalable, allowing FalconStor
solutions to address the needs of small/medium businesses, large organizations,
and global enterprises. Our solutions offer high availability (HA) through RAID,
synchronous and asynchronous mirroring, HA failover, and clustering
technologies.
 
 Network
Storage Server (NSS)
 
 FalconStor®
Network Storage Server (NSS) integrates storage virtualization and provisioning
across multiple disk arrays and connection protocols for an easy-to-use,
scalable SAN solution. From a small iSCSI virtual server lab to an
enterprise-class Fibre Channel SAN running Tier-1 database applications,
FalconStor NSS is designed to meet all of the storage needs of any
organization.
 
 By
virtualizing storage on any disk array, FalconStor NSS provides the ability to
pool and tier disk assets, simplifying provisioning, reducing allocation errors,
and maximizing resource utilization. This allows IT organizations to avoid
over-provisioning of disk resources and to bring new servers and projects online
quickly and efficiently. FalconStor NSS incorporates a full set of
application-aware data protection services, including real-time synchronous
mirroring, volume snapshots and site-to-site WAN-optimized data replication, for
disaster recovery.
 
 Virtual
server environments are well served by virtualized
storage.  FalconStor NSS is designed to make it easy to create a new
disk resource to house virtual machine files, and disk resources are
re-allocated to different servers or shared among servers to facilitate virtual
machine high-availability operations that require shared disk. Specific
integration tools allow FalconStor NSS to service virtual server environments in
an optimal manner providing rapid and effective recovery processes of a virtual
machine or entire virtual server farms.
 
 In
addition, FalconStor NSS enables and automates server-less backup
processes.  FalconStor backup server integration tools offload backup
processes from the server to the FalconStor NSS repository, freeing up the
application host server and completely eliminating the backup
window.
 
 The
FalconStor NSS Virtual Appliance enables cost-effective server virtualization by
converting internal or external server storage resources into shared storage
resources to enable high availability options across virtual servers. The
solution reduces infrastructure cost and complexity while maximizing customers’
return on investment. The FalconStor NSS Virtual Appliance brings all the
benefits and features of server and storage virtualization to the remote and
branch offices to reduce costs and to enable effective data protection and
recovery solutions across the enterprise.
 
 Virtual
Tape Library (VTL)
 
 FalconStor®
Virtual Tape Library (VTL) is the industry’s leading virtual tape solution, and
we believe it is unmatched in terms of performance and
scalability.  With virtual tape, backups complete faster and more
reliably, with little or no change needed to the backup environment. It enhances
backup operations seamlessly without changing any backup processes or policies.
Sophisticated physical tape integration and data security complete the
solution.  Designed from the start as an enterprise-class application,
FalconStor VTL can achieve high backup speeds allowing users to solve the single
biggest issue in backup: meeting the backup window.
 
 Built-in
data deduplication significantly reduces the amount of data needed to be stored
on disk. By eliminating redundant backup data, the storage footprint can be
reduced by 95% or more, allowing organizations to keep weeks or even months
worth of data on disk, for fast, dependable restore, without any of the
reliability concerns of a tape-based restore.
 
 While
deduplication can eliminate or greatly reduce the need for physical tapes, many
organizations still require tape for long-term, off-site, or archival storage.
FalconStor VTL has what it believes are the industry’s most sophisticated and
the broadest integration with physical tape libraries, allowing companies to
export data directly to physical tape, leveraging the speed of the FalconStor
VTL without impacting the backup network.
  5
 Table of Contents
  FalconStor
VTL also supports small and remote office environments through FalconStor VTL
storage appliances and small footprint virtual appliances.
 
 Continuous
Data Protector (CDP)
 
 FalconStor®
Continuous Data Protector (CDP) technology reinvents the way data backup and
recovery are implemented and performed. Moving far beyond failure-prone
once-a-day tape backup models, FalconStor CDP combines local and remote
protection into a cost-effective, unified, disk-based solution that allows
organizations to recover data back to the most recent transaction. Combining
application-aware snapshot agents and continuous journaling functions,
FalconStor CDP enables customers to recover data to any point in time. The
Recovery Point Objective (RPO) shrinks to mere seconds.
 
 In
addition, FalconStor CDP software delivers instant data availability and
reliable recovery, bringing business applications back online in a matter of
minutes after a failure. Using a wealth of sophisticated technologies —
including application integration, physical-to-virtual recovery, and
WAN-optimized replication — entire systems can be restored in under ten minutes.
Lost files can be recovered in as little as two minutes. Data is protected in
its native format, and is instantly accessible. With FalconStor CDP, the
Recovery Time Objective (RTO) changes from hours to minutes, minimizing system
downtime and economic impact.
 
 In
addition, FalconStor CDP enables and automates serverless backup processes.
FalconStor backup server integration tools offload backup processes from the
server to the FalconStor CDP repository, freeing up the application host server
and completely eliminating the backup window.
 
 The
FalconStor CDP Virtual Appliance is a pre-configured, ready-to-run software
application packaged for quick, easy deployment in virtual environments. The
solution reduces infrastructure cost and complexity while maximizing customers’
return on investment. The FalconStor CDP Virtual Appliance provides all the
benefits and features of FalconStor CDP to the remote and branch office to
enable comprehensive and effective data protection and recovery solutions across
the enterprise.
 
 File-interface
Deduplication System (FDS)
 
 FalconStor®
File-interface Deduplication System (FDS) extends FalconStor’s deduplication
technology to service a broader set of applications that goes beyond tape backup
applications.  FalconStor FDS allows companies to optimize storage
capacity services for disk-to-disk backup and archiving
applications.
 
 FalconStor
FDS presents Network Attached Storage (NAS) interface accessibility to a block
level deduplication repository through common LAN-based file access protocols
such as CIFS and NFS. Its deployment simplicity easily extends the FalconStor
data deduplication technology across multiple applications. FalconStor FDS
delivers global deduplication and is enabled with a WAN-optimized replication
option for cost-effective DR implementations. Its high availability feature
provides a value in the market to organizations that depend on the data
deduplication infrastructure to support their backup and DR
environments.
 
 FalconStor
FDS is also offered as a Virtual Appliance, providing remote and branch offices
as well as small enterprises with an economical data deduplication solution. The
Virtual Appliance deployment model can eliminate tape-based backup processes at
the remote office and the costs and risks associated with physical tape
shipments.
  Application-Aware
Snapshot Agents
 
 FalconStor
Snapshot Agents automate and minimize quiescence time during data replication,
backup, and other snapshot-based operations to ensure transactional integrity
and point-in-time consistency of Windows, Unix, Linux, and VMware systems,
databases applications and messaging stores for fast
time-to-recovery.  Snapshot Agents are available for IBM®
DB2® UDB,
Informix®,
Microsoft® SQL
Server, Oracle®,
Prevasive.SQL®,
Sybase®, IBM
Lotus Notes®/Domino,
Microsoft®
Exchange Server, Microsoft®
Hyper-V, Microsoft® VSS,
Novell®
Groupwise®,
VMWare®, and
many file systems.
  6
 Table of Contents
  Application
Specific Recovery Options
 
 FalconStor
recovery agents offer recovery solutions for database and messaging systems. For
instance, FalconStor Message Recovery for Microsoft Exchange and Message
Recovery for Lotus Notes/Domino expedite mailbox/message recovery by enabling IT
administrators to recover individual mailboxes quickly from point-in-time
snapshot images of their messaging server. In addition, FalconStor Database
Recovery for Microsoft SQL Server expedites database recovery by enabling IT
administrators to recover a database quickly from point-in-time snapshot images
of their Microsoft SQL database.
 
 BUSINESS
STRATEGY
 
 FalconStor
intends to maintain its position as the provider of TOTALLY Open disk-based data
protection and storage virtualization solutions serving enterprises and SMBs
worldwide. FalconStor intends to achieve this objective through the following
strategies.
 
 Disk-Based
Data Protection Leadership
 
 FalconStor
intends to continue to leverage the protocol-independent, unified architecture,
and robust TOTALLY Open data protection technology of its solution to maintain a
leadership position in the enterprise and SMB disk-based data protection
software markets. FalconStor plans to continue its leadership in this market
through its deep commitment to research and development and through continued
rapid technology innovation. For information on our research and development
expenditures, please see “Management’s Discussion and Analysis of Financial
Condition and Results of Operations” and our audited consolidated financial
statements.
 
 Expand
Product Offerings
 
 In 2009,
FalconStor continued aggressively to develop its product portfolio. In February,
the Company introduced FalconStor®
HyperTracTM Backup Accelerator technology for VMware Consolidated Backup, a
backup enhancement option for VMware Consolidated Backup (VCB). FalconStor
HyperTrac technology for VMware environments integrates with FalconStor Network
Storage Server (NSS), a feature-rich, open storage virtualization and
provisioning platform that provides a full range of data protection and DR
solutions for the VMware platform.  The FalconStor HyperTrac
technology for VMware Consolidated Backup (VCB) further extends FalconStor NSS
services to VMware Infrastructure by optimizing VCB backups in order to minimize
impact on virtual machines and the storage servicing those environments. The
no-impact backups enabled by FalconStor HyperTrac technology for VCB provides
high performance backup for virtual machines, eliminating the disruption of
backup windows required by traditional backup solutions for physical
environments.
 
 In March
2009, FalconStor announced the general availability of the FalconStor
File-interface Deduplication System (FDS). FalconStor FDS opened up a new market
for FalconStor Software by offering block-level deduplication of backup data via
a simple file interface. This gives customers a choice between a file interface
or a VTL interface or both, depending on data center requirements. FalconStor
FDS extends the company ́s highly scalable data deduplication technology --
already widespread as part of the industry-leading FalconStor VTL solution – to
LAN-based disk-to-disk backup environments. In August, 2009, FalconStor
announced a strategic venture for FalconStor FDS with our partner Nexsan
Technologies, to offer an integrated deduplication product for high-performance,
power-efficient data storage.
 
 In
September 2009, FalconStor introduced new storage management and new disaster
recovery (DR) extensions for VMware vCenterTM Server and VMware vCenter Site
Recovery Manager that provide virtual machine storage provisioning as well as
automated failback of remote virtual machines to the primary data center.
Additionally, FalconStor packaged our FalconStor File-interface Deduplication
System as a Virtual Appliance for easy-to-deploy data deduplication for VMware
vSphere 4 environments.  FalconStor’s entire product portfolio is now
available as virtual appliances.
 
 In
October 2009, FalconStor announced that our storage virtualization and data
replication solutions for virtual servers were integrated and available for
Oracle VM, bringing a high level of data protection, recoverability and
continuous availability to Oracle virtual environments.
  7
 Table of Contents
  Expand
Corporate Visibility
 
 Throughout
2009, FalconStor took significant steps to increase our market presence and
awareness. First, we took additional steps to increase our online presence in
the form of banner ads on key media and industry community sites.  In
addition, we added an updated look and feel, a more user-friendly navigation,
and additional resources to our website to make information more readily
available to our customers and partners.
 
 Second,
through the release of new products, strategic relationships, and customer wins,
we continued to increase our engagement with the press, analyst and blogging
communities to create awareness of and credibility for our TOTALLY Open data
protection message. We have stepped up our participation in online social
networking sites and social media outlets such as youtube.com and twitter, as
well as online conversations both with our own FalconStor expert bloggers and by
monitoring and commenting on other blogs.
 
 In late
2009 a new Chief Strategist was hired along with additional staff for product
marketing. We have heavily reinforced our outreach with the press and analyst
community to bring our comprehensive disk-based data protection message to the
market. Our focus has turned significantly to highlighting our success with our
customers and partners throughout the world, as well as the value our solutions
bring to solving their data protection challenges. This broad effort has led to
several awards and accolades:
 
 ·
              Long
      Island Business News recognized our CFO, James Weber, for his leadership
      in Business
 ·
              Business
      Solutions Magazine named FalconStor among the Best Channel Vendors for
      storage in 2009
 ·
              FalconStor
      was Certified by United Business Media's Everything Channel as a 5-Star
      Overall Winner in its 2009 Partner Program
Guide
 ·
              Our
      Chairman and CEO, ReiJane Huai was an Ernst & Young Entrepreneur Of
      The Year 2009 Award Finalist in Metro New York
  Region
 ·
              Our
      Vice President of North American Sales, Wendy Petty was recognized by
      Everything Channel's CRN Magazine as One of the Top 100 Women in the
      Channel
 ·
              FalconStor
      was selected by Everything Channel’s CRN as the 2009 Tech Innovator of the
      Year for FalconStor FDS
 
 We
anticipate that this positive recognition will continue throughout 2010, as we
continue to innovate in our products and to refine our message to address new
market conditions while delivering targeted marketing campaigns.
 
 In
addition we increased our investment in our partners, both OEM and channel, for
joint marketing and field engagement. We have also expanded our channel by
partnering with new distributors and Direct Market Resellers (DMR) to further
penetrate the mid-range market and extend our channel and customer
reach.
 
 Scalable
Packaging
 
 All
FalconStor solutions support variable deployment options offering great
flexibility to seamlessly fit within our customer’s environments and respond to
their exact needs and requirements. The scalability of our solutions can support
the smallest environments such as Remote and Branch Offices (ROBO) with
prepackaged virtual appliances or small hardware appliances, as well as the
largest deployments supporting multi-petabyte environments in large
datacenters.
 
 The
different packaging options include virtual appliances for small and remote
offices, storage appliances for small to medium enterprises and clustered
gateway appliances and software appliance kits for large enterprise
deployments.
 
 Expand
Technologies and Capabilities through Strategic Acquisitions and
Alliances
 
 FalconStor
believes that opportunities may exist to expand our technological capabilities,
product offerings, and services, whether through acquisition of businesses or
software technology, or through strategic alliances. FalconStor will focus on
opportunities that enable us to acquire or to license:
 
 ·
              Important
      enabling technology;
 ·
              Complementary
      applications;
 ·
              Marketing,
      sales, customers and technological synergies;
  and/or
 ·
              Key
      personnel.
  8
 Table of Contents
 
 Seek
OEM Relationships with Industry Leaders
 
 FalconStor
intends to continue to enter into OEM agreements with strategic switch, storage,
appliance, and operating system vendors. Besides accelerating overall market
growth, the OEM relationships should continue to bolster FalconStor’s product
recognition, corporate credibility, and revenue stream.
 
 Expand
Software and Hardware Strategic Alliances
 
 In August
2009, FalconStor formed a strategic alliance with Nexsan Technologies to deliver
a data deduplication appliance to the market through Nexsan’s channel community,
combining the storage capacity optimization benefits of FalconStor FDS and the
energy saving capabilities of the Nexsan AutoMAID technology. In 2010,
FalconStor will seek to continue to form similar alliances to support the
channel and to reach a broader market while continuing to raise the FalconStor
brand awareness and recognition.
  Identify
and Nurture New Growth Drivers
 
 FalconStor
has made key investments in several areas from which we expect growth in the
coming years. We believe we are strongly positioned to take advantage of the
rapid storage growth in China. Our OEM relationships with Acer, Inspur Group,
and others, and the joint development/production agreement with The Chinese
Academy of Science for enterprise-class storage, archiving and compliance
solutions, will continue our growth in this market.
 
 Current
economic conditions suggest that there will be continued limited IT spending
budgets into 2010. We anticipate that companies will be looking for innovative
solutions to reduce their IT costs and to take full advantage of their current
investments.  FalconStor has been helping companies to reduce Capital
Expenditures (CapEx), and to minimize Operating Expenditures (OpEx) through the
deployment of cost-effective solutions that maximize the utilization rates for
IT resources, consolidate management operations, and reduce storage capacity and
networking bandwidth requirements.
 
 Industry
analysts predict that technologies such as data deduplication, storage
virtualization, and network bandwidth optimization are on the top of almost
every IT project list for 2010. We believe that FalconStor will see a growing
demand for its products and solutions, as a market leader of disk-based data
protection solutions, and as a leading developer of technologies such as data
deduplication, storage virtualization, and WAN-optimized
replication.
 
 With a
server virtualization market that is gaining rapid adoption, we anticipate a
growing need for integrated storage and server virtualization solutions for
maximizing IT productivity and business continuity. This combination of
solutions will improve data center resource management by increasing utilization
of existing physical resources, while optimizing virtual infrastructure
performance through real-time data migration, to deliver more cost-effective and
reliable high-availability and disaster recovery.  In 2009, we
strengthened our relationships with vendors like VMware, Oracle, and Microsoft
and we have developed more integration tools and solutions to support and
enhance these environments. We expect that in 2010 these relationships and joint
technology solutions will continue to grow and will put FalconStor in a strong
position to service customers that are looking at deploying these
solutions.
 
 SALES,
MARKETING AND CUSTOMER SERVICE
 
 FalconStor plans to continue to sell our
products primarily through original equipment manufacturers (OEMs), value-added
resellers (VARs) or solution providers, large system integrators, Direct Market
Resellers (DMRs), and distributors.
 
 OEM Relationships. OEMs
collaborate with FalconStor to integrate FalconStor technology into their own
product offerings or to resell FalconStor technology under their own
label.
 
 VAR and Distributor
Relationships. FalconStor has entered into VAR and distributor agreements
to help sell our products in various geographic areas. We have increased our
sales and marketing infrastructure to further support and expand our network of
VARs worldwide. FalconStor’s VARs and distributors market various FalconStor
products and receive a discount off of the list price on products sold.
FalconStor scalable solutions are also being deployed by Managed Service
Providers (MSP) to deliver online data protection and recovery services across
different vertical markets.
  9
 Table of Contents
 
 Storage
Appliances.  FalconStor has agreements with strategic partners
to adapt FalconStor products for use in the strategic partners’ special-purpose
storage appliances.
 
 Direct Sales to End
Users.   In a limited number of circumstances, FalconStor
has entered into software license agreements directly with end
users.
 
 FalconStor’s
marketing efforts focus on building brand recognition among customers, partners,
analysts, and the media, and developing qualified leads for the sales
force.
 
 FalconStor’s
Professional Services personnel are also available to assist customers and
partners throughout the lifecycle of FalconStor solution deployments. The
Professional Services team includes experienced Storage Architects (expert field
engineers) who can assist in the assessment, planning/design, deployment, and
test phases of the deployment project, and a Technical Support Group for
post-deployment assistance and ongoing support.
 
 COMPETITION
 
 As the
demand for data protection and network-based storage products and services
increases, more competitors will enter this high-growth market segment. Although
there are several companies attempting to offer unified storage services or data
protection, FalconStor believes it is the only software-based solution provider
capable of delivering a high level of data protection services across the data
center. FalconStor holds multiple patents on key technologies that enable and
optimize our data protection and data reduction platform. We believe that our
integrated services and products based on our common storage virtualization
platform including -- NSS, VTL, CDP, FDS, and WAN-optimized replication for
remote offices and data centers are unique to the industry.
 
 Although
some of FalconStor’s products provide capabilities that put them in competition
with products from a number of companies with substantially greater financial
resources, FalconStor is not aware of any other software company providing the
same range of unified data protection storage service running on a standard
Linux-, Windows-, or Solaris-based appliance. FalconStor believes that the
principal competitive factors enhancing its marketability include product
features such as scalability, data availability, ease of use, price,
reliability, hardware/platform neutrality, and customer service and
support.
 
 As
FalconStor continues its move into the non-enterprise storage market, the
products and services offered by its partners may compete with existing or new
products and services offered by current and new entrants to the
market.
 
 FalconStor’s
future and existing competitors could conceivably introduce products with
superior features, scalability, and functionality at lower prices than
FalconStor’s products and could also bundle existing or new products with other
more established products to compete with FalconStor products. Increased
competition could result in price reductions and reduced gross margins, which
could impact FalconStor’s business.  FalconStor’s success will depend
largely on its ability to generate market demand and awareness of its products
and to develop additional or enhanced products in a timely
manner.  FalconStor’s success will also depend on its ability to
convince potential partners of the benefits of licensing its software rather
than that of competing technologies.
 
 INTELLECTUAL
PROPERTY
 
 FalconStor’s
success is dependent in part upon its proprietary technology. The IPStor
platform forms the core of this proprietary technology. FalconStor currently has
thirteen patents and numerous pending patent applications; and multiple
registered trademarks – including “FalconStor Software” and “IPStor” – and
pending trademark applications related to FalconStor and its
products.
 
 FalconStor  seeks  to  protect  its  proprietary  rights  and  other  intellectual  property  through  a
combination of copyright, patents, trademark and trade secret protection, as
well as through
contractual  protections  such  as  proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leader position.
  10
 Table of Contents
 
 FalconStor
generally enters into confidentiality or license agreements with employees,
consultants, and corporate partners, and generally controls access to and
distribution of its software, documentation, and other proprietary information.
Despite FalconStor’s efforts to protect its proprietary rights, unauthorized
parties may attempt to copy or otherwise obtain and use its products or
technology. Monitoring unauthorized use of
its  products  is  difficult,  and there
can be no assurance that the steps FalconStor  has  taken
will
prevent  misappropriation  of  its  technology,  particularly  in
foreign countries where laws may not protect its proprietary rights as fully as
do the laws of the United States.
 
 MAJOR
CUSTOMERS
 
 For the
year ended December 31, 2009, we had two customers, EMC Corporation and Sun
Microsystems, which accounted for 14% and 12%, respectively, of our total
revenues. For the year ended December 31, 2008, EMC Corporation and Sun
Microsystems, accounted for 20% and 13%, respectively, of our total revenues.
For  the  year  ended  December 31,
2007,  EMC  Corporation and Sun Microsystems
accounted  for  26%  and  12%,  respectively,
of our total revenues. As of December 31, 2009, there were no customers which
accounted for more than 10% of our gross accounts receivable balance. As of
December 31, 2008, EMC Corporation and H3C Technologies Co., Ltd.’s accounts
receivable balance were each 11% of our gross accounts receivable
balance.
 
 EMPLOYEES
 
 As  of  December  31,  2009,  we  had  542  full-time
and part-time employees, consisting of 210 in research and
development,  192  in  sales  and  marketing,
109  in  service, and 31 in general administration. We are
not subject to any collective bargaining agreements and believe our employee
relations are good.
 
 INTERNET
ADDRESS AND AVAILABILTY OF FILINGS
 
 Our
internet address is www.falconstor.com. The Company makes available free of
charge, on or through its Internet website, the Company’s Annual Report on Form
10-K, Quarterly Reports on Form 10-Q, current Reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Sections 13(a) or
(15)(d) of the Securities Exchange Act of 1934, as amended, as soon as
reasonably practicable after the Company electronically files such material
with, or furnishes it to, the Securities and Exchange Commission. The Company
complied with this policy for every Securities Exchange Act of 1934, as amended,
report filed during the year ended December 31, 2009.
 
 Item1A.  Risk Factors
  We are
affected by risks specific to us as well as factors that affect all businesses
operating in a global market. The significant factors known to us that could
materially adversely affect our business, financial condition, or operating
results are set forth below.
 
 We face a number
of risks related to the recent financial crisis and severe tightening in the
global credit markets.
 The
ongoing global financial crisis affecting the banking system and financial
markets has resulted in a severe tightening in the credit markets, a low level
of liquidity in many financial markets, and extreme volatility in credit and
equity markets. This financial crisis has impacted us and could continue to
impact our business in a number of ways, including:
  Potential Deferment
of Purchases and Orders by Customers: Uncertainty about current and future
global economic conditions may cause end users, including businesses and
governments, to defer purchases in response to tighter credit, decreased cash
availability and declining consumer confidence. Accordingly, future demand for
our products could differ materially from our current expectations.
 
 Customers’
Inability to Obtain Financing to Make Purchases from Us and/or Maintain Their
Business:Some
of our customers require financing in order to fund their operations and make
purchases from us. The inability of these customers to obtain sufficient credit
to finance purchases of our products and meet their payment obligations to us
could adversely impact our financial results. In addition, if the financial
crisis results in insolvencies for our customers, it could adversely impact our
financial results.
  11
 Table of Contents
 
 Negative Impact from Increased
Financial Pressures on Third-Party OEMs and Resellers: Most of our
software licenses are sold through third-party OEMs, solution providers and
distributors. Although many of these third parties have significant operations
and maintain access to available credit, others are smaller and more likely to
be impacted by the significant decrease in available credit that has resulted
from the current financial crisis. If credit pressures or other financial
difficulties result in insolvency for these third parties and we are unable to
successfully transition end users to purchase our products from other third
parties, or from us directly, it could adversely impact our financial
results.
 
 Due
to the uncertain and shifting development of the data protection and network
storage software markets and our reliance on our partners, we may have
difficulty accurately predicting revenue for future periods and appropriately
budgeting for expenses.
 
 The
rapidly evolving nature of the data protection and network storage software
markets in which we sell our products, the degrees of effort and success of our
partners’ sales and marketing efforts, and other factors that are beyond our
control, reduce our ability to accurately forecast our quarterly and annual
revenue. However, we must use our forecasted revenue to establish our expense
budget. Most of our expenses are fixed in the short term or incurred in advance
of anticipated revenue. As a result, we may not be able to decrease our expenses
in a timely manner to offset any shortfall in revenue.
  This is
what happened in 2009. We had planned our expenses based on our revenue
projections. Strategic transactions involving three of our OEM customers caused
our revenues to fall below our projections which resulted in a net loss for the
full year 2009.
  The
markets for many of our products are still maturing, and our business will
suffer if they do not continue to develop as we expect.
  The
continued adoption of Storage Area Networks (IP/iSCSI-, Fibre Channel-, and
InfiniBand-based)) and Network Attached Storage solutions, disk-based backup and
disaster recovery solutions, storage virtualization solutions, deduplication
solutions, and virtual environments is critical to our future success. The
markets for these solutions are still maturing, making it difficult to predict
their potential sizes or future growth rates. If these markets develop more
slowly than we expect, our business, financial condition and results of
operations would be adversely affected.
  We
may not be able to penetrate the small/medium business and small office/home
office markets.
  We offer
products for the small/medium business (SMB) and small office/home office (SOHO)
markets.  Our products may not be attractive to the SMB and the SOHO
markets, or we may not be able to reach agreements with OEMs and resellers with
significant presences in the SMB and SOHO markets. If we are unable to penetrate
the SMB and SOHO markets, we will not be able to recoup the expenses associated
with our efforts in these markets and our ability to grow revenues could
suffer.
  If
we are unable to develop and manufacture new products that achieve acceptance in
the data protection and the network storage software markets, our operating
results may suffer.
  The data
protection and the network storage software markets continue to evolve and as a
result there is continuing demand for new products. Accordingly, we may need to
develop and manufacture new products that address additional data protection or
network storage software market segments and emerging technologies to remain
competitive in the data storage software industry.  We are uncertain
whether we will successfully qualify new data protection or network storage
software products with our customers by meeting customer performance and quality
specifications. Any failure to address additional market segments could harm our
business, financial condition and operating results.
  12
 Table of Contents
  Our
products must conform to industry standards in order to be accepted by customers
in our markets.
  Our
current products are only one part of a storage system. All components of these
systems must comply with the same industry standards in order to operate
together efficiently. We depend on companies that provide other components of
these systems to conform to industry standards. Some industry standards may not
be widely adopted or implemented uniformly, and competing standards may emerge
that may be preferred by OEM customers or end users. If other providers of
components do not support the same industry standards as we do, or if competing
standards emerge, our products may not achieve market acceptance, which would
adversely affect our business.
  Our
products may have errors or defects that could result in reduced demand for our
products or costly litigation.
  Our
IPStor platform, the basic building block of all of our solutions, is complex
and is designed to be deployed in large and complex networks. Many of our
customers have unique infrastructures, which may require additional professional
services in order for our software to work within their infrastructures. Because
our products are critical to the networks of our customers, any significant
interruption in their service as a result of defects in our product could result
in damage to our customers. These problems could cause us to incur significant
service and engineering costs, divert engineering personnel from product
development efforts and significantly impair our ability to maintain existing
customer relationships and attract new customers. In addition, a product
liability claim, whether successful or not, would likely be time consuming and
expensive to resolve and would divert management time and attention. Further, if
we are unable to fix the errors or other problems that may be identified in full
deployment, we would likely experience loss of or delay in revenues and loss of
market share and our business and prospects would suffer.
  Our other
products may also contain errors or defects. If we are unable to fix the errors
or other problems that may be discovered, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.
  Failure
of storage appliances to integrate smoothly with end user systems could impact
demand for the appliances.
  We offer
our software on a stand-alone basis and as part of an appliance in which we
install our software onto third party hardware. In addition, we have entered
into agreements with resellers and OEM partners to develop storage appliances
that combine VTL, CDP, NSS or FDS functionality with third party hardware to
create single purpose turnkey solutions that are designed to be easy to deploy.
If the storage appliances are not easy to deploy or do not integrate smoothly
with end user systems, the basic premise behind the appliances will not be met
and sales would suffer.
  Issues
with the hardware on which our software products are installed could increase
our support costs and result in lower sales of our products.
  We
deliver some of our products, both through our resellers and directly to
end-users, installed on third party hardware. If the hardware does not function
properly, our support costs will go up. We will have to arrange or pay for the
repair or replacement of the broken hardware and we may have to increase the
size of our support operations. Hardware reliability issues could also cause
resellers and end-users to refuse to make purchases from us, even if our
software products function properly.
  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.
  13
 Table of Contents
  We
rely on our OEM customers and resellers for most of our sales.
  The vast
majority of our sales come from sales to end users of our products by our OEM
customers and by our resellers. These OEM customers and resellers have limited
resources and sales forces and sell many different products, both in the network
storage software market and in other markets. The OEM customers and resellers
may choose to focus their sales efforts on other products in the network storage
software market or other markets. The OEM customers might also choose not to
continue to develop or to market products which include our products. This would
likely result in lower revenues to us and would impede our ability to grow our
business.
  Our
OEM customers are not obligated to continue to sell our products.
  We have
no control over the shipping dates or volumes of systems incorporation of our
product that our OEM customers ship and they have no obligation to ship systems
incorporating our software applications. Our OEM customers also have no
obligation to recommend or offer our software applications exclusively or at
all, and they have no minimum sales requirements. These OEMs also could choose
to develop their own data protection and network storage software internally, or
to license software from our competitors, and incorporate those products into
their systems instead of our software applications. The OEMs that we do business
with also compete with one another. If one of our OEMs views our arrangement
with another OEM as competing with its products, it may decide to stop doing
business with us. Any material decrease in the volume of sales generated by OEMs
with whom we do business, as a result of these factors or otherwise, would have
a material adverse effect on our revenues and results of operations in future
periods.
  The
failure of our resellers to sell our software applications effectively could
have a material adverse effect on our revenues and results of
operations.
 We rely
significantly on our value-added resellers, systems integrators and corporate
resellers, which we collectively refer to as resellers, for the marketing and
distribution of our software applications and services. However, our agreements
with resellers are generally not exclusive, are generally renewable annually and
in many cases may be terminated by either party without cause. Many of our
resellers carry software applications that are competitive with ours. These
resellers may give a higher priority to other software applications, including
those of our competitors, or may not continue to carry our software applications
at all. If a number of resellers were to discontinue or reduce the sales of our
products, or were to promote our competitors’ products in lieu of our
applications, it would have a material adverse effect on our future revenues.
Events or occurrences of this nature could seriously harm our sales and results
of operations. In addition, we expect that a significant portion of our sales
growth will depend upon our ability to identify and attract new reseller
partners. The use of resellers is an integral part of our distribution network.
We believe that our competitors also use reseller arrangements. Our competitors
may be more successful in attracting reseller partners and could enter into
exclusive relationships with resellers that make it difficult to expand our
reseller network. Any failure on our part to expand our network of resellers
could impair our ability to grow revenues in the future.
 We are dependent
on certain key customers and a significant portion of our receivables is
concentrated with two customers.
  We tend
to have one or more customers account for 10% or more of our revenues during
each fiscal quarter and fiscal year. For the year ended December 31, 2009, we
had two customers, EMC Corporation and Sun Microsystems which accounted for 14%
and 12%, respectively of our total revenues. For the year ended December 31,
2008, we had two customers, EMC Corporation and Sun Microsystems, which
accounted for 20% and 13%, respectively of our total revenues. For the year
ended December 31, 2007, we had two customers, EMC Corporation and Sun
Microsystems, which accounted for 26% and 12%, respectively of our total
revenues. EMC purchased Data Domain, one of our competitors, in 2009. Sun
Microsystems was recently purchased by Oracle Corporation. Oracle is continuing
to sell the Sun products that incorporate our software, but there can be no
assurance that these products will be actively marketed or sold in the future.
While we believe that we will continue to receive revenue from these customers,
our agreements do not have any minimum sales requirements and we cannot
guarantee continued revenue. If our contract with any of these customers
terminates, or if the volume of sales from any of these customers significantly
declines, it would have a material adverse effect on our operating
results.
  As of
December 31, 2009, there were no customers with accounts receivable balances
greater than 10% of our gross accounts receivable. As of December 31, 2008, EMC
Corporation’s and H3C Technologies Co., Ltd.’s accounts receivable balance were
each 11% of our gross accounts receivable.
  14
 Table of Contents
  We
must maintain our existing relationships and develop new relationships with
strategic industry partners.
  Part of
our strategy is to partner with major third-party software and hardware vendors
who integrate our products into their offerings and/or market our products to
others. These strategic partners often have customer or distribution networks to
which we otherwise would not have access or the development of which would take
up large amounts of our time and other resources. There is intense competition
to establish relationships with these strategic partners. Some of our agreements
with our OEM customers grant to the OEMs limited exclusivity rights to portions
of our products for periods of time. This could result in lost sales
opportunities for us with other customers or could cause other potential OEM
partners to consider or select software from our competitors for their storage
solutions. In addition, the desire for product differentiation could cause
potential OEM partners to select software from our competitors. We cannot
guarantee that our current strategic partners, or those companies with whom we
may partner in the future, will continue to be our partners for any period of
time. If our software was to be replaced in an OEM solution by competing
software, or if our software is not selected by OEMs for future solutions, it
would likely result in lower revenues to us and would impede our ability to grow
our business.
  We
rely on channel partners to sell our solutions, and disruptions to, or our
failure to develop and manage our channel partners would harm our
business.
 
 Our
future success is partially dependent upon establishing and maintaining
successful relationships with the right channel partners. A portion of our
revenue is generated by sales through our channel partners, and we expect
channel sales to continue to make up a significant portion of our total revenue
in the future. Accordingly, our revenue depends in part on the effective sales
and lead generation activities of these channel partners.
 
 Recruiting
and retaining qualified channel partners and training them in our technology and
product offerings requires significant time and resources. In order to develop
and expand our distribution channel, we must continue to scale and improve our
processes and procedures that support our channel, including investment in
systems and training. Those processes and procedures may become increasingly
complex and difficult to manage as we grow our organization. We have no minimum
purchase commitments from any of our channel partners, and our contracts with
these channel partners do not prohibit them from offering products or services
that compete with ours. Our competitors may provide incentives to existing and
potential channel partners to favor their products or to prevent or reduce sales
of our solutions. Our channel partners may choose not to offer our solutions
exclusively or at all. Establishing relationships with channel partners who have
a history of selling our competitors’ products may also prove to be difficult.
In addition, some of our channel partners are also competitors. Our failure to
establish and maintain successful relationships with channel partners would harm
our business and operating results.
  Consolidation
in the data protection or the network storage industries could hurt our
strategic relationships.
  In the
past, companies with whom we have OEM relationships have been acquired by other
companies. In 2009, Oracle announced it was acquiring Sun and Hewlett Packard
announced it was acquiring 3Com, the parent of our Chinese OEM. These
acquisitions caused disruptions in the sales and marketing of our products and
have had an impact on our revenues. If additional OEM customers are acquired,
the acquiring entity might choose to stop offering solutions containing our
software. Even if the solutions continued to be offered, there might be a loss
of focus and sales momentum as the companies are integrated.
  The
data protection and network storage software markets are highly competitive and
intense competition could negatively impact our business.
  The data
protection and network storage software markets are intensely competitive even
during periods when demand is stable. Some of our current and potential
competitors have longer operating histories, significantly greater resources,
broader name recognition and a larger installed base of customers than we have.
Those competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.
  15
 Table of Contents
  Our
competitors also may:
  ·
              consolidate
      or establish strategic relationships among themselves to lower their
      product costs or to otherwise compete more effectively against us;
      or
  ·
              bundle
      their products with other products to increase demand for their
      products.
  In
addition, some OEMs with whom we do business, or hope to do business, may enter
the market directly and rapidly capture market share. If we fail to compete
successfully against current or future competitors, our business, financial
condition and operating results may suffer.
 Our ability to
sell our software applications is highly dependent on the quality of our
services offerings, and our failure to offer high quality support and
professional services would have a material adverse affect on our sales of
software applications and results of operations.
 Our
services include the assessment and design of solutions to meet our customers’
data protection and storage management requirements and the efficient
installation and deployment of our software applications based on specified
business objectives. Further, once our software applications are deployed, our
customers depend on us to resolve issues relating to our software applications.
A high level of service is critical for the successful marketing and sale of our
software. If our partners or we do not effectively install or deploy our
applications, or succeed in helping our customers quickly resolve
post-deployment issues, it would adversely affect our ability to sell software
products to existing customers and could harm our reputation with potential
customers. As a result, our failure to maintain high quality support and
professional services would have a material adverse effect on our sales of
software applications and results of operations.
 
 Failure
to achieve anticipated growth could harm our business and operating
results.
  Achieving
our anticipated growth will depend on a number of factors, some of which
include:
  ·
              retention
      of key management, marketing and technical
  personnel;
  ·
              our
      ability to increase our customer base and to increase the sales of our
      products; and
  ·
              competitive
      conditions in the network storage infrastructure software
      market.
  We cannot
assure you that the anticipated growth will be achieved. The failure to achieve
anticipated growth could harm our business, financial condition and operating
results.
  Our
revenues depend in part on spending by corporate customers.
  The
operating results of our business depend in part on the overall demand for data
protection and network storage software. Because the market for our software is
primarily major corporate customers, any softness in demand for data protection
or network storage software may result in decreased revenues.
  Our
future quarterly results may fluctuate significantly, which could cause our
stock price to decline.
  Our
previous results are not necessarily indicative of our future performance and
our future quarterly results may fluctuate significantly.
  Historically,
information technology spending has been higher in the fourth and second
quarters of each calendar year and somewhat slower in the other quarters,
particularly the first quarter. Our quarterly results reflected this seasonality
in 2009, and we anticipate that our quarterly results for 2010 will show the
effects of seasonality as well.
  16
 Table of Contents
  Our
future performance will depend on many factors, including:
  ·
              fluctuations
      in the economy;
  ·
              the
      timing of securing software license contracts and the delivery of software
      and related revenue recognition;
  ·
              the
      seasonality of information technology, including network storage
      products,  spending;
  ·
              the
      average unit selling price of our
products;
  ·
              existing
      or new competitors introducing better products at competitive prices
      before we do;
  ·
              our
      ability to manage successfully the complex and difficult process of
      qualifying our products with our
customers;
  ·
              new
      products or enhancements from us or our
  competitors;
  ·
              import
      or export restrictions on our proprietary technology;
  and
  ·
              personnel
      changes.
  Many of
our expenses are relatively fixed and difficult to reduce or modify. As a
result, the fixed nature of our expenses will magnify any adverse effect of a
decrease in revenue on our operating results.
  Our
stock price may be volatile.
  The
market price of our common stock has been volatile in the past and may be
volatile in the future. For example, during the past twelve months ended
December 31, 2009, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $2.10 and $5.57 per share. The market
price of our common stock may be significantly affected by the following
factors:
  ·
              actual
      or anticipated fluctuations in our operating
  results;
  ·
              failure
      to meet financial estimates;
  ·
              changes
      in market valuations of other technology companies, particularly those in
      the network storage software
market;
  ·
              announcements
      by us or our competitors of significant technical innovations,
      acquisitions, strategic partnerships, joint ventures or capital
      commitments;
  ·
              loss
      of one or more key OEM customers;
and
  ·
              departures
      of key personnel.
  The stock
market has experienced extreme volatility that often has been unrelated to the
performance of particular companies. These market fluctuations may cause our
stock price to fall regardless of our performance.
  Our
ability to forecast earnings is limited by the impact of certain accounting
requirements.
  The
Financial Accounting Standards Board requires companies to recognize the fair
value of stock options and other share-based payment compensation to employees
as compensation expense in the statement of operations.  However, this
expense, which we estimate based on the “Black-Scholes” model, is subject to
factors beyond our control. These factors include the market price of our stock
on a particular day and stock price “volatility.” These unknowns make it
difficult for us to forecast accurately what the amount of share-based
compensation expense will be in the future. Because of these factors, our
ability to make accurate forecasts of future earnings is
compromised.
  17
 Table of Contents
  Our
marketable securities portfolio could experience a decline in market value which
could materially and adversely affect our financial results.
 As of
December 31, 2009, we held short-term and long-term marketable securities
aggregating $26.0 million. We invest in a mixture of corporate bonds,
government securities and marketable debt securities, the majority of which are
high investment grade, and we limit the amount of credit exposure through
diversification and investment in highly rated securities. However, investing in
highly rated securities does not entirely mitigate the risk of potential
declines in market value. A further deterioration in the economy, including
further tightening of credit markets or significant volatility in interest
rates, could cause our marketable securities to decline in value or could impact
the liquidity of the portfolio. If market conditions deteriorate significantly,
our results of operations or financial condition could be materially and
adversely affected.
  The
ability to predict our future effective tax rates could impact our ability to
accurately forecast future earnings.
  We are
subject to income taxes in both the United States and the various foreign
jurisdictions in which we operate. Judgment is required in determining our
provision for income taxes and there are many transactions and calculations
where the tax determination may be uncertain. Our future effective tax rates
could be affected by changes in our (i) earnings or losses; (ii) changes in the
valuation of our deferred tax assets; (iii) changes in tax laws; and (iv) other
factors. Our ability to correctly predict our future effective tax rates based
upon these possible changes could significantly impact our forecasted
earnings.
  The likelihood of
a change of control in our company could be impacted by the fact that we have a
significant amount of authorized but unissued preferred stock, a staggered Board
of Directors, change of control agreements with certain executives as well as
certain provisions under Delaware law.
  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 a staggered Board of Directors and have entered into change of
control agreements with certain executives, which may also have the effect of
delaying, deterring or preventing a change in control.
  We
have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders’ percentage ownership of our common stock,
and a smaller number of restricted shares of stock, the vesting of which will
also dilute the then-existing stockholders’ percentage ownership of our common
stock.
  As of
December 31, 2009, we had options to purchase 12,538,338 shares of our common
stock outstanding, and we had an aggregate of 1,253,661 outstanding restricted
shares and restricted stock units. If all of these outstanding options were
exercised, and all of the outstanding restricted stock and restricted stock
units vested, the proceeds to the Company would average $5.01 per share. We also
had 1,626,805 shares of our common stock reserved for issuance under our stock
plans with respect to options (or restricted stock or restricted stock units)
that have not been granted. In addition, if, on July 1st of any calendar year in
which our 2006 Incentive Stock Plan, as amended (the “2006 Plan”), is in effect,
the number of shares of stock to which options, restricted shares and restricted
stock units may be granted is less than five percent (5%) of the number of
outstanding shares of stock, then the number of shares of stock available for
issuance under the 2006 Plan shall be increased so that the number equals five
percent (5%) of the shares of stock outstanding. In no event shall the number of
shares of stock subject to the 2006 Plan in the aggregate exceed twenty million
shares, subject to adjustment as provided in the 2006 Plan. See Note (8) Share-Based Payment
Arrangements to our consolidated financial statements.
  The
exercise of all of the outstanding options and/or the vesting of all outstanding
restricted shares and restricted stock units and/or the grant and exercise of
additional options and/or the grant and vesting of restricted stock and
restricted stock units would dilute the then-existing stockholders’ percentage
ownership of common stock, and any sales in the public market of the common
stock issuable upon such exercise could adversely affect prevailing market
prices for the common stock.  Moreover, the terms upon which we would
be able to obtain additional equity capital could be adversely affected because
the holders of such securities can be expected to exercise or convert them at a
time when we would, in all likelihood, be able to obtain any needed capital on
terms more favorable than those provided by such securities.
  18
 Table of Contents
  Our
business could be materially affected as a result of a natural disaster,
terrorist acts, or other catastrophic events.
  While our
headquarters facilities contain redundant power supplies and generators, our
domestic and foreign operations, and the operations of our industry partners,
remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.
  Terrorist
actions domestically or abroad could lead to business disruptions or to
cancellations of customer orders or a general decrease in corporate spending on
information technology, or could have direct impact on our marketing,
administrative or financial functions and our financial condition could
suffer.
  We
are dependent on a variety of IT and telecommunications systems, and any failure
of these systems could adversely impact our business and operating
results.
 
 We depend
on IT and telecommunications systems for our operations. These systems support a
variety of functions including order processing, shipping, shipment tracking,
billing, support center and internal information exchange.
 
 Failures
or significant downtime of our IT or telecommunications systems could prevent us
from taking customer orders, shipping products, billing customers, handling
support calls, or communication among our offices. The Internet and individual
websites have experienced a number of disruptions and slowdowns, some of which
were caused by organized attacks. In addition, some websites have experienced
security breakdowns. If we were to experience a security breakdown, disruption
or breach that compromised sensitive information, it could harm our relationship
with our customers. Our support centers are dependent upon telephone and data
services provided by third party telecommunications service vendors and our IT
and telecommunications system. Any significant increase in our IT and
telecommunications costs or temporary or permanent loss of our IT or
telecommunications systems could harm our relationships with our customers. The
occurrence of any of these events could have an adverse effect on our operations
and financial results.
 
 United
States Government export restrictions could impede our ability to sell our
software to certain end users.
  Certain
of our products include the ability for the end user to encrypt data. The United
States, through the Bureau of Industry Security, places restrictions on the
export of certain encryption technology. These restrictions may
include:  the requirement to have a license to export the technology;
the requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. Certain of our products
are subject to various levels of export restrictions. These export restrictions
could negatively impact our business.
  The
international nature of our business could have an adverse affect on our
operating results.
  We sell
our products worldwide. Accordingly, our operating results could be materially
adversely affected by various factors including regulatory, political, or
economic conditions in a specific country or region, trade protection measures
and other regulatory requirements, and acts of terrorism and international
conflicts.
  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 needs as
compared with the U.S., and potentially adverse tax consequences. Such factors
could materially adversely affect our future international sales and,
consequently, our operating results.
  19
 Table of Contents
  Foreign
currency fluctuations may impact our revenues.
  Our
licenses and services in Japan are sold in Yen. Our licenses and services in the
Republic of Korea are sold in Won. Many of the sales of our licenses and
services in Europe, the Middle East and Africa, are made in European Monetary
Units (“Euros”).
  Changes
in economic or political conditions globally and in any of the countries in
which we operate could result in exchange rate movements, new currency or
exchange controls or other restrictions being imposed on our
operations.
  Fluctuations
in the value of the U.S. dollar may adversely affect our results of operations.
Because our consolidated financial results are reported in U.S. dollars,
translation of sales or earnings generated in other currencies into U.S. dollars
can result in a significant increase or decrease in the reported amount of those
sales or earnings.  Significant changes in the value of these foreign
currencies relative to the U.S. dollar could have a material adverse effect on
our financial condition or results of operations.
  Fluctuations
in currencies relative to currencies in which our earnings are generated make it
more difficult to perform period-to-period comparisons of our reported results
of operations. For purposes of accounting, the assets and liabilities of our
foreign operations, where the local currency is the functional currency, are
translated using period-end exchange rates, and the revenues, expenses and cash
flows of our foreign operations are translated using average exchange rates
during each period.
  In
addition to currency translation risks, we incur currency transaction risk
whenever we enter into either a purchase or a sales transaction using a currency
other than the local currency of the transacting entity. Given the volatility of
exchange rates, we cannot be assured we will be able to effectively manage our
currency transaction and/or translation risks. Volatility in currency exchange
rates may have a material effect on our financial condition or results of
operations. Currency exchange rate fluctuations have not, in the past, resulted
in a material impact on earnings. However, we may experience at times in the
future an impact on earnings as a result of foreign currency exchange rate
fluctuations.
  In April
2009, we began a program to hedge some of our foreign currency risks. The
hedging program will not remove all downside risk and limits the gains we might
otherwise receive from currency fluctuations. There can be no assurance that we
will be able to enter into future currency hedges on terms acceptable to us (see
Note (11) Derivative Financial
Instruments to our consolidated financial statements).
  Because
we conduct operations in China, risks associated with economic, political and
social events in China could negatively affect our business and operating
results.
 
 China is becoming a significant market
for our products and we are increasing our operations in China. In addition to
two joint ventures with the Chinese Academy of Science, we have OEM agreements
with several Chinese companies.  We also have research and development
and sales offices in China employing a total of 56 people as of December 31,
2009. Our operations in China are subject to a number of risks relating to
China’s economic and political systems, including:
 
 •
              
              government
      controlled foreign exchange rate and limitations on the convertibility of
      the Chinese Renminbi;
 
 •
              
              extensive
      government regulation;
 
 •
              
              changing
      governmental policies relating to tax benefits available to foreign-owned
      businesses;
 
 •
              
              the
      telecommunications infrastructure;
 
 •
              
              relatively
      uncertain legal system; and
 
 •
              
              uncertainties
      related to continued economic and social
reform.
  20
 Table of Contents
 
 Any
significant interruption in our China operations, whether resulting from any of
the above uncertainties, natural disasters or otherwise, could result in delays
or disruptions in our revenue and our research development operations, either of
which could cause our business and operating results to suffer.
 
 If
we are unable to protect our intellectual property, our business will
suffer.
  Our
success is dependent upon our proprietary technology. Currently, the IPStor
software suite is the core of our proprietary technology. We have thirteen
patents issued, and we have multiple pending patent applications, numerous
trademarks registered and multiple pending trademark applications related to our
products. We cannot predict whether we will receive patents for our pending or
future patent applications, and any patents that we own or that are issued to us
may be invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.
  We also
rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
  Our
efforts to protect our intellectual property may cause us to become involved in
costly and lengthy litigation, which could seriously harm our
business.
  In recent
years, there has been significant litigation in the United States involving
patents, trademarks and other intellectual property rights.
 
 We were
already subject to one action, which alleged that our technology infringed on
patents held by a third party. While we settled this litigation, the fees and
expenses of the litigation as well as the litigation settlement were expensive
and the litigation diverted management’s time and attention. Any additional
litigation, regardless of its outcome, would likely be time consuming and
expensive to resolve and would divert management's time and attention and might
subject us to significant liability for damages or invalidate our intellectual
property rights. Any potential intellectual property litigation against us could
force us to take specific actions, including:
 
 ·
              cease
      selling our products that use the challenged intellectual
      property;
 
 ·
              obtain
      from the owner of the infringed intellectual property right a license to
      sell or use the relevant technology or trademark, which license may not be
      available on reasonable terms, or at all;
or
 
 ·
              redesign
      those products that use infringing intellectual property or cease to use
      an infringing product or trademark.
 
 Developments
limiting the availability of Open Source software could impact our ability to
deliver products and could subject us to costly litigation.
  Many of
our products are designed to include software or other intellectual property
licensed from third parties, including “Open Source” software. At least one
intellectual property rights holder has alleged that it holds the rights to
software traditionally viewed as Open Source. In addition, United States courts
have not interpreted the terms of many open source licenses, and there is a risk
that such licenses could be construed in a manner that could impose
unanticipated conditions or restrictions on our ability to commercialize our
appliances. We could be required to seek licenses from third parties in order to
continue offering our software, to re-engineer our software, to discontinue the
sale of our software in the event re-engineering cannot be accomplished on a
timely basis or to litigate any disputes relating to our use of open source
software, any of which could harm our business. There can be no assurance that
the necessary licenses would be available on acceptable terms, if at all. The
inability to obtain certain licenses or other rights or to obtain such licenses
or rights on favorable terms, or the need to engage in litigation regarding
these matters, could have a material adverse effect on our business, operating
results, and financial condition. Moreover, the inclusion in our products of
software or other intellectual property licensed from third parties on a
nonexclusive basis could limit our ability to protect our proprietary rights in
our products.
  21
 Table of Contents
  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 accounting principles requires management to
establish policies that contain estimates and assumptions that affect the
amounts reported in the consolidated financial statements and the accompanying
notes. Note 1 to the Consolidated Financial Statements in this Report on Form
10-K describes the significant accounting policies and estimates essential to
preparing our financial statements. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related
disclosures.  We base our estimates on historical experience and
assumptions that we believe to be reasonable under the circumstances. Actual
future results may differ materially from these estimates. We evaluate, on an
ongoing basis, our estimates and assumptions.
 
 Long
Term Character of Investments
 
 Our
present and future equity investments may never appreciate in value, and are
subject to normal risks associated with equity investments in businesses. These
investments may involve technology risks as well as commercialization risks and
market risks. As a result, we may be required to write down some or all of these
investments in the future.
 
 Unknown
Factors
 
 Additional
risks and uncertainties of which we are unaware or which currently we deem
immaterial also may become important factors that affect us.




Item1B.  Unresolved Staff Comments
  None
  Item2.  Properties
  The
Company’s headquarters are located in an approximately 45,000 square foot
facility in Melville, New York.  Offices are also leased for
development, sales and marketing personnel, which total an aggregate of
approximately 67,000 square feet in Le Chesnay and Toulouse, France; Taipei and
Taichung, Taiwan; Tokyo, Japan; Beijing, Shenzhen, Shanghai, Kunshan and Hong
Kong, China; Munich, Germany; Seoul, Korea; Kuala Lumpur, Malaysia; North
Sydney, Australia; London, UK; Singapore; Newport Beach and Fremont, California;
and Acton, Massachusetts. Initial lease terms range from one to eight years,
with multiple renewal options.
  22
 Table of Contents
  Item3.   Legal Proceedings
  We are
subject to various legal proceedings and claims, asserted or unasserted, which
arise in the ordinary course of business. While the outcome of any such matters
cannot be predicted with certainty, we believe that such matters will not have a
material adverse effect on our financial condition, results of operations, cash
flows or liquidity.
 
 Item4.   “Reserved”
  
 PARTII
  Item5. Market
for Registrant’s Common Equity, Related Stockholder Matters and
Issuer  Purchases
of Equity Securities
  Market
Information
  Our
      Common Stock is listed on The Nasdaq Global Market (“Nasdaq”) under the
      symbol “FALC”. The following table sets forth the range of high and low
      closing sales prices of our Common Stock for the periods indicated as
      reported by Nasdaq:


2009
              2008High
              Low
              High
              LowFourth
      Quarter
              $4.60
              $3.31
              $5.09
              $2.09Third
      Quarter
              $5.57
              $4.27
              $7.80
              $5.05Second
      Quarter
              $4.85
              $2.41
              $9.13
              $6.99First
      Quarter
              $3.77
              $2.10
              $10.74
              $6.85




Holders
of Common Stock
  We had
approximately 139 holders of record of Common Stock as of February 26, 2010.
This does not reflect persons or entities that hold Common Stock in nominee or
“street” name through various brokerage firms.
  Dividends
  We have
not paid any cash dividends on our common stock since inception. We expect to
reinvest any future earnings to finance growth, and therefore do not intend to
pay cash dividends in the foreseeable future. Our board of directors may
determine to pay future cash dividends if it determines that dividends are an
appropriate use of Company capital.
  23
 Table of Contents
  Equity
Compensation Plan Information
  The
Company currently does not have any equity compensation plans not approved by
security holders.
 Number
      of Securities to be Issued upon Exercise of Outstanding Options, Warrants
      and Rights (1)
                
                
                Weighted
      - Average exercise Price of Outstanding Options, Warrants and Rights
      (1)
                
                
                Number
      of Securities Remaining Available for Future Issuance Under Equity
      Compensation Plans (Excluding Securities Reflected in Column
      (a)(1)Plan Category
                
                (a)
                
                
                (b)
                
                
                (c)Equity
      compensation plans approved by security holders........
                
                
                13,791,999
                
                
                $
                5.01
                
                
                
                1,626,805
 
 (1) As of
December 31, 2009 we had 1,626,805 shares of our common stock reserved for
issuance under our stock plans with respect to options (or restricted stock or
restricted stock units) that have not been granted. In addition, if, on July 1st
of any calendar year in which our 2006 Plan is in effect, the number of shares
of stock to which options may be granted is less than five percent (5%) of the
number of outstanding shares of stock, then the number of shares of stock
available for issuance under the 2006 Plan shall be increased so that the number
equals five percent (5%) of the shares of stock outstanding. See Note (8) Share-Based Payment
Arrangements to our consolidated financial statements for further
information.
  
 Common Stock Performance: The
following graph compares, for each of the periods indicated, the percentage
change in the Company’s cumulative total stockholder return on the Company’s
Common Stock with the cumulative total return of a) an index consisting of
Computer Software and Services companies, a peer group index, and b) the Russell
3000 Index, a broad equity market index.
 
 
 24
 Table of Contents




ASSUMES
$100 INVESTED ON DEC. 31, 2004


ASSUMES
DIVIDEND REINVESTED


FISCAL
YEAR ENDING DECEMBER 31, 2009





Fiscal Year Ending2004
            
            
            2005
            
            
            2006
            
            
            2007
            
            
            2008
            
            
            2009FALCONSTOR
      SOFTWARE, INC.
            
            $
            100.00
            
            
            $
            77.22
            
            
            $
            90.39
            
            
            $
            117.66
            
            
            $
            29.05
            
            
            $
            42.42PEER
      GROUP INDEX
            
            $
            100.00
            
            
            $
            99.75
            
            
            $
            116.20
            
            
            $
            136.90
            
            
            $
            82.66
            
            
            $
            125.16RUSSELL
      3000 INDEX
            
            $
            100.00
            
            
            $
            106.12
            
            
            $
            122.80
            
            
            $
            129.11
            
            
            $
            80.94
            
            
            $
            103.88





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







Issuer
Purchase of Equity Securities




Shares of
common stock repurchased during the quarter ended December 31,
2009:




Total
      Number of
                Shares
      Purchased
              
              Average
      Price
                Paid
      per Share
              
              Total
      Number of
                Shares
      Purchased
                as
      Part of Publicly
                Announced
      Plan
              
              
              Maximum
      Number
                of
      Shares that May
                Yet
      Be Purchased Underthe
      Planat Month EndNovember
      2009
              
              
              350,845
              
              
              $
              3.93
              
              
              
              350,845
              
              
              
              6,258,220December  2009
              
              
              263,455
              
              
              $
              4.11
              
              
              
              263,455
              
              
              
              5,994,765Total
              
              
              614,300
              
              
              $
              4.01
              
              
              
              614,300
              
              
              
              5,994,765




On
February 4, 2009, the Company’s Board of Directors increased its authorization
to repurchase the Company’s outstanding common stock from eight million shares
to fourteen million shares in the aggregate. As of December 31, 2009, the
Company had repurchased 8,005,235 shares since October 2001. The program has no
expiration date. See Note (7) Stockholders’ Equity to our
consolidated financial statements for further information.




25
 Table of Contents




Item6.   Selected Financial Data
  The
selected financial data appearing below have been derived from our audited
consolidated financial statements, and should be read in conjunction with these
consolidated financial statements and the notes thereto and the information
contained in Item 7, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations.”
  CONSOLIDATED
STATEMENTS OF OPERATIONS DATA:
  Year
      Ended
                  December
      31,
                
                
                Year
      Ended
                  December
      31,
                
                
                Year
      Ended
                  December
      31,
                
                
                Year
      Ended
                  December
      31,
                
                
                Year
      Ended
                  December
      31,2009
      (a)
                
                
                2008
      (a)
                
                
                
                2007(a),
      (b)
                
                
                
                2006(a)
                
                
                
                2005(In
      thousands, except per share data)Revenues:Software
      license revenue
                
                $
                58,155
                
                
                $
                58,590
                
                
                $
                53,154
                
                
                $
                38,317
                
                
                $
                29,544Maintenance
      revenue
                
                
                25,477
                
                
                
                23,283
                
                
                
                18,607
                
                
                
                12,475
                
                
                
                7,594Software
      services and other revenue
                
                
                5,827
                
                
                
                5,152
                
                
                
                5,639
                
                
                
                4,274
                
                
                
                3,82689,459
                
                
                
                87,025
                
                
                
                77,399
                
                
                
                55,066
                
                
                
                40,964Operating
      expenses:Amortization
      of purchased and capitalized software
                
                
                719
                
                
                
                221
                
                
                
                122
                
                
                
                362
                
                
                
                782Cost
      of maintenance, software services and other revenue
                
                
                16,197
                
                
                
                13,653
                
                
                
                11,091
                
                
                
                9,048
                
                
                
                6,114Software
      development costs
                
                
                26,761
                
                
                
                25,296
                
                
                
                22,405
                
                
                
                20,022
                
                
                
                12,039Selling
      and marketing
                
                
                42,255
                
                
                
                38,097
                
                
                
                29,656
                
                
                
                23,713
                
                
                
                16,109General
      and administrative
                
                
                9,875
                
                
                
                8,746
                
                
                
                8,024
                
                
                
                5,828
                
                
                
                4,213Litigation
      settlement
                
                
                --
                
                
                
                --
                
                
                
                --
                
                
                
                799
                
                
                
                --95,807
                
                
                
                86,013
                
                
                
                71,298
                
                
                
                59,772
                
                
                
                39,257Operating
      (loss) income
                
                
                (6,348
                )
                
                
                1,012
                
                
                
                6,101
                
                
                
                (4,706
                )
                
                
                1,707Interest
      and other (loss) income
                
                
                (128
                )
                
                
                1,689
                
                
                
                2,329
                
                
                
                1,650
                
                
                
                705(Loss)
      income before income taxes
                
                
                (6,476
                )
                
                
                2,700
                
                
                
                8,430
                
                
                
                (3,056
                )
                
                
                2,412(Benefit)
      provision for income taxes
                
                
                (3,383
                )
                
                
                1,498
                
                
                
                (4,312
                )
                
                
                319
                
                
                
                119Net
      (loss) income
                
                $
                (3,093
                )
                
                $
                1,203
                
                
                $
                12,742
                
                
                $
                (3,375
                )
                
                $
                2,293Basic
      net (loss) income per share
                
                $
                (0.07
                )
                
                $
                0.03
                
                
                $
                0.26
                
                
                $
                (0.07
                )
                
                $
                0.05Diluted
      net (loss) income per share
                
                $
                (0.07
                )
                
                $
                0.02
                
                
                $
                0.24
                
                
                $
                (0.07
                )
                
                $
                0.05Basic
      weighted average common shares
      outstanding
                
                
                44,782
                
                
                
                47,859
                
                
                
                49,421
                
                
                
                48,045
                
                
                
                47,662Diluted
      weighted average common shares
      outstanding
                
                
                44,782
                
                
                
                49,497
                
                
                
                53,131
                
                
                
                48,045
                
                
                
                50,776
  (a)
                We
      adopted the authoritative guidance issued by the Financial Accounting
      Standards Board (“FASB”) on  stock compensation, on January 1,
      2006, and recorded $8.8 million, $9.1 million, $7.9 million and $9.4
      million of compensation expenses in our consolidated statements of
      operations for the years ended December 31, 2009, 2008, 2007 and 2006,
      respectively. See Note (8) Share-Based Payment
      Arrangements to our consolidated financial statements for further
      information.
  (b)
                During
      2007, we recorded a non-recurring tax benefit of $8.9 million (included
      within our net tax benefit of $4.3 million) primarily due to our
      recognition of a significant portion of our deferred tax assets through a
      reduction in our deferred tax asset valuation allowance. See Note (6)
      Income Taxes to
      our consolidated financial statements for further
    information.
 26
 Table of Contents




CONSOLIDATED
BALANCE SHEET DATA:
 
  December
      31,
                2009
              
              
              
              December
      31,
                2008
              
              
              
              December
      31,
                2007
              
              
              
              December
      31,
                2006
              
              
              
              December
      31,
                2005(In
  thousands)Cash
      and cash equivalents andmarketable
      securities
              
              $
              41,783
              
              
              $
              42,810
              
              
              $
              62,904
              
              
              $
              40,960
              
              
              $
              36,631Working
      capital
              
              
              46,097
              
              
              
              48,329
              
              
              
              71,845
              
              
              
              46,934
              
              
              
              39,730Total
      assets
              
              
              99,002
              
              
              
              96,364
              
              
              
              115,182
              
              
              
              78,231
              
              
              
              63,974Long-term
      obligations
              
              
              6,254
              
              
              
              6,192
              
              
              
              5,070
              
              
              
              3,783
              
              
              
              2,316Stockholders’
      equity
              
              
              66,153
              
              
              
              65,076
              
              
              
              87,478
              
              
              
              55,043
              
              
              
              48,658
  27
 Table of Contents
  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
  Due to
the continuing economic downturn, and as a result of unanticipated mergers and
acquisition activity among three of our largest OEM partners, our revenue and
net income fell short of our expectations for 2009.
  Despite
the economic downturn, we continued to make progress toward our goal of ramping
up the sale of FalconStor-branded products to end users, what we call “non-OEM
sales.” We have made investments in our sales and our marketing functions,
increasing headcount and spending on advertising, promotions and other public
relations, to increase market awareness of the branded products. We also focused
and increased our efforts in creating FalconStor-branded storage
appliances.
  We had
previously put most of our non-OEM sales efforts behind FalconStor-branded
software. But feedback we received from our resellers and the end users
suggested that we could increase sales if we offered storage appliances with our
software installed on hardware. To meet this demand, we have created
FalconStor-branded gateway appliances and complete storage appliances with
integrated disks.
  These
combined efforts led to a 15% increase in gross non-OEM software license revenue
in 2009. We expect that the investment we made in these areas, combined with an
improved macroeconomic environment, will cause our non-OEM sales to continue to
increase in 2010.
  Unfortunately,
the gains we made in non-OEM sales in 2009 were offset by declines in our OEM
sales. During 2009, three of our largest OEM customers – EMC, Sun Microsystems,
and 3Com – became involved in transactions that had substantial negative effects
on our revenues.
  In July
2009, EMC acquired Data Domain, Inc. This acquisition resulted in changes to
EMC’s product lines and sales and marketing focus. As result, sales of the EMC
products that incorporate our software declined 31%. Total revenue from EMC on
an annual basis was still 14% of our total revenue for 2009. While our agreement
with EMC runs through 2013, there are no minimum revenue commitments from EMC.
Due to the changes at EMC we cannot say whether EMC will account for 10% or more
of our revenue in 2010.
  In June
2009, Oracle Corporation announced that it had reached an agreement to buy Sun
Microsystems.  Before completing the acquisition, Oracle was required
to get approval for the purchase from various jurisdictions worldwide. This
approval process took several months, and at various points the statements of
the regulators cast doubt on whether the transaction would be approved.
Ultimately, the purchase of Sun was not completed until January 2010. During
this period of delay and uncertainty, Sun suffered a substantial decline in its
sales, including sales of the Sun products that incorporate our software. While
for the full year, software license revenues from Sun declined only 3%, we fully
anticipated at the outset of 2009 that Sun’s software license revenues would
increase when compared with 2008. Oracle is continuing to sell the Sun products
that incorporate our software, but we do not yet know the level of sales and
marketing effort and support that Oracle will put into sales of these
products.
  In
December of each of the past several years, 3Com, through a Chinese subsidiary,
had placed a multi-million dollar order with us for licenses to our software. In
December, 2009, Hewlett-Packard announced that it had reached an agreement to
purchase 3Com. This agreement caused 3Com to vary from its historical licensing
pattern and to place a substantially smaller order than previous years. The
purchase of 3Com by HP has not yet been completed. We do not know when or if
3Com will continue to license our software.
  28
 Table of Contents
  Collectively,
these three merger and acquisition events were the major factor contributing to
the twenty-four percent decrease in OEM software license revenue.
  Overall,
our revenues for the full year increased to $89.5 million from $87 million in
2008. This is a 3% year over year increase in revenues.  We currently
anticipate that revenue will increase in 2010.
  Net loss
for the year was $3.1 million compared with net income of $1.2 million in 2008.
We had stock-based compensation expense – which relates to stock options and
restricted stock we grant to employees, officers and directors as part of our
incentive compensation plan, and to some consultants as payment for services –
of $8.8 million in 2009 and $9.1 million in 2008, which is reflected in the net
results for each year.
  We
look to operating income as another measure of our progress. This number enables
us to measure and to compare our results of operations from one year to the
next. Operating loss for 2009 was $6.3 million, compared with operating income
of $1 million in 2008. These numbers again include stock-based compensation
expense. We attribute the decline in operating income from 2008 to 2009
primarily to the shortfall in anticipated revenue from our OEM customers. We
planned our expenses for 2009 based on our assumptions about revenue growth.
When the OEM revenue fell short, the result was a loss from
operations.
  This same
OEM revenue shortfall negatively impacted gross margin, another important
measure of our business. Among other things, gross margin measures our ability
to scale our business. Our gross margins tend to increase as our software
license revenue increases. Our gross margin for 2009 was 81% compared with 84%
for 2008. The impact of the equity-based compensation expense on gross margin
was equivalent to 2% for each of 2009 and 2008. The decline of OEM revenue was
particularly harmful to our gross margin because the cost of OEM revenues tends
to be much lower than the cost of channel revenue.
  Operating
margin is a measure of operating efficiency. We incur research and development
expenses before the product is offered for licensing. These expenses consist
primarily of personnel costs for engineering and testing, but also include other
items such as the depreciation and amortization of hardware and software used in
development. We also have expenses for software support, sales and marketing,
and general and administrative functions. Our operating margin decreased in 2009
to (7%), compared with 1% in 2008. The impact of the equity-based compensation
expense on operating margin in 2009 and 2008 was equivalent to 10% each
year.
  Our focus
for 2010 will be to continue to manage our business with a view towards
long-term success and growth.  Our goal is to keep making the Company
more profitable, but we do not manage the business to meet quarterly or annual
earnings targets.  Our continued ability to generate cash from
operations allows us to put money back into the business to continue its
growth.
  We
anticipate that our cost of maintenance, software services and other revenue,
research and development, sales and marketing and general and administrative
expenses will be higher in 2010 as compared with 2009, as a result of the
investments we made throughout 2009, which will now have a full-year impact on
2010.
  The key
factors we look to for our future business prospects are:
  ·
                our
      ability to establish and to expand relationships with resellers, and sales
      and re-orders by those resellers;
  ·
                our
      ability to establish and to expand relationships with key industry OEMs,
      and sales by those OEMs;
  ·
                growth
      in deferred revenue;
  ·
                the
      development and sales of our new
products;
  ·
                re-orders
      from existing customers; and
  ·
                the
      growth of the overall market for data protection and storage
      solutions.
  29
 Table of Contents
 
 We
anticipate that in 2010 software license sales by resellers and, to a lesser
extent, direct licenses to end users, or our non-OEM business, will continue to
grow in both absolute dollars and as a percentage of sales. Software license
revenue from our non-OEM business increased 15% in 2009. Increasing sales from
our non-OEM business remains an area of focus for us and in 2009 we made
significant investments in our sales force and in our marketing team to help
grow these sales. We also have instituted, and we will be instituting further,
support, training and incentive programs intended to increase sales by
resellers.
  We
continue to enhance our reseller program. Many enterprises look to value added
resellers or solution providers to assist them in making their information
technology purchases. These resellers typically review an enterprise’s needs and
suggest a hardware, software, or combined hardware and software solution to
fulfill the enterprise’s requirements.
  As
service providers to companies, resellers’ reputations are dependent on
satisfying their customers’ needs efficiently and effectively. Resellers have
wide choices in fulfilling their customers’ needs. If resellers determine that a
product they have been providing to their customers is not functioning as
promised, or is not providing adequate return on investment, or if the customers
are not satisfied with the level of support they are receiving from the
suppliers, the resellers will move quickly to offer different solutions to their
customers. Additional sales by resellers are therefore an important indicator of
our business prospects.
  In 2009,
we signed agreements with new resellers worldwide. The type of resellers with
whom we are signing agreements has continued to evolve. While we still sign
agreements with strong local and regional resellers, we have also entered into
reseller agreements with national and multi-national resellers who have their
own distribution networks. The enhanced distribution and marketing networks
offered by these larger resellers should help us to continue to grow our
sales.
  We also
terminated relationships with resellers who we believed were not properly
selling our products in 2009. We will continue to enter into relationships with
resellers and to discontinue relationships with resellers with whom we are not
satisfied.
  Despite
the decline in OEM revenue, OEM relationships continue to be important to us for
two main reasons:
  First,
sales by our OEM partners contribute to our revenues. Overall, total revenue
from OEMs accounted for approximately 36% of our revenues in 2009, down from 45%
in 2008. Accordingly, the loss of these customers would have a material adverse
effect on our business.
  Second,
having our products selected by respected, established industry leaders signals
to customers, resellers and other potential OEM partners that our products are
quality products that add value to their enterprise. Before licensing software,
OEM partners typically undertake broad reviews of many of the competing software
solutions available. The choice of our products by major industry participants
validates both the design and the capabilities of the products and our product
roadmaps.
  We do
everything we can to assure that our products meet the needs of our OEM partners
and their customers. However, as was shown in 2009 we are vulnerable to
strategic and tactical decisions made by our OEM partners that can result in
lower revenue for us.  In addition to potential changes in ownership
and the effects that can result, we cannot control decisions by our OEM partners
to change their product or marketing mix in ways that impact sales of products
licensed by the OEMs from us. Over our history, we have entered into OEM
agreements with partners, only to see those OEM partners change their strategies
and make significant reductions in their commitments to the products that
incorporate our technology.
  Our
deferred revenues consist primarily of amounts attributable to future support
and maintenance of our products. The level of deferred revenue is an important
indicator of our success. Maintenance and support for our products is sold for
fixed periods of time. Maintenance and support agreements are typically for one
year, although some agreements are for terms in excess of one year. If we do not
deliver the support needed by end users of our products or by our OEM partners
and resellers, then they will not renew their maintenance and support
agreements. If end users stop using our products, they also will not renew their
maintenance and support agreements. An increase in deferred revenues thus
indicates growth in our installed base and end user and OEM satisfaction with
our products and our maintenance and support services. Our deferred revenue
increased 1% to $22.2 million as of December 31, 2009, compared with $22.1
million as of December 31, 2008. We expect deferred revenue to continue to grow
in 2010.
  30
 Table of Contents
  As
discussed above, consolidation in the data protection and network storage market
continued in 2009. The consolidation significantly impacted our
revenue.
  Our
expenses increased 11% in 2009 from $86 million in 2008 to $95.8 million in
2009. This is well below the increase from 2007 to 2008, which was 21%, and the
increase from 2006 to 2007, which was 19%. However, the increase in expenses
outpaced our increase in revenues. Most of the increase in expenses related to
our successful efforts to continue to build our non-OEM business. We continue to
believe that the investments we have made in our business will provide a pay off
in the long run through increased sales and market share. Included in our
operating expenses for the years ended December 31, 2009 and 2008 was $8.8
million and $9.1 million, respectively, of share-based compensation
expense.
  We expect
to continue to be affected by seasonality of the information technology business
on a quarterly basis. Historically, information technology spending has been
higher in the fourth and second quarters of each calendar year, and somewhat
slower in the other quarters, particularly the first quarter. While our results
were skewed by the impact of the strategic transactions affecting our OEM
customers, our quarterly results reflected this seasonality in 2009, and we
anticipate that our quarterly results for 2010 will show the effects of
seasonality as well.
   Accounting
rules relating to share-based compensation expense continued to have a negative
impact on our earnings in 2009. On an on-going basis we weigh the impact of the
expense on our consolidated financial statements against the impact of
discontinuing the grant of equity-based compensation to our worldwide workforce.
It continues to be our view that the opportunity to participate in the growth of
our Company is an important motivating factor for our current employees and a
valuable recruiting tool for new employees. We will thus continue to apply the
criteria and the methodology we have used in the past to determine grants of
stock options or other equity-based compensation to our employees. For the
management of our business and the review of our progress, we will continue to
look to our results before share-based compensation expense. We will use these
non-GAAP financial measures in making operating decisions because they measure
the results of our day-to-day operations and because they provide a more
consistent basis for evaluating and comparing our results across different
periods.
  RESULTS
OF OPERATIONS – FOR THE YEAR ENDED DECEMBER 31, 2009 COMPARED WITH THE YEAR
ENDED DECEMBER 31, 2008
  Revenues
for the year ended December 31, 2009 increased 3% to $89.5 million compared with
$87.0 million for the year ended December 31, 2008. Our operating expenses
increased 11% from $86.0 million in 2008 to $95.8 million in 2009. Included in
our operating expenses for the years ended December 31, 2009 and 2008 were $8.8
million and $9.1 million, respectively, of share-based compensation expense. Net
loss for the year ended December 31, 2009 was $3.1 million compared with net
income of $1.2 million for the year ended December 31, 2008. Included in our net
loss for the year ended December 31, 2009 was an income tax benefit of $3.4
million compared with an income tax provision of $1.5 million for the year ended
December 31, 2008. The $3.4 million income tax benefit was primarily
attributable to (i) a benefit of $1.4 million related to research and
development credits we recognized during 2009, and (ii) the impact of our full
year effective tax rate on our pre-tax losses for 2009.
  Our 3%
revenue growth in 2009 as compared with 2008 was primarily driven by increases
in both our maintenance and our software services revenues. This growth was
offset by slight declines in our total software license revenues of 1% for the
year ended December 31, 2009 as compared with the same period 2008. Although our
software license revenue declined during 2009 compared with 2008, our gross
software license revenues from non-OEM partners increased 15% during 2009
compared with 2008, while our gross software license revenues from OEM partners
decreased by 24% during 2009 compared with 2008. The increase in our non-OEM
partner gross software license revenues was primarily driven by our ongoing
focus and investments on the FalconStor branded non-OEM channel business, which
resulted in increases in software licenses for our network storage solution
software from both new customers and our installed customer base. The decrease
in our OEM partner gross software license revenues was primarily attributable to
the merger and acquisition activity that adversely impacted some of our key OEM
partners, specifically, EMC, Sun Microsystems and 3Com. As a result of the
current macroeconomic environment, we continued to experience slowed revenue
growth, particularly in software license revenues, as a result of the downturn
in information technology spending and disruptions in the global financial
markets, which commenced during the third quarter of 2008 and continued
throughout 2009. However, because of our well-established installed customer
base, revenue from our maintenance agreements were not as significantly impacted
as compared with our software license revenues. Overall, total revenue
contribution from our OEM partners decreased in both absolute dollars and as a
percentage of total revenues for the year ended December 31, 2009 as compared
with 2008. Total revenue from non-OEM partners increased in both absolute
dollars and as a percentage of total revenue for the year ended December 31,
2009 as compared with 2008.
  31
 Table of Contents
  Expenses
increased in all aspects of our business as we continued to invest in our future
by increasing headcount both domestically and internationally. To support our
expected growth, we increased our worldwide headcount to 542 employees as of
December 31, 2009, as compared with 505 employees as of December 31, 2008. As we
stated throughout 2009, our investments in our future through additional
headcount, specifically in sales and marketing functions for our non-OEM
channel, would result in lower operating profits and margins. However, we have
already began to recognize returns on our investments from our non-OEM channel
business as indicated by the 15% growth in our gross software license revenues
from this part of our business. We anticipate that these investments will
continue to provide positive returns and accelerated sales momentum into 2010,
and that these investments are in line with our long-term outlook. Finally, we
continue to invest in our infrastructure by continued capital expenditures,
particularly with purchases of equipment in support of our existing and future
product offerings.
  Revenues
  Year
      Ended December 31,2009
                  
                  
                  2008Revenues:Software
      license revenue
                  
                  $
                  58,154,948
                  
                  
                  $
                  58,590,246Maintenance
      revenue
                  
                  
                  25,476,989
                  
                  
                  
                  23,283,094Software
      services and other revenue
                  
                  
                  5,827,244
                  
                  
                  
                  5,151,520Total
      Revenues
                  
                  $
                  89,459,181
                  
                  
                  $
                  87,024,860Year-over-year
      Percentage GrowthSoftware
      license revenue
                  
                  
                  -1
                  %
                  
                  
                  10
                  %Maintenance
      revenue
                  
                  
                  9
                  %
                  
                  
                  25
                  %Software
      services and other revenue
                  
                  
                  13
                  %
                  
                  
                  -9
                  %Total
      percentage growth
                  
                  
                  3
                  %
                  
                  
                  12
                  %
  Software
license revenue
 
 Software
license revenue is comprised of software licenses sold through our OEMs, and
through (i) value-added resellers, and (ii) distributors, and/or (iii) directly
to end-users (collectively “non-OEMs”). 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.
 
 Software
license revenue decreased 1% from $58.6 million for the year ended December 31,
2008 to $58.2 million for the year ended December 31, 2009. Software license
revenue represented 65% and 67% of our total revenues for the years ended
December 31, 2009 and 2008, respectively. The decrease in software license
revenues was primarily attributable to a decline of 24% in gross software
license revenues from our OEM partners as a result of the merger and acquisition
activity surrounding some of our key OEM partners during the year ended December
31, 2009, as compared with the same period in 2008. This decrease was offset by
the growth of 15% in gross software license revenues from our non-OEM partners
during the year ended December 31, 2009, as compared with the same period in
2008.
 
 Over the
past several years, we have experienced broader market acceptance of our
software applications and we have continued to offer new product solutions,
which has resulted in increased demand for our software solutions. Additionally,
during 2009 we focused our investments on the FalconStor branded non-OEM channel
business as we feel this is in line with our long-term outlook. However, overall
software license revenues continued to be impacted by the downturn in
information technology spending as a result of the current macroeconomic
environment, which commenced during the second half of 2008, and continued
throughout 2009. While we anticipate this trend to continue into 2010, we also
anticipate that our investments in the FalconStor branded business will result
in our non-OEM generated software license revenue to grow at a greater rate in
future years as compared with our OEM generated software license
revenue.
  32
 Table of Contents
  Maintenance
revenue
 
 Maintenance
revenue is comprised of software maintenance and technical support services.
Revenues derived from maintenance and technical support contracts are deferred
and recognized ratably over the contractual maintenance term. Maintenance
revenues increased 9% from $23.3 million for the year ended December 31, 2008 to
$25.5 million for the year ended December 31, 2009.
  The major
factor behind the increase in maintenance revenue was an increase in the number
of maintenance and technical support contracts we sold. As we are in business
longer, and as we license more software to new customers and grow our installed
customer base, we expect the amount of maintenance and technical support
contracts we have to grow as well. While we expect our maintenance revenue to
continue to grow primarily because (i) the majority of our new customers
purchase maintenance and support contracts, and (ii) the majority of our growing
existing customer base renewed their maintenance and support contracts after
their initial contracts expire, the slowed growth in software license revenues
we have experienced since the second half of 2008 and throughout 2009, as
discussed above, has impacted the typical maintenance revenue growth levels we
have experienced historically year over year.
 
 Software
services and other revenue
 
 Software
services and other revenues are comprised of professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Professional services revenue is recognized in the period
that the related services are performed. Revenue from engineering services is
primarily related to customizing software product masters for some of our OEM
partners. Revenue from engineering services is recognized in the period in which
the services are completed. We have transactions in which we purchase hardware
and bundled this hardware with our software and sell this bundled solution to
our customer base. Our software is not essential to the functionality of the
bundled hardware. The amount of revenue allocated to the software and hardware
bundle is recognized as revenue in the period delivered provided all other
revenue recognition criteria have been met. We further separate the software
sales revenue from the hardware revenue for purposes of classification in the
consolidated statements of operations in a systematic and rational manner based
on their deemed relative fair values. Software services and other revenue
increased 13% from $5.2 million for the year ended December 31, 2008 to $5.8
million for the year ended December 31, 2009.
 
 The
increase in software services and other revenue was primarily due to increases
in both (i) computer hardware sales, which increased from $3.0 million for the
year ended December 31, 2008 to $3.1 million for the same period in 2009, and
(ii) our professional services revenue, which increased from $2.2 million for
the year ended December 31, 2008 to $2.7 million for the same period in 2009.
The professional services revenue varies from year to year based upon (i) the
number of software license contracts sold during the year, (ii) the number of
our software license customers who elected to purchase professional services,
and (iii) the number of professional services contracts that were completed
during the year. We expect professional services revenues to continue to vary
from year to year based upon the number of customers who elect to utilize our
professional services upon purchasing our software licenses. We expect the
hardware revenue will continue to vary from year to year based upon the number
of customers who wish to have us bundle hardware with our software for one
complete solution.
 
 Cost
of Revenues
  Year
      ended December 31,2009
                    
                    
                    2008Total
      Revenues:
                    
                    $
                    89,459,181
                    
                    
                    $
                    87,024,860Cost
      of maintenance, software servicesand
      other revenue (including amortizationof
      purchased and capitalized software)
                    
                    $
                    16,915,407
                    
                    
                    $
                    13,874,238Gross
      Profit
                    
                    $
                    72,543,774
                    
                    
                    $
                    73,150,622Gross
      Margin
                    
                    
                    81
                    %
                    
                    
                    84
                    %
 33
 Table of Contents
  Cost
of maintenance, software services and other revenue
 
 Cost of
maintenance, software services and other revenues consists primarily of
personnel and other costs associated with providing software implementations,
technical support under maintenance contracts, training, amortization of
purchased and capitalized software and share-based compensation expense. 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, 2009
increased $3.0 million, or 22% to $16.9 million compared with $13.9 million for
the same period in 2008. The increase in cost of maintenance, software services
and other revenue for the year ended December 31, 2009 as compared with the same
period in 2008 was primarily due to (i) an increase in personnel and related
costs, (ii) increased hardware costs associated with the transactions in which
we bundled purchased hardware with our software and sold the bundled solution,
and (iii) an increase in amortization related to purchased and capitalized
software, specifically related to the acquisition of World Venture Limited on
July 1, 2008 (see Note (9) Acquisitions to our
consolidated financial statements for additional information). As a result of
our increased sales of maintenance and support contracts, we continued to hire
additional employees to provide technical support services. Our cost of
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenues from these services also increase.
 
 Gross
profit decreased $0.6 million, or 1%, from $73.1 million for the year ended
December 31, 2008 to $72.5 million for the year ended December 31, 2009. Gross
margins decreased to 81% for the year ended December 31, 2009 from 84% in the
same period in 2008. The decrease in both our gross profit and gross margins for
the year ended December 31, 2009, as compared with the same period in 2008, was
primarily due to our investment in 2009 in additional headcount to support our
anticipated revenue growth for both the short and the long-term. These
investments in headcount outpaced our actual revenue growth of 3% in 2009, and
adversely impacted both our gross profit and gross margins. Generally, our gross
profits and gross margins may fluctuate based on several factors, including (i)
revenue growth levels, (ii) changes in personnel headcount and related costs,
and (iii) our product offerings and service mix of sales.
 
 Share-based
compensation expense included in the cost of maintenance, software services and
other revenue increased to $1.5 million from $1.4 million for the year ended
December 31, 2009 and December 31, 2008, respectively. Share-based compensation
expense was equal to 2% of revenue for each of the years ended December 31, 2009
and December 31, 2008.
 
 Software
Development Costs
  Software
development costs consist primarily of personnel costs for product development
personnel, share-based compensation expense, and other related costs associated
with the development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased $1.5 million, or 6%
to $26.8 million for the year ended December 31, 2009 from $25.3 million in the
same period in 2008. The major contributing factors to the increase in software
development costs were higher salary and personnel related costs as a result of
increased headcount to enhance and to test our core network storage software
product and the development of new innovative products, features and options.
Share-based compensation expense included in software development costs
decreased to $3.1 million from $3.2 million for the years ended December 31,
2009 and 2008, respectively. Share-based compensation expense included in
software development costs was equal to 3% of revenue for the year ended
December 31, 2009 and 4% for the year ended December 31, 2008.
  34
 Table of Contents
  Selling
and Marketing
  Selling
and marketing expenses consist primarily of sales and marketing personnel and
related costs, share-based compensation expense, 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 $4.2 million, or 11% to $42.3 million for the year ended
December 31, 2009 from $38.1 million for the same period in 2008. The increase
in selling and marketing expenses was primarily due to (i) higher salary and
personnel related costs as a result of increased sales and marketing headcount,
specifically in support of our non-OEM channel business, (ii) higher commissions
paid as a result of increase in our non-OEM channel business revenues, and (iii)
higher marketing expenses related to our ongoing product branding campaign of
such initiatives. Share-based compensation expense included in selling and
marketing decreased to $3.1 million from $3.5 million for the years ended
December 31, 2009 and 2008, respectively. Share-based compensation expense
included in selling and marketing expenses was equal to 3% and 4% for the years
ended December 31, 2009 and 2008, respectively.
  General
and Administrative
  General
and administrative expenses consist primarily of personnel costs of general and
administrative functions, share-based compensation expense, public company
related costs, directors and officers insurance, legal and professional fees,
and other general corporate overhead costs. General and administrative expenses
increased $1.1 million, or 13% to $9.9 million for the year ended December 31,
2009 from $8.7 million for the same period in 2008. The overall increase within
general and administrative expenses related to increases in various
administrative costs including (i) personnel related costs, (ii) general
corporate insurances, and (iii) various professional fees. Share-based
compensation expense included in general and administrative expenses increased
to $1.1 million from $0.9 million for the years ended December 31, 2009 and
2008, respectively. Share-based compensation expense included in general and
administrative expenses was equal to 1% of revenue for each of the years ended
December 31, 2009 and 2008, respectively.
  Interest
and Other (Loss) Income
  We invest
our cash primarily in money market funds, commercial paper, government
securities, and corporate bonds. As of December 31, 2009, our cash, cash
equivalents, and marketable securities totaled $41.8 million, compared with
$42.8 million as of December 31, 2008. Interest and other (loss) income
decreased $1.8 million to ($0.1) million for the year ended December 31, 2009,
compared with $1.7 million for the same period in 2008. The decrease in interest
and other (loss) income was due to (i) the decrease in interest income of $0.8
million for the year ended December 31, 2009, as compared with the same period
in 2008, as a result of the continued suppressed interest rates on average cash
balances invested and (ii) foreign currency losses of $0.6 million incurred
during the year ended December 31, 2009 as compared with a foreign currency gain
of $0.2 million for the same period in 2008.
  Income
Taxes
  For the year ended December 31, 2009,
we recorded an income tax benefit of $3.4 million, which was primarily
attributable to (i) a benefit of $1.4 million which resulted from previously
unrecognized tax benefits in connection with our completion of a research and
development study finalized during 2009, and (ii) the impact of our full year
effective tax rate on our pre-tax losses for 2009. For the year ended December
31, 2008, our provision for income taxes was $1.5 million and consisted
primarily of U.S., state, local and foreign taxes.
  As of
January 1, 2008, we had approximately $5.1 million of federal net operating loss
carryforwards available to offset future taxable income. These net operating
loss carryforwards related to excess compensation deductions from previous
years’ exercises of stock options. During 2008, we utilized all of our net loss
carryforwards, the benefits of which were credited to
additional-paid-in-capital. As of December 31, 2009 and December 31, 2008, our
deferred tax assets, net of a deferred tax liabilities and valuation allowance,
were $14.0 million and $10.0 million, respectively.
  35
 Table of Contents
  RESULTS
OF OPERATIONS – FOR THE YEAR ENDED DECEMBER 31, 2008 COMPARED WITH THE YEAR
ENDED DECEMBER 31, 2007
  Revenues
for the year ended December 31, 2008 increased 12% to $87.0 million compared
with $77.4 million for the year ended December 31, 2007. Our operating expenses
increased 21% from $71.3 million in 2007 to $86.0 million in 2008. Included in
our operating expenses for the years ended December 31, 2008 and 2007 were $9.1
million and $7.9 million, respectively, of share-based compensation expense. Net
income for the years ended December 31, 2008 and 2007 was $1.2 million and $12.7
million, respectively. Included in our net income for the year ended December
31, 2008 was a tax provision of $1.5 million compared with the year ended
December 31, 2007 which included an income tax benefit of $4.3 million, that
primarily consisted of a reversal of certain deferred tax asset valuation
allowances as a result of our continuing positive operating results and
financial projections. Our 12% revenue growth for the year ended December 31,
2008 as compared with the same period in 2007 was due to growth in both our
software license revenue and maintenance revenues. This growth in revenues was
primarily driven by increases in (i) demand for our data protection and network
storage solution software, and (ii) maintenance revenue from new and existing
customers. However, during the second half of 2008, our revenue growth slowed,
particularly software license revenues, as a result of the difficult economic
conditions encountered as a result of the disruptions in the global financial
markets, specifically in North America, when compared with the same period in
2007. Because of our well-established installed customer base and growing number
of software licenses sold, our revenue from maintenance agreements were not
significantly impacted as compared with our software license revenues as a
result of the downturn in information technology spending experienced during the
second half of 2008. Revenue contribution from our OEM partners increased in
absolute dollars for the year ended December 31, 2008 as compared with the same
period in 2007. Revenue from our non-OEM partners increased in both absolute
dollars and as a percentage of total revenue for the year ended December 31,
2008 as compared with the same period in 2007. Expenses increased in all aspects
primarily as a result of increased worldwide headcount to 505 employees as of
December 31, 2008, as compared with 414 employees as of December 31,
2007.
  Revenues
  Year
      Ended December 31,2008
                
                
                2007Revenues:Software
      license revenue
                
                $
                58,590,246
                
                
                $
                53,153,980Maintenance
      revenue
                
                
                23,283,094
                
                
                
                18,606,591Software
      services and other revenue
                
                
                5,151,520
                
                
                
                5,638,651Total
      Revenues
                
                $
                87,024,860
                
                
                $
                77,399,222Year-over-year
      Percentage GrowthSoftware
      license revenue
                
                
                10
                %
                
                
                39
                %Maintenance
      revenue
                
                
                25
                %
                
                
                49
                %Software
      services and other revenue
                
                
                -9
                %
                
                
                32
                %Total
      percentage growth
                
                
                12
                %
                
                
                41
                %




Software
license revenue
 
 Software
license revenue increased 10% from $53.2 million for the year ended December 31,
2007 to $58.6 million for the year ended December 31, 2008. Software license
revenue represented 67% and 69% of our total revenues for the years ended
December 31, 2008 and 2007, respectively. As a result of broader market
acceptance of our software applications, new product offerings and increased
demand for our products from our expanding base of customers, we continued to
experience increased software license revenues. However, during the second half
of 2008, as a result of the difficult economic conditions encountered as a
result of the disruptions in the global financial markets, specifically in North
America, our software license revenue growth slowed when compared with the same
period in 2007. Overall, during the year ended December 31, 2008, gross software
license revenue from our OEM partners decreased 7%, while gross software license
revenues from our non-OEM partners increased 22% when compared to the same
period in 2007.
  Maintenance
revenue
 
 Maintenance
revenues increased 25% from $18.6 million for the year ended December 31, 2007
to $23.3 million for the year ended December 31, 2008. The major factor behind
the increase in maintenance revenue was an increase in the number of maintenance
and technical support contracts we sold.
  36
 Table of Contents




Software
services and other revenue
  Software
services and other revenue decreased 9% from $5.6 million for the year ended
December 31, 2007 to $5.2 million for the year ended December 31, 2008. The
decrease in software services and other revenue was primarily due to a decrease
in computer hardware sales, which declined from $3.4 million for the year ended
December 31, 2007 to $3.0 million for the year ended December 31, 2008. Our
professional services revenue decreased $0.1 million to $2.2 million for the
year ended December 31, 2008 from $2.3 million in the same period in 2007. We
expect professional services revenues to vary from year to year based upon the
number of customers who elect to utilize our professional services upon
purchasing our software licenses. The hardware revenue will vary from year to
year based upon the number of customers who wish to have us bundle hardware with
our software for one complete solution.
 
 Cost
of Revenues
  Year
      ended December 31,2008
                
                
                2007Total
      Revenues:
                
                $
                87,024,860
                
                
                $
                77,399,222Cost
      of maintenance, software servicesand
      other revenue (including amortizationof
      purchased and capitalized software)
                
                $
                13,874,238
                
                
                $
                11,213,935Gross
      Profit
                
                $
                73,150,622
                
                
                $
                66,185,287Gross
      Margin
                
                
                84
                %
                
                
                86
                %




Cost
of maintenance, software services and other revenue
 
 Cost of
maintenance, software services and other revenues increased $2.7 million or 24%
to $13.9 million for the year ended December 31, 2008, from $11.2 million for
the same period in 2007. The increase in cost of maintenance, software services
and other revenue was primarily due to the increase in personnel and related
costs. As a result of our increased sales from maintenance and support
contracts, we continued to hire additional employees to provide technical
support services.
 
 Gross
profit increased $7.0 million or 11% to $73.2 million for the year ended
December 31, 2008, from $66.2 million for the same period in
2007.  Gross margins decreased from 86% for the year ended December
31, 2007, to 84% for the year ended December 31, 2008. Even though we had an
increase in our gross profit, our gross margins decreased. Generally, our gross
margins may fluctuate based on several factors, including (i) revenue growth
levels, (ii) timing of changes in personnel headcount and related costs, (iii)
our mix of product offerings and services, and (iv) costs related to the
procurement of hardware for our bundled solutions. Share-based compensation
expense included in the cost of maintenance, software services and other revenue
increased to $1.4 million from $1.0 million for the years ended December 31,
2008 and 2007, respectively. Share-based compensation expense was equal to 2%
and 1% of revenue for the years ended December 31, 2008 and 2007,
respectively.
 
 Software
Development Costs
  Software
development costs increased 13% to $25.3 million for the year ended December 31,
2008, from $22.4 million in the same period in 2007. The major contributing
factors to the increase in software development costs were higher salary and
personnel related costs as a result of increased headcount to enhance and test
our core network storage software product and the development of new innovative
features and options. Share-based compensation expense included in software
development costs decreased to $3.2 million from $3.3 million for the years
ended December 31, 2008 and 2007, respectively. Share-based compensation expense
included in software development costs was equal to 4% of revenue for each of
the years ended December 31, 2008 and 2007, respectively.
  37
 Table of Contents
  Selling
and Marketing
  Selling
and marketing expenses increased 28% to $38.1 million for the year ended
December 31, 2008, from $29.7 million for the same period in 2007. The increase
in selling and marketing expenses was primarily due to (i) higher salary and
personnel related costs as a result of increased sales and marketing headcount,
and (ii) higher advertising and marketing related expenses as a result of trade
and industry shows, new product offerings/enhancements, new product branding and
related advertising and marketing of such initiatives. Share-based compensation
expense included in selling and marketing increased to $3.5 million from $2.6
million for the years ended December 31, 2008 and 2007, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 4% and 3% for the years ended December 31, 2008 and 2007,
respectively.
  General
and Administrative
  General
and administrative expenses increased 9% to $8.7 million for the year ended
December 31, 2008 from $8.0 million for the same period in 2007. Increased
compensation and personnel related costs as a result of increased headcount to
support our general and administrative needs was offset by decreases in
professional fees and various administrative expenses during the year ended
December 31, 2008, as compared with the same period in 2007. Share-based
compensation expense included in general and administrative expenses decreased
to $0.9 million from $1.0 million for the years ended December 31, 2008 and
2007, respectively. Share-based compensation expense included in general and
administrative expenses was equal to 1% of revenue for each of the years ended
December 31, 2008 and 2007, respectively.
  Interest
and Other Income
  We invest
our cash primarily in money market funds, commercial paper, government
securities, and corporate bonds. As of December 31, 2008, our cash, cash
equivalents, and marketable securities totaled $42.8 million, compared with
$62.9 million as of December 31, 2007. Interest and other income decreased to
$1.7 million for the year ended December 31, 2008, compared with $2.3 million
for the same period in 2007. The decrease in interest income was primarily
related to (i) a decrease in our cash, cash equivalents and marketable
securities balances as a result of our repurchase of 5.6 million shares of our
common stock at a total cost of $33.9 million during 2008, and (ii) lower
interest rates on average cash balance invested during the year ended December
31, 2008, particularly during the second half of 2008, as a result of the U.S.
banking liquidity crisis, as compared with the same period in 2007. The interest
income in both 2008 and 2007 was impacted partially by other non-operating
income and expenses, particularly, foreign currency gains of $0.2 million and
$22,000, respectively.
  Income
Taxes
  For the
year ended December 31, 2008, our provision for income taxes was $1.5 million
which consisted primarily of U.S., state, local and foreign taxes. For the year
ended December 31, 2007, our benefit from income taxes was $4.3 million, which
primarily related to a substantial reversal of our deferred income tax valuation
allowance. During the year ended December 31, 2007, we determined that based
upon a number of factors, including our then cumulative taxable income over the
prior three years and expected profitability in future years, certain of our
deferred tax assets were “more likely than not” realizable through future
earnings. Accordingly, we recognized a significant portion of our deferred tax
assets through a reduction in our deferred tax asset valuation allowance of
approximately $8.9 million. As of December 31, 2008 and December 31, 2007, our
deferred tax assets, net of a deferred tax liabilities and valuation allowance,
were $10 million and $9.8 million, respectively.
  38
 Table of Contents
  LIQUIDITY
AND CAPITAL RESOURCES
  Cash flow
information is as follows:
 Years
      Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007Cash
      provided by (used in):Operating
      activities
                  
                  $
                  8,806,491
                  
                  
                  $
                  18,231,609
                  
                  
                  $
                  16,588,539Investing
      activities
                  
                  
                  (11,019,560
                  )
                  
                  
                  3,335,856
                  
                  
                  
                  (12,357,286
                  )Financing
      activities
                  
                  
                  (3,826,699
                  )
                  
                  
                  (30,998,308
                  )
                  
                  
                  11,803,544Effect
      of exchange rate changes
                  
                  
                  (571,939
                  )
                  
                  
                  (424,271
                  )
                  
                  
                  79,543Net
      (decrease) increase in cash and cash equivalents
                  
                  $
                  (6,611,707
                  )
                  
                  $
                  (9,855,114
                  )
                  
                  $
                  16,114,340




Our
principal sources of liquidity are cash flows generated from operations and our
cash, cash equivalents, and marketable securities balances. Our cash and cash
equivalents and marketable securities balance as of December 31, 2009 totaled
$41.8 million, as compared with $42.8 million as of December 31, 2008. Cash and
cash equivalents totaled $15.8 million and marketable securities totaled $26.0
million at December 31, 2009. As of December 31, 2008, we had $22.4 million in
cash and cash equivalents and $20.4 million in marketable
securities.
  In 2009,
we continued making investments in our infrastructure in anticipation of our
current and long-term outlook. As we continue to grow, we will continue to make
investments in capital expenditures and we will continue to evaluate the need 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. In 2008, we
purchased certain assets of World Venture Limited for an aggregate purchase
price of $1.7 million including transaction and closing costs (see Note (9)
Acquisitions to our
consolidated financial statements). As of the date of this filing, we have no
other agreements, commitments or understandings with respect to any such
acquisitions.
  We
currently do not have any debt and our only significant commitments are related
to our office leases.
  At
various times from October 2001 through February 2009 our Board of Directors has
authorized the repurchase of up to 14 million shares of our outstanding common
stock in the aggregate. During 2009, we repurchased 1,181,185 shares of our
common stock in open market purchases at an aggregate purchase price of $4.0
million. During 2008, we repurchased 5,639,950 shares of our common stock in
open market purchases at an aggregate purchase price of $33.9 million. During
2007, we repurchased 318,900 shares of our common stock in open market purchases
at an aggregate purchase price of $3.3 million. Since October 2001, we have
repurchased a total of 8,005,235 shares at an aggregate purchase price of $46.9
million. As of December 31, 2009, we had the authority to repurchase an
additional 5,994,765 shares of our common stock based upon our judgment and
market conditions. See Note (7) Stockholders’ Equity to our
consolidated financial statements for further information.
  Net cash
provided by operating activities totaled $8.8 million for the year ended
December 31, 2009, compared with net cash provided by operating activities of
$18.2 million and $16.6 million for the years ended December 31, 2008 and 2007,
respectively. The decrease in net cash provided by operating activities for the
year ended December 31, 2009, as compared with the same periods in 2008 and
2007, respectively, was the result of recording a net loss of $3.1 million in
2009 compared with net income of $1.2 million and $12.7 million in 2008 and
2007, respectively, adjusted for: (i) the impact of non-cash charges,
particularly relating to deferred income taxes and tax benefits from stock-based
awards; and (ii) adjustments for net changes in operating assets and
liabilities, primarily changes in our accounts payable, accrued expenses and
deferred revenues. In addition, net cash provided by operating activities was
impacted by the tax benefits recognized as a result of excess stock-based
compensation deductions and exercises of stock options, particularly in 2008 and
2007. Based upon the authoritative guidance issued by the FASB on stock
compensation, tax benefits relating to excess stock-based compensation
deductions are to be presented as cash outflows from operating activities. We
recognized tax benefits related to stock-based compensation deductions of $0.1
million, $2.1 million and $5.1 million for the years ended December 31, 2009,
2008, and 2007, respectively.
  39
 Table of Contents
  Net cash
used in investing activities was $11.0 million for the year ended December 31,
2009, compared with net cash provided by investing activities of $3.3 million
for the year ended December 31, 2008 and net cash used in investing activities
of $12.4 million for the year ended December 31, 2007. Included in investing
activities for each year are the sales and purchases of our marketable
securities. These represent the sales, maturities and reinvesting of our
marketable securities. The net cash provided by investing activities from the
net sales (purchases) of securities was ($5.6) million, $9.9 million and ($5.7)
million for the years ended December 31, 2009, 2008 and 2007, respectively.
These amounts will fluctuate from year to year depending on the maturity dates
of our marketable securities. The cash used to purchase property and equipment
was $4.3 million, $4.5 million and $5.5 million for the years ended December 31,
2009, 2008 and 2007, respectively. In addition, as discussed above and further
in Note (9) Acquisitions to our
consolidated financial statements, during 2008 we used $1.7 million for the
acquisition of assets, while we did not have any acquisitions of assets in the
same periods of 2009 or 2007. The cash used to purchase software licenses was
$1.0 million for the year ended December 31, 2009. We did not have any
significant purchases of software licenses during the years ended December 31,
2008 and 2007. We continually evaluate potential software license purchases and
acquisitions, and we may continue to make similar investments if we find
opportunities that would benefit our business. We anticipate continued capital
expenditures as we invest in our infrastructure to support our ongoing growth
and expansion both domestically and internationally.
  Net cash
used in financing activities was $3.8 million for the year ended December 31,
2009, compared with net cash used in financing activities of $31.0 million for
the year ended December 31, 2008 and net cash provided by financing activities
of $11.8 million for the year ended December 31, 2007. Cash outflows from
financing activities resulted from the repurchase of our outstanding common
stock. During 2009, we repurchased 1.2 million shares of our common stock at an
aggregate purchase price of $4.0 million. During 2008, we repurchased 5.6
million shares of our common stock at an aggregate purchase price of $33.9
million. During 2007, we repurchased 0.3 million shares of our common stock at
an aggregate purchase price of $3.3 million. Cash inflows from financing
activities primarily result from proceeds received from the exercise of stock
options. We received proceeds from the exercise of stock options of $35,000,
$0.8 million and $10.0 million in 2009, 2008, and 2007, respectively. Cash
inflows from financing activities were also impacted by the tax benefits
recognized as a result of excess stock-based compensation deductions and
exercises of stock options. Based upon the authoritative guidance issued by the
FASB on stock compensation, tax benefits relating to excess stock-based
compensation deductions are to be presented as cash inflows from financing
activities. We recognized tax benefits related to stock-based compensation
deductions of $0.1 million, $2.1 million and $5.1 million for the years ended
December 31, 2009, 2008 and 2007, respectively.
  As
discussed in Note (4) Fair Value Measurements to
our consolidated financial statements, on January 1, 2008, we adopted the
authoritative guidance issued by the FASB on fair value measurements and
disclosures. We utilize unobservable (Level 3) inputs in determining
the fair value of auction rate securities we hold.
  As of
December 31, 2009 and 2008, $1.4 million and $1.5 million (at par value),
respectively, of our investments was comprised of auction rate securities.
Liquidity for these auction rate securities is typically provided by an auction
process, which allows holders to sell their notes, and resets the applicable
interest rate at pre-determined intervals. During the first quarter of 2008, we
began experiencing failed auctions on auction rate securities. An auction
failure means that the parties wishing to sell their securities could not be
matched with an adequate volume of buyers. In the event that there is a failed
auction, the indenture governing the security requires the issuer to pay
interest at a contractually defined rate that is generally above market rates
for other types of similar short-term instruments. The securities for which
auctions have failed will continue to accrue interest at the contractual rate
and continue to reset the next auction date every 28 - 35 days until the
auction succeeds, the issuer calls the securities, or they mature. Because there
is no assurance that auctions for these securities will be successful in the
near term and due to our ability and intent to hold these securities to
maturity, the auction rate securities were classified as long-term investments
in our consolidated balance sheet at both December 31, 2009 and
2008.
  Our
auction rate securities are classified as available-for-sale securities and are
reflected at fair value. In prior periods during the auction process, quoted
market prices were readily available, which would qualify as Level 1 under
FASB authoritative guidance. However, due to events in the credit markets
beginning in the second half of 2008, and continuing throughout 2009, the
auction events for most of these instruments failed and, therefore, we have
determined the estimated fair values of these securities utilizing a discounted
cash flow analysis or other type of valuation model as of both December 31, 2009
and 2008. These analyses consider, among other items, the collateral underlying
the security, the creditworthiness of the issuer, the timing of the expected
future cash flows, including the final maturity, associated with the securities,
and an assumption of when the next time the security is expected to have a
successful auction. These securities were also compared, when possible, to other
observable and relevant market data, which is limited at this time. Due to these
events, we reclassified these instruments as Level 3 commencing in 2008 and
we continued to do so in 2009.
  40
 Table of Contents
  As of
December 31, 2009, we have recorded $40,000 cumulatively in other-than-temporary
impairment and a cumulative temporary decline in fair value of approximately
$282,534 in accumulated other comprehensive loss. As of December 31, 2008, the
losses related to our auction rate securities recorded in accumulated other
comprehensive loss totaled $333,055. During the first quarter of 2009, we
determined that a decline in the fair value of one of our particular investments
was the result of a downgrade in the credit rating of certain underlying
subordinate securities within the auction rate security. As a result, we
determined a portion of the overall decline in fair value of the auction rate
security to be other-than-temporary due to the creditworthiness of the
underlying securities, and accordingly recorded $40,000 in other-than-temporary
impairments on this auction rate security. Accordingly, any future fluctuation
in the fair value related to any of the auction rate securities that we deem to
be temporary, including any recoveries of previous write-downs, would be
recorded to accumulated other comprehensive loss, net of tax. In addition,
during the fourth quarter of 2009, $100,000 of our auction rate securities were
called by the issuer at par value. Finally, with the exception of the
creditworthiness of one of our auction rate securities, we believe that the
remaining temporary declines in fair value are primarily due to liquidity
concerns and not to the creditworthiness of the remaining underlying assets,
because the majority of the underlying securities are almost entirely backed by
the U.S. Government. However, if at any time in the future that we
determine that a valuation adjustment is other-than-temporary, we will record a
charge to earnings in the period of determination.
  Our
holdings of auction rate securities (at par value) represented approximately 3%
of our cash equivalents, and marketable securities balance as of each December
31, 2009 and 2008, respectively, which we believe allows us sufficient time for
the securities to return to full value or to be refinanced by the issuer.
Because we believe that the decline in fair value deemed to be temporary is
primarily due to liquidity issues in the credit markets, any difference between
our estimate and an estimate that would be arrived at by another party would
have no impact on our earnings, since such difference would also be recorded to
accumulated other comprehensive loss. We will continue to re-evaluate each of
these factors as market conditions change in subsequent periods.
  We
currently do not have any debt and our only material cash commitments are
related to our office leases. We have an operating lease covering our corporate
office facility that expires in February 2012. We also have several operating
leases related to offices in the United States and foreign countries. The
expiration dates for these leases range from 2010 through 2012. The following is
a schedule of future minimum lease payments for all operating leases as of
December 31, 2009:
  Year ending December 31,2010
                
                
                2,541,2072011
                
                
                1,875,3762012
                
                
                522,353$
                4,938,936
  We
believe that our current balance of cash, cash equivalents and marketable
securities, and our expected cash flows from operations, will be sufficient to
meet our cash requirements for at least the next twelve months. However, any
projections of future cash needs and cash flows are subject to substantial
uncertainty. See Item 1A of Part I, “Risk Factors.”
  Off-Balance
Sheet Arrangements
  As of
December 31, 2009 and 2008, we had no off-balance sheet
arrangements.
  41
 Table of Contents
  Critical
Accounting Policies and Estimates
  Our
critical accounting policies and estimates are those related to revenue
recognition, accounts receivable allowances, deferred income taxes, accounting
for share-based payments, acquisitions, goodwill and other intangible assets,
and fair value measurements.
  Revenue Recognition. We
recognize revenue in accordance with the authoritative guidance issued by the
FASB on revenue recognition.  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, a customer purchase order, and/or a royalty report
summarizing software licenses sold for each software license resold by an OEM,
distributor or solution provider to an end user. The software license fees are
fixed and determinable as our standard payment terms range from 30 to 90 days,
depending on regional billing practices, and we have not provided any of our
customers extended payment terms. When a customer licenses software together
with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.
  Accounts Receivable. We review
accounts receivable to determine which are doubtful of collection.  In
making the determination of the appropriate allowance for uncollectible accounts
and returns, we consider (i) historical return rates, (ii) specific past due
accounts, (iii) analysis of our accounts receivable aging, (iv) customer payment
terms, (v) historical collections, write-offs and returns, (vi) changes in
customer demand and relationships, and (vii) concentrations of credit risk and
customer credit worthiness. Historically, we have experienced a somewhat
consistent level of write-offs and returns as a percentage of revenue due to our
customer relationships, contract provisions and credit
assessments.  Changes in the product return rates; credit worthiness
of customers; general economic conditions and other factors may impact the level
of future write-offs, revenues and our general and administrative expenses.
 
 Deferred Income Taxes.In
accordance with the authoritative guidance issued by the FASB on income taxes,
we regularly estimate our ability to recover deferred tax assets, and report
such deferred tax assets at the amount that is determined to be
more-likely-than-not recoverable. We also have to estimate our income taxes in
each of the taxing jurisdictions in which we operate. This process involves
estimating our current tax expense together with assessing any temporary
differences resulting from the different treatment of certain items, such as the
timing for recognizing revenue and expenses for tax and accounting purposes, as
well as estimating foreign tax credits. These differences may result in deferred
tax assets and liabilities, which are included in our consolidated balance
sheet. We are required to assess the likelihood that our deferred tax assets,
which include temporary differences that are expected to be deductible in future
years, will be recoverable from future taxable income or other tax planning
strategies. If recovery is not likely, we have to provide a valuation allowance
based on our estimates of future taxable income in the various taxing
jurisdictions, and the amount of deferred taxes that are ultimately realizable.
The provision for current and deferred taxes involves evaluations and judgments
of uncertainties in the interpretation of complex tax regulations. This
evaluation considers several factors, including an estimate of the likelihood of
generating sufficient taxable income in future periods, the effect of temporary
differences, the expected reversal of deferred tax liabilities, past and
projected taxable income, and available tax planning strategies.
 
 Accounting for Share-Based
Payments. As discussed further in Note (8) Share-Based Payment
Arrangements, to our consolidated financial statements, we account for
stock-based awards in accordance with the authoritative guidance issued by the
FASB on stock compensation.
  We have
used and expect to continue to use the Black-Scholes option-pricing model to
compute the estimated fair value of share-based compensation expense. The
Black-Scholes option-pricing model includes assumptions regarding dividend
yields, expected volatility, expected option term and risk-free interest rates.
The assumptions used in computing the fair value of share-based compensation
expense reflect our best estimates, but involve uncertainties relating to market
and other conditions, many of which are outside of our control. We estimate
expected volatility based primarily on historical daily price changes of our
stock and other factors. The expected option term is the number of years that we
estimate that the stock options will be outstanding prior to exercise. The
expected term of the awards issued prior to January 1, 2008, was determined
using the “simplified method” prescribed in SEC Staff Accounting Bulletin
(“SAB”) No. 107. The estimated expected term of the stock awards issued
since January 1, 2008 has been determined pursuant to SAB No. 110.
Additionally, we estimate forfeiture rates based primarily upon historical
experiences, adjusted when appropriate for known events or expected trends. We
may adjust share-based compensation expense on a quarterly basis for changes to
our estimate of expected equity award forfeitures based on our review of these
events and trends, and recognize the effect of adjusting the forfeiture rate for
all expense amortization in the period in which we revised the forfeiture
estimate. If other assumptions or estimates had been used, the share-based
compensation expense that was recorded for the years ended December 31, 2009,
2008, and 2007, could have been materially different. Furthermore, if different
assumptions or estimates are used in future periods, share-based compensation
expense could be materially impacted in the future.
  42
 Table of Contents
  Acquisitions. We account for
acquisitions in accordance with the authoritative guidance issued by the FASB on
business combinations. Pursuant to the authoritative guidance, the acquiring
company must allocate the purchase price of the assets acquired and liabilities
assumed based on their estimated fair values at the date of acquisition,
including intangible assets that can be identified. The purchase price in excess
of the fair value of the net assets and liabilities is recorded as goodwill.
Among other sources of relevant information, we use independent appraisals or
other valuations to assist in determining the estimated and final recorded fair
value of assets and liabilities acquired. As discussed further in Note (9) Acquisitions to our
consolidated financial statements, in 2008 we purchased certain assets of World
Venture Limited for an aggregate purchase price of $1.7 million including
transaction and closing costs, and recorded approximately $0.6 million of
goodwill as a result of the related fair value appraisals
performed.
 
 Goodwill and Other Intangible
Assets. As discussed further in Note (1) Summary of Significant Accounting
Policies, to our consolidated financial statements, we account for
goodwill and other intangible assets in accordance with the authoritative
guidance issued by the FASB on goodwill and other intangibles. The authoritative
guidance requires an impairment-only approach to accounting for goodwill and
other intangibles with an indefinite life. Absent any prior indicators of
impairment, we perform an annual impairment analysis during the fourth quarter
of each our fiscal year.
  As of
each December 31, 2009 and 2008, we had $4.2 million of goodwill,
respectively.  As of each December 31, 2009 and 2008, we had $0.8
million and $1.4 million (net of amortization), respectively, of other
identifiable intangible assets. We do not amortize goodwill, but we assess for
impairment at least annually and more often if a trigger event occurs. We
amortize identifiable intangible assets over their estimated useful lives, which
typically is three-years. We evaluate the recoverability of goodwill using a
two-step process based on an evaluation of the reporting unit. The first step
involves a comparison of a reporting unit’s fair value to its carrying value. In
the second step, if the reporting unit’s carrying value exceeds its fair value,
we compare the goodwill’s implied fair value and its carrying value. If the
goodwill’s carrying value exceeds its implied fair value, we recognize an
impairment loss in an amount equal to such excess. We evaluate the
recoverability of other identifiable intangible assets whenever events or
changes in circumstances indicate that its carrying value may not be
recoverable. Such events include significant adverse changes in business
climate, several periods of operating or cash flow losses, forecasted continuing
losses or a current expectation that an asset or asset a group will be disposed
of before the end of its useful life. As discussed further in Note (9) Acquisitions, to our
consolidated financial statements, in 2008 we purchased certain assets of World
Venture Limited for an aggregate purchase price of $1.7 million including
transaction and closing costs, and recorded approximately $0.6 million of
goodwill as a result of the related fair value appraisals
performed.
  Throughout
2009, we continually monitored the actual performance of the business relative
to the fair value assumptions used during our annual goodwill impairment test.
For the periods presented, we did not identify any triggering events which would
require an update to our annual impairment test. A 20% decrease in the fair
value of our reporting unit as of December 31, 2009 would have had no
impact on the carrying value of our goodwill. As of both December 31, 2009 and
2008, we did not record any impairment charges on either our goodwill or other
identifiable intangible assets.
  Fair Value Measurement. As
discussed further in Note (4), Fair Value Measurements, to
our consolidated financial statements, we determine fair value measurements of
both financial and nonfinancial assets and liabilities in accordance with the
authoritative guidance issued by the FASB on fair value measurements and
disclosures.
  In the
current market environment, the assessment of the fair value of our marketable
securities, specifically our debt instruments, can be difficult and subjective.
The volume of trading activity of certain debt instruments has declined, and the
rapid changes occurring in the current financial markets can lead to changes in
the fair value of financial instruments in relatively short periods of time. The
FASB authoritative guidance establishes three levels of inputs that may be used
to measure fair value. Each level of input has different levels of subjectivity
and difficulty involved in determining fair value.
  43
 Table of Contents
  Level 1 - instruments
represent quoted prices in active markets. Therefore, determining fair value for
Level 1 instruments does not require significant management judgment, and the
estimation is not difficult.
  Level 2 - instruments include
observable inputs other than Level 1 prices, such as quoted prices for identical
instruments in markets with insufficient volume or infrequent transactions (less
active markets), issuer credit ratings, non-binding market consensus prices that
can be corroborated with observable market data, model-derived valuations in
which all significant inputs are observable or can be derived principally from
or corroborated with observable market data for substantially the full term of
the assets or liabilities, or quoted prices for similar assets or liabilities.
These Level 2 instruments require more management judgment and subjectivity
compared to Level 1 instruments.
  Level 3 - instruments include
unobservable inputs to the valuation methodology that are significant to the
measurement of fair value of assets or liabilities. The determination of fair
value for Level 3 instruments requires the most management judgment and
subjectivity. All of our marketable debt instruments classified as Level 3 are
valued using a undiscounted cash flow analysis, non-binding market consensus
price and/or a non-binding broker quote, all of which we corroborate with
unobservable data. Non-binding market consensus prices are based on the
proprietary valuation models of pricing providers or brokers. These valuation
models incorporate a number of inputs, including non-binding and binding broker
quotes; observable market prices for identical and/or similar securities; and
the internal assumptions of pricing providers or brokers that use observable
market inputs, and to a lesser degree non-observable market inputs. Adjustments
to the fair value of instruments priced using non-binding market consensus
prices and non-binding broker quotes, and classified as Level 3, were not
significant for each of the years ended December 31, 2009 and 2008.
  Other-Than-Temporary
Impairment
  After
determining the fair value of our available-for-sale debt instruments, gains or
losses on these investments are recorded to other comprehensive income, until
either the investment is sold or we determine that the decline in value is
other-than-temporary. Determining whether the decline in fair value is
other-than-temporary requires management judgment based on the specific facts
and circumstances of each investment. For investments in debt instruments, these
judgments primarily consider the financial condition and liquidity of the
issuer, the issuer’s credit rating, and any specific events that may cause us to
believe that the debt instrument will not mature and be paid in full; and our
ability and intent to hold the investment to maturity. Given the current market
conditions, these judgments could prove to be wrong, and companies with
relatively high credit ratings and solid financial conditions may not be able to
fulfill their obligations.
  As of
December 31, 2009, our investments in marketable securities included $1.4
million (at par value) of available-for-sale auction rate securities, and
recognized $40,000 cumulatively in other-than-temporary impairments on our
available-for-sale auction rate securities. As of December 31, 2008, our
investments in marketable securities included $1.5 million (at par value) of
available-for-sale auction rate securities and we did not recognize any
other-than-temporary impairments on our available-for-sale auction rate
securities.
 
 Impact of Recently Issued Accounting
Pronouncements
 
 See Item
8 of Part II, Consolidated Financial Statements – Note (1) Summary of Significant Accounting
Policies – New Accounting Pronouncements.
  Item7A.  Quantitative and Qualitative Disclosures
About Market Risk
  Interest Rate Risks. Our
cash, cash equivalents and marketable securities aggregated $41.8 million as of
December 31, 2009. Our exposure to market risk for changes in interest rates
relates primarily to our investment portfolio. All of our cash equivalent and
marketable securities are designated as available-for-sale and, accordingly, are
presented at fair value on our consolidated balance sheets. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities. We generally invest our excess cash in
investment grade short- to intermediate-term fixed income securities and
AAA-rated money market funds. Fixed rate securities may have their fair market
value adversely affected due to a rise in interest rates, and we may suffer
losses in principal if forced to sell securities that have declined in market
value due to changes in interest rates. Due to the short-term nature of the
majority of our investments, the already severely suppressed interest rates we
currently earn, and the fact that over 30% of our total cash, cash equivalents
and marketable securities are comprised of money market funds and cash, we do
not believe we are subject to any material interest rate risks on our investment
balances levels at December 31, 2009.
  44
 Table of Contents
 
 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. For the
years ended December 31, 2009, 2008 and 2007, approximately 40%, 40% and 34%,
respectively, of our sales were from outside the United States. Not all of these
transactions were made in foreign currencies. Our primary exposure is to
fluctuations in exchange rates for the U.S. dollar versus the Euro, Japanese
yen, the New Taiwanese Dollar, Korean won, and to a lesser extent the Canadian
dollar and the Australian dollar. Changes in exchange rates in the functional
currency for each geographic area’s revenues are primarily offset by the related
expenses associated with such revenues. However, changes in exchange rates of a
particular currency could impact the remeasurement of such balances on our
balance sheets.
 
 If
foreign currency exchange rates were to change adversely by 10% from the levels
at December 31, 2009, the effect on our results before taxes from foreign
currency fluctuations on our balance sheet would be approximately $0.8 million.
Commencing in the second quarter of 2009, we began entering into foreign
currency hedges to minimize our exposure to changes in certain foreign currency
exchange rates on the balance sheet (see Note (11) Derivative Financial
Instruments, to our consolidated financial statements.) The above
analysis disregards the possibility that rates for different foreign currencies
can move in opposite directions and that losses from one currency may be offset
by gains from another currency.
  Item 8.  Financial Statements
and Supplementary Data
 Index
      to Consolidated Financial Statements
                    PageReports
      of Independent Registered Public Accounting Firm
                    47Consolidated
      Balance Sheets as of December 31, 2009 and 2008
                    49Consolidated
      Statements of Operations for the years ended December 31, 2009, 2008 and
      2007
                    50Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the
      years ended
      December 31, 2009, 2008 and 2007
                    51Consolidated
      Statements of Cash Flows for the years ended December 31, 2009, 2008 and
      2007
                    52Notes
      to Consolidated Financial Statements
                    54
  45
 Table of Contents
  Report
of Independent Registered Public Accounting Firm
  
 The Board
of Directors and Stockholders
 FalconStor
Software, Inc.:
 
 We have
audited the accompanying consolidated balance sheets of FalconStor Software,
Inc. and subsidiaries as of December 31, 2009 and 2008, 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, 2009.  These consolidated financial statements are
the responsibility of the Company’s management.  Our responsibility is
to express an opinion on these consolidated financial statements based on our
audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of FalconStor Software, Inc.
and subsidiaries as of December 31, 2009 and 2008, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2009, in conformity with U.S. generally accepted accounting
principles.
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of FalconStor Software, Inc.
and subsidiaries’ internal control over financial reporting as of December 31,
2009, based on criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report, dated March 12, 2010, expressed an
unqualified opinion on the effectiveness of the Company’s internal control over
financial reporting.
 
  /s/ KPMG
LLP
  Melville,
New York,
 March 12,
2010
  46
 Table of Contents
  Report
of Independent Registered Public Accounting Firm
  
  The Board
of Directors and Stockholders
 FalconStor
Software, Inc.:
 
 We have
audited FalconStor Software, Inc. and subsidiaries’ internal control over
financial reporting as of December 31, 2009, based on criteria established in
Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). FalconStor Software, Inc.'s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying Management’s Report on Internal Control
Over Financial Reporting.  Our responsibility is to express an opinion
on the Company’s internal control over financial reporting based on our
audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
 
 A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 In our
opinion, FalconStor Software, Inc. and subsidiaries maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2009, based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).
 
 We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of FalconStor
Software, Inc. and subsidiaries as of December 31, 2009 and 2008, 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, 2009, and our report dated March 12, 2010,
expressed an unqualified opinion on those consolidated financial
statements.
 
 /s/  KPMG
LLP
 
 Melville,
New York
 March 12,
2010
 
 47
 Table of
Contents
  FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
  December
      312009
                    
                    
                    2008AssetsCurrent
      assets:Cash
      and cash equivalents
                    
                    $
                    15,752,528
                    
                    
                    $
                    22,364,235Marketable
      securities
                    
                    
                    24,952,966
                    
                    
                    
                    19,279,010Accounts
      receivable, net of allowances of $7,503,338
      and   $8,474,428, respectively
                    
                    
                    24,948,261
                    
                    
                    
                    25,015,848Prepaid
      expenses and other current
      assets
                    
                    
                    2,717,260
                    
                    
                    
                    2,468,632Deferred
      tax assets,
      net
                    
                    
                    4,320,773
                    
                    
                    
                    4,296,297Total
      current
      assets
                    
                    
                    72,691,788
                    
                    
                    
                    73,424,022Property
      and equipment, net of accumulated depreciation of $17,380,681 and
      $18,342,081 , respectively
                    
                    
                    7,601,727
                    
                    
                    
                    7,963,019Long-term
      marketable securities
                    
                    
                    1,077,466
                    
                    
                    
                    1,166,945Deferred
      tax assets,
      net
                    
                    
                    9,698,859
                    
                    
                    
                    5,739,195Other
      assets,
      net
                    
                    
                    2,958,229
                    
                    
                    
                    2,544,545Goodwill
                    
                    
                    4,150,339
                    
                    
                    
                    4,150,339Other
      intangible assets,
      net
                    
                    
                    823,416
                    
                    
                    
                    1,375,695Total
      assets
                    
                    $
                    99,001,824
                    
                    
                    $
                    96,363,760Liabilities
      and Stockholders' EquityCurrent
      liabilities:Accounts
      payable
                    
                    $
                    1,570,190
                    
                    
                    $
                    738,140Accrued
      expenses
                    
                    
                    8,454,743
                    
                    
                    
                    8,288,732Deferred
      revenue,
      net
                    
                    
                    16,570,076
                    
                    
                    
                    16,068,370Total
      current liabilities
                    
                    
                    26,595,009
                    
                    
                    
                    25,095,242Other
      long-term
      liabilities
                    
                    
                    608,907
                    
                    
                    
                    199,323Deferred
      revenue,
      net
                    
                    
                    5,644,994
                    
                    
                    
                    5,992,843Total
      liabilities
                    
                    
                    32,848,910
                    
                    
                    
                    31,287,408Commitments
      and ContingenciesStockholders'
      equity:Preferred
      stock - $.001 par value, 2,000,000 shares authorized, none
      issued
                    
                    
                    --
                    
                    
                    
                    --Common stock - $.001 par value,
      100,000,000 shares authorized,52,389,028 and 51,970,442 shares
      issued,
                      respectively and 44,383,793 and 45,146,392 shares outstanding,
      respectively
                    
                    
                    52,389
                    
                    
                    
                    51,970Additional
      paid-in capital
                    
                    
                    141,726,802
                    
                    
                    
                    132,998,230Accumulated
      deficit
                    
                    
                    (27,181,894
                    )
                    
                    
                    (24,089,189
                    )Common
      stock held in treasury, at cost (8,005,235 and 6,824,050 shares,
      respectively)
                    
                    
                    (46,916,339
                    )
                    
                    
                    (42,928,328
                    )Accumulated
      other comprehensive loss, net
                    
                    
                    (1,528,044
                    )
                    
                    
                    (956,331
                    )Total
      stockholders' equity
                    
                    
                    66,152,914
                    
                    
                    
                    65,076,352Total
      liabilities and stockholders' equity
                    
                    $
                    99,001,824
                    
                    
                    $
                    96,363,760




See
accompanying notes to consolidated financial statements.
  48
 Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
  CONSOLIDATED
STATEMENTS OF OPERATIONS




Years
      Ended December 31,2009
              
              
              2008
              
              
              2007Revenues:Software
      license revenue
              
              $
              58,154,948
              
              
              $
              58,590,246
              
              
              $
              53,153,980Maintenance
      revenue
              
              
              25,476,989
              
              
              
              23,283,094
              
              
              
              18,606,591Software
      services and other revenue
              
              
              5,827,244
              
              
              
              5,151,520
              
              
              
              5,638,65189,459,181
              
              
              
              87,024,860
              
              
              
              77,399,222Operating
      expenses:Amortization
      of purchased and capitalized software
              
              
              718,448
              
              
              
              221,344
              
              
              
              122,560Cost
      of maintenance, software services and other revenue
              
              
              16,196,959
              
              
              
              13,652,894
              
              
              
              11,091,375Software
      development costs
              
              
              26,761,384
              
              
              
              25,296,404
              
              
              
              22,405,058Selling
      and marketing
              
              
              42,255,099
              
              
              
              38,096,693
              
              
              
              29,656,034General
      and administrative
              
              
              9,875,254
              
              
              
              8,745,777
              
              
              
              8,023,56295,807,144
              
              
              
              86,013,112
              
              
              
              71,298,589Operating
      (loss) income
              
              
              (6,347,963
              )
              
              
              1,011,748
              
              
              
              6,100,633Interest
      and other (loss) income, net
              
              
              (127,803
              )
              
              
              1,688,699
              
              
              
              2,329,187(Loss)
      income before income taxes
              
              
              (6,475,766
              )
              
              
              2,700,447
              
              
              
              8,429,820(Benefit)
      provision for income taxes
              
              
              (3,383,061
              )
              
              
              1,497,635
              
              
              
              (4,312,036
              )Net
      (loss) income
              
              $
              (3,092,705
              )
              
              $
              1,202,812
              
              
              $
              12,741,856Basic
      net (loss) income per share
              
              $
              (0.07
              )
              
              $
              0.03
              
              
              $
              0.26Diluted
      net (loss) income per share
              
              $
              (0.07
              )
              
              $
              0.02
              
              
              $
              0.24Basic
      weighted average common shares outstanding
              
              
              44,781,918
              
              
              
              47,858,679
              
              
              
              49,420,848Diluted
      weighted average common shares outstanding
              
              
              44,781,918
              
              
              
              49,496,736
              
              
              
              53,130,903


See
accompanying notes to consolidated financial statements.
  49
 Table of Contents




FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
  CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
  AccumulatedAdditional
                
                
                
                
                
                
                
                
                other
                
                
                TotalCommon
                
                
                paid-in
                
                
                Accumulated
                
                
                Treasury
                
                
                comprehensive
                
                
                stockholders'
                
                
                Comprehensivestock
                
                
                capital
                
                
                deficit
                
                
                stock
                
                
                (loss)
                
                
                equity
                
                
                income
      (loss)Balance,
      December 31, 2006
                
                $
                49,086
                
                
                $
                99,282,308
                
                
                $
                (38,033,857
                )
                
                $
                (5,780,163
                )
                
                $
                (474,127
                )
                
                $
                55,043,247
                
                
                
                –Exercise
      of stock awards
                
                
                2,254
                
                
                
                10,004,920
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                10,007,174
                
                
                
                –Net
      effects of tax benefits from stock-based award activity
                
                
                –
                
                
                
                5,070,031
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                5,070,031
                
                
                
                –Issuance
      of stock options to non-employees
                
                
                –
                
                
                
                209,218
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                209,218
                
                
                
                –Share-based
      compensation
                
                
                –
                
                
                
                7,728,305
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                7,728,305Net
      Income
                
                
                –
                
                
                
                –
                
                
                
                12,741,856
                
                
                
                –
                
                
                
                –
                
                
                
                12,741,856
                
                
                
                12,741,856Acquisition
      of treasury stock
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (3,273,661
                )
                
                
                –
                
                
                
                (3,273,661
                )
                
                
                –Minimum
      pension liability adjustment, net (Note 12)
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (115,925
                )
                
                
                (115,925
                )
                
                
                (115,925
                )Change
      in unrealized gains / losses on marketable securities, net
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                66,975
                
                
                
                66,975
                
                
                
                66,975Foreign
      currency translation adjustment
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                1,157
                
                
                
                1,157
                
                
                
                1,157Balance,
      December 31, 2007
                
                $
                51,340
                
                
                $
                122,294,782
                
                
                $
                (25,292,001
                )
                
                $
                (9,053,824
                )
                
                $
                (521,920
                )
                
                $
                87,478,377
                
                
                $
                12,694,063Exercise
      of stock awards
                
                
                630
                
                
                
                820,652
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                821,282
                
                
                
                –Net
      effects of tax benefits from stock-based award activity
                
                
                –
                
                
                
                798,280
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                798,280
                
                
                
                –Issuance
      of stock options to non-employees
                
                
                –
                
                
                
                140,975
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                140,975
                
                
                
                –Share-based
      compensation
                
                
                –
                
                
                
                8,943,541
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                8,943,541Net
      Income
                
                
                –
                
                
                
                –
                
                
                
                1,202,812
                
                
                
                –
                
                
                
                –
                
                
                
                1,202,812
                
                
                
                1,202,812Acquisition
      of treasury stock
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (33,874,504
                )
                
                
                –
                
                
                
                (33,874,504
                )
                
                
                –Minimum
      pension liability adjustment, net (Note 12)
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                61,454
                
                
                
                61,454
                
                
                
                61,454Change
      in unrealized gains / losses on marketable securities, net
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (224,299
                )
                
                
                (224,299
                )
                
                
                (224,299
                )Foreign
      currency translation adjustment
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (271,566
                )
                
                
                (271,566
                )
                
                
                (271,566
                )Balance,
      December 31, 2008
                
                $
                51,970
                
                
                $
                132,998,230
                
                
                $
                (24,089,189
                )
                
                $
                (42,928,328
                )
                
                $
                (956,331
                )
                
                $
                65,076,352
                
                
                $
                768,401Exercise
      of stock awards
                
                
                419
                
                
                
                35,101
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                35,520
                
                
                
                –Net
      effects of tax shortfalls from stock-based award activity
                
                
                –
                
                
                
                (133,970
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (133,970
                )
                
                
                –Issuance
      of stock options to non-employees
                
                
                –
                
                
                
                275,480
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                275,480
                
                
                
                –Share-based
      compensation
                
                
                –
                
                
                
                8,551,961
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                8,551,961Net
      Loss
                
                
                –
                
                
                
                –
                
                
                
                (3,092,705
                )
                
                
                –
                
                
                
                –
                
                
                
                (3,092,705
                )
                
                
                (3,092,705
                )Acquisition
      of treasury stock
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (3,988,011
                )
                
                
                –
                
                
                
                (3,988,011
                )
                
                
                –Minimum
      pension liability adjustment, net (Note 12)
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (50,850
                )
                
                
                (50,850
                )
                
                
                (50,850
                )Change
      in unrealized gains / losses on marketable securities, net
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                24,031
                
                
                
                24,031
                
                
                
                24,031Foreign
      currency translation adjustment
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (544,894
                )
                
                
                (544,894
                )
                
                
                (544,894
                )Balance,
      December 31, 2009
                
                $
                52,389
                
                
                $
                141,726,802
                
                
                $
                (27,181,894
                )
                
                $
                (46,916,339
                )
                
                $
                (1,528,044
                )
                
                $
                66,152,914
                
                
                $
                (3,664,418
                )
 
 See
accompanying notes to consolidated financial
statements.
  50
 Table of Contents
  FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
   Years
      Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007Cash
      flows from operating activities:Net
      (loss) income
                  
                  $
                  (3,092,705
                  )
                  
                  $
                  1,202,812
                  
                  
                  $
                  12,741,856Adjustments
      to reconcile net (loss) income to net cash provided by operating
      activities:Depreciation
      and amortization
                  
                  
                  5,889,353
                  
                  
                  
                  5,075,090
                  
                  
                  
                  3,917,484Share-based
      payment employee compensation
                  
                  
                  8,551,961
                  
                  
                  
                  8,943,541
                  
                  
                  
                  7,728,305Non-cash
      professional services expenses
                  
                  
                  275,480
                  
                  
                  
                  140,975
                  
                  
                  
                  209,218Realized
      loss (gain) on marketable securities
                  
                  
                  21,582
                  
                  
                  
                  (7,403
                  )
                  
                  
                  (24,928
                  )Impairment
      of cost method investments
                  
                  
                  57,068
                  
                  
                  
                  65,424
                  
                  
                  
                  124,038Excess
      tax benefits from stock-based award activity
                  
                  
                  (125,792
                  )
                  
                  
                  (2,054,914
                  )
                  
                  
                  (5,070,031
                  )Provision
      for returns and doubtful accounts
                  
                  
                  3,163,697
                  
                  
                  
                  4,088,575
                  
                  
                  
                  5,041,216Deferred
      income taxes
                  
                  
                  (4,112,205
                  )
                  
                  
                  (1,125,867
                  )
                  
                  
                  (9,837,482
                  )Changes
      in operating assets and liabilities:Accounts
      receivable
                  
                  
                  (3,111,342
                  )
                  
                  
                  (2,968,069
                  )
                  
                  
                  (7,033,855
                  )Prepaid
      expenses and other current assets
                  
                  
                  (244,843
                  )
                  
                  
                  (848,588
                  )
                  
                  
                  (367,972
                  )Other
      assets
                  
                  
                  31,153
                  
                  
                  
                  139,253
                  
                  
                  
                  (129,459
                  )Accounts
      payable
                  
                  
                  839,210
                  
                  
                  
                  (1,020,454
                  )
                  
                  
                  300,766Accrued
      expenses and other liabilities
                  
                  
                  507,140
                  
                  
                  
                  3,503,772
                  
                  
                  
                  5,139,110Deferred
      revenue
                  
                  
                  156,734
                  
                  
                  
                  3,097,462
                  
                  
                  
                  3,850,273Net
      cash provided by operating activities
                  
                  
                  8,806,491
                  
                  
                  
                  18,231,609
                  
                  
                  
                  16,588,539Cash
      flows from investing activities:Purchase
      of marketable securities
                  
                  
                  (35,066,943
                  )
                  
                  
                  (99,690,769
                  )
                  
                  
                  (110,825,016
                  )Sale
      of marketable securities
                  
                  
                  29,499,217
                  
                  
                  
                  109,569,524
                  
                  
                  
                  105,156,272Purchase
      of cost method investments
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  (923,636
                  )Acquisition
      of assets
                  
                  
                  --
                  
                  
                  
                  (1,696,000
                  )
                  
                  
                  --Purchase
      of property and equipment
                  
                  
                  (4,303,718
                  )
                  
                  
                  (4,502,417
                  )
                  
                  
                  (5,510,953
                  )Purchase
      of software licenses
                  
                  
                  (950,000
                  )
                  
                  
                  --
                  
                  
                  
                  (185,000
                  )Capitalized
      software development costs
                  
                  
                  (80,703
                  )
                  
                  
                  --
                  
                  
                  
                  --Purchase
      of intangible assets
                  
                  
                  (83,973
                  )
                  
                  
                  (340,482
                  )
                  
                  
                  (266,401
                  )Security
      deposits
                  
                  
                  (33,440
                  )
                  
                  
                  (4,000
                  )
                  
                  
                  197,448Net
      cash (used in) provided by investing Activities
                  
                  
                  (11,019,560
                  )
                  
                  
                  3,335,856
                  
                  
                  
                  (12,357,286
                  )Cash
      flows from financing activities:Proceeds
      from exercise of stock options
                  
                  
                  35,520
                  
                  
                  
                  821,282
                  
                  
                  
                  10,007,174Payments
      to acquire treasury stock
                  
                  
                  (3,988,011
                  )
                  
                  
                  (33,874,504
                  )
                  
                  
                  (3,273,661
                  )Excess
      tax benefits from stock-based award activity
                  
                  
                  125,792
                  
                  
                  
                  2,054,914
                  
                  
                  
                  5,070,031Net
      cash (used in) provided by financing activities
                  
                  
                  (3,826,699
                  )
                  
                  
                  (30,998,308
                  )
                  
                  
                  11,803,544Effect
      of exchange rate changes
                  
                  
                  (571,939
                  )
                  
                  
                  (424,271
                  )
                  
                  
                  79,543Net
      (decrease) increase in cash and cash equivalents
                  
                  
                  (6,611,707
                  )
                  
                  
                  (9,855,114
                  )
                  
                  
                  16,114,340Cash
      and cash equivalents, beginning of year
                  
                  
                  22,364,235
                  
                  
                  
                  32,219,349
                  
                  
                  
                  16,105,009Cash
      and cash equivalents, end of year
                  
                  $
                  15,752,528
                  
                  
                  $
                  22,364,235
                  
                  
                  $
                  32,219,349Cash
      paid for income taxes
                  
                  $
                  130,125
                  
                  
                  $
                  1,125,415
                  
                  
                  $
                  273,631
 
 
 The
Company did not pay any interest for the three years ended December 31,
2009.
  51
 Table of Contents
 FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
  Notes
to Consolidated Financial Statements
  December
31, 2009
   (1)
Summary of Significant Accounting Policies
 (a)
                      The
      Company and Nature of Operations
  FalconStor
Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures
and sells network storage software solutions and provides the related
maintenance, implementation and engineering services.
  (b)
                      Principles
      of Consolidation
  The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries.  All significant intercompany balances and
transactions have been eliminated in consolidation.
  (c)
                      Use of Estimates
  The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  The Company’s significant estimates
include
those related to revenue recognition, accounts receivable allowances,
share-based payment compensation, cost-based investments, marketable securities
and deferred income taxes. Actual results could differ from those
estimates.
  The
financial market volatility and poor economic conditions beginning in the third
quarter of 2008 and continuing throughout 2009, both in the U.S. and in many
other countries where the Company operates, have impacted and may continue to
impact the Company’s business. Such conditions could have a material impact to
the Company’s significant accounting estimates discussed above, in particular
those around accounts receivable allowances, cost-based investments and
marketable securities.
  (d)
                      Cash
      Equivalents and Marketable
Securities
  The
Company considers all highly liquid investments with maturities of three months
or less when purchased to be cash equivalents. The Company records its cash
equivalents and marketable securities at fair value in accordancewith
the authoritative guidance issued by the Financial Accounting Standards Board
(“FASB”) on fair value measurements and disclosures. As of December 31, 2009 and
December 31, 2008, the Company’s cash equivalents consisted of money market
funds, government securities and/or commercial paper. At December 31, 2009 and
December 31, 2008, the fair value of the Company’s
cash equivalents amounted to approximately $8.8 million and $15.9 million,
respectively. As of December 31, 2009 and December 31, 2008, the Company’s
marketable securities consisted of corporate bonds, auction rate securities, and
government securities. As of December 31, 2009 and December 31, 2008, the fair
value of the Company’s current marketable securities was approximately $25.0
million and $19.3 million, respectively. In addition, at December 31, 2009 and
December 31, 2008, the Company had an additional $1.1 million and $1.2 million,
respectively, of long-term marketable securities that required a higher level of
judgment to determine the fair value. All of the Company’s marketable securities
are classified as available-for-sale, and accordingly, unrealized gains and
losses on marketable securities, net of tax, are reflected as a component of
accumulated other comprehensive loss in stockholders’ equity. Any
other-than-temporary impairments are recorded in other income in the
consolidated statement of operations. See Note (4) Fair Value
Measurements for additional information.
  52
 Table of Contents
  (e)
                      Fair
      Value of Financial Instruments
  Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at
the measurement date. To increase the comparability of fair value measurements,
a three-tier fair value hierarchy, which prioritizes the inputs used in the
valuation methodologies, is as follows:
 
 Level 1 –Valuations
based on quoted prices for identical assets and liabilities in active
markets.
  Level 2 –Valuations
based on observable inputs other than quoted prices included in Level 1, such as
quoted prices for similar assets and liabilities in active markets, quoted
prices for identical or similar assets and liabilities in markets that are not
active, or other inputs that are observable or can be corroborated by observable
market data.
  Level 3 – Valuations based
on unobservable inputs reflecting our own assumptions, consistent with
reasonably available assumptions made by other market participants. These
valuations require significant judgment.
 As
of each December 31, 2009 and 2008, the fair value of the Company’s financial
instruments including cash and cash equivalents, accounts receivable, accounts
payable, and accrued expenses, approximates book value due to the short maturity
of these instruments.
See Note (4) Fair Value
Measurementsfor additional information.
  (f)
                      Revenue
      Recognition
  In
accordancewith
the authoritative guidance issued by the FASB on revenue recognition, the
Company recognizes revenue from software
licenses when persuasive evidence of an arrangement exists, the fee is fixed and
determinable and the software is delivered and collection of the resulting
receivable is deemed probable. Software delivered to a customer on a trial basis
is not recognized as revenue until a permanent key code is delivered to the
customer. Reseller customers typically send the Company a purchase order when
they have an end user identified. When a customer licenses software together
with the purchase of maintenance, the Company allocates a portion of the fee to
maintenance for its fair value. Software maintenance fees are deferred and
recognized as revenue ratably over the term of the contract. The long-term
portion of deferred revenue relates to maintenance contracts with terms in
excess of one year. The cost of providing technical support is included in cost
of maintenance, software service and other revenues. The Company provides an
allowance for software product returns as a reduction of revenue, based upon
historical experience and known or expected trends.
  Revenues
associated with software implementation and software engineering services are
recognized when the services are performed. Costs of providing these services
are included in cost of maintenance, software services and other
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. Such payments from
the OEM or distributor are recognized as revenue in the period reported by the
OEM or distributor.
  The
Company has transactions in which it purchases hardware and bundles this
hardware with the Company’s software and sells the bundled solution to its
customer. The Company’s software is not essential to the functionality of the
bundled hardware. The amount of revenue allocated to the software and hardware
bundle is recognized as revenue in the period delivered provided all other
revenue recognition criteria have been met. The Company further separates the
software sales revenue from the hardware revenue for purposes of classification
in the consolidated statements of operations in a systematic and rational manner
based on their deemed relative fair values.
  53
 Table of Contents
  (g)
                      Property
      and Equipment
  Property
and equipment are recorded at cost. Depreciation is recognized using the
straight-line method over the estimated useful lives of the assets (3 to 7
years). Leasehold improvements are amortized on a straight-line basis over the
terms of the respective leases or over their estimated useful lives, whichever
is shorter.
  (h)
                      Goodwill
      and Other Intangible Assets
  Goodwill
represents the excess of the purchase price over the estimated fair value of net
tangible and identifiable intangible assets acquired in business combinations.
The Company has not amortized goodwill related to its acquisitions, but instead
tests the balance for impairment. The Company’s annual impairment assessment is
performed during the fourth quarter of each year, and an assessment is made at
other times if events or changes in circumstances indicate that it is more
likely than not that the asset is impaired. Identifiable intangible assets,
which include (i) assets acquired through business combinations, which include
customer contracts and intellectual property, and (ii) patents amortized over
three years using the straight-line method.  See Note (9) Acquisitions
for additional information.
  Amortization expense
was $636,252, $464,495 and $229,808 for the years ended December 31, 2009, 2008
and 2007, respectively. The gross carrying amount and accumulated amortization
of other intangible assets as of December 31, 2009 and December 31, 2008 are as
follows:
  December
      31,
                        
                        
                        December
      31,2009
                        
                        
                        2008Goodwill:
                        
                        $
                        4,150,339
                        
                        
                        $
                        4,150,339Other
      intangible assets:Gross
      carrying amount
                        
                        $
                        2,769,748
                        
                        
                        $
                        2,685,775Accumulated
      amortization
                        
                        
                        (1,946,332
                        )
                        
                        
                        (1,310,080
                        )Net
      carrying amount
                        
                        $
                        823,416
                        
                        
                        $
                        1,375,695




As of
December 31, 2009, amortization expense for existing identifiable intangible
assets is expected to be $544,033, $261,142, and $18,241 for the years ended
December 31, 2010, 2011 and 2012,
respectively.  Such assets will be fully amortized at December 31,
2012.
  (i)
              Software
      Development Costs and Purchased Software
  Technology
  In
accordance with the authoritative guidance issued by the FASB on costs of
software to be sold, leased, or marketed, costs associated with the development
of new software products and enhancements to existing software products are
expensed as incurred until technological feasibility of the product has been
established. Based on the Company’s product development process, technological
feasibility is established upon completion of a working model. Amortization of
software development costs is recorded at the greater of the straight-line basis
over the products estimated life, typically three years, or the ratio of current
revenue of the related products to total current and anticipated future revenue
of these products. During the first quarter of 2009, the Company capitalized
$80,703 related to software development projects. The Company did not capitalize
any other software development costs during 2009. Amortization expense was
$20,176 for the year ended December 31, 2009.
  The
purchased software technology net carrying value of $510,000 and $102,540, after
accumulated amortization of $5,817,431 and $5,274,891, is included in “other
assets” in the consolidated balance sheets as of December 31, 2009 and December
31, 2008, respectively. Amortization expense was $542,540, $143,477 and $122,560
for the years ended December 31, 2009, 2008 and 2007, 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.
  54
 Table of Contents
  As of
December 31, 2009, amortization expense for software development costs and
purchased software technology is expected to be $536,901,
$26,901 and $6,725 for the years ended December 31, 2010, 2011 and 2012,
respectively.  Such assets will be fully amortized at December 31,
2012.
  (j)
              Income
      Taxes
  The
Company records income taxes under the liability method. Deferred tax assets and
liabilities are recognized for future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
realized or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. In determining the period in which related tax benefits are
realized for book purposes, excess share-based compensation deductions included
in net operating losses are realized after regular net operating losses are
exhausted.
  Since
January 1, 2007, the Company
accounted for uncertain tax positions in accordance with the authoritative
guidance issued by the FASB on income taxes, which addresses the determination
of whether tax benefits claimed or expected to be claimed on a tax return should
be recorded in the financial statements. Pursuant to the authoritative guidance,
the Company may recognize the tax benefit from an uncertain tax position only if
it meets the “more likely than not” threshold that the position will be
sustained on examination by the taxing authority, based on the technical merits
of the position. The tax benefits recognized in the financial statements from
such a position should be measured based on the largest benefit that has a
greater than fifty percent likelihood of being realized upon ultimate
settlement. In addition, the authoritative guidance addresses de-recognition,
classification, interest and penalties on income taxes, accounting in interim
periods, and also requires increased disclosures. The Company includes interest
and penalties related to its uncertain tax positions as part of income tax
expense within its consolidated statement of operations. See Note (6) Income Taxes for additional
information.
  (k)
              Long-Lived
      Assets
  The
Company reviews its long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of the asset may not be
recoverable.  If the sum of the expected future cash flows,
undiscounted and without interest is less than the carrying amount of the asset,
an impairment loss is recognized as the amount by which the carrying amount of
the asset exceeds its fair value.
  (l)
              Share-Based
      Payments
  The
Company accounts for share-based payments in accordance with the authoritative
guidance issued by the FASB on stock compensation, which establishes the
accounting for transactions in which an entity exchanges its equity instruments
for goods or services. Under the provisions of the authoritative guidance,
share-based compensation expense is measured at the grant date, based on the
fair value of the award, and is recognized as an expense over the requisite
employee service period (generally the vesting period), net of estimated
forfeitures. The Company estimates the fair value of share-based payments using
the Black-Scholes option-pricing model. The estimation of share-based awards
that will ultimately vest requires judgment, and to the extent actual results or
updated estimates differ from the Company’s current estimates, such amounts will
be recorded as a cumulative adjustment in the period estimates are revised. The
Company considers many factors when estimating expected forfeitures, including
types of awards, employee class and historical experience. Additionally,
share-based awards to non-employees are expensed over the period in which the
related services are rendered at their fair value. All share-based awards are
expected to be fulfilled with new shares of common stock.
  55
 Table of Contents
 (m)
                    Foreign
      Currency
 Assets
and liabilities of foreign operations are translated at rates of exchange at the
end of the period, while results of operations are translated at average
exchange rates in effect for the period. Unrealized gains and losses from the
translation of foreign assets and liabilities are classified as a separate
component of stockholders’ equity.  Realized gains and losses from
foreign currency transactions are included in the consolidated statements of
operations within interest and other income, net. During the years ended
December 31, 2009, 2008, and 2007, foreign currency realized (losses) gains
totaled approximately ($626,000), $199,000 and $22,000, respectively. See Note
(11) Derivative Financial
Instruments for additional information.
  (n)
                  Earnings
      Per Share (EPS`)
  Basic EPS
is computed based on the weighted average number of shares of common stock
outstanding. Diluted EPS is computed based on the weighted average number of
common shares outstanding increased by dilutive common stock equivalents. Due to
the net loss for the year ended December 31, 2009, all common stock equivalents
of 13,791,999 were excluded from diluted net loss per share because they were
anti-dilutive. As of December 31, 2009, 2008 and 2007, potentially dilutive
common stock equivalents included 13,791,999, 8,525,928, and 6,454,969
respectively, attributable to stock option awards, restricted stock awards and
restricted stock unit awardsoutstanding.
  The
following represents a reconciliation of the numerators and denominators of the
basic and diluted earnings per share (“EPS”) computation:
  Year
      Ended December 31, 2009
                    
                    
                    Year
      Ended December 31, 2008
                    
                    
                    Year
      Ended December 31, 2007Net
      Loss
                    
                    
                    Shares
                    
                    
                    Per
      Share
                    
                    
                    Net
      Income
                    
                    
                    Shares
                    
                    
                    Per
      Share
                    
                    
                    Net
      Income
                    
                    
                    Shares
                    
                    
                    Per
      Share(Numerator)
                    
                    
                    (Denominator)
                    
                    
                    Amount
                    
                    
                    (Numerator)
                    
                    
                    (Denominator)
                    
                    
                    Amount
                    
                    
                    (Numerator)
                    
                    
                    (Denominator)
                    
                    
                    AmountBasic
      EPS
                    
                    $
                    (3,092,705
                    )
                    
                    
                    44,781,918
                    
                    
                    $
                    (0.07
                    )
                    
                    $
                    1,202,812
                    
                    
                    
                    47,858,679
                    
                    
                    $
                    0.03
                    
                    
                    $
                    12,741,856
                    
                    
                    
                    49,420,848
                    
                    
                    $
                    0.26Effect
      of dilutive
                      securities:Stock Options and
                      Restricted
      Stock
                    
                    
                    
                    -
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,638,057
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,710,055Diluted
      EPS
                    
                    $
                    (3,092,705
                    )
                    
                    
                    44,781,918
                    
                    
                    $
                    (0.07
                    )
                    
                    $
                    1,202,812
                    
                    
                    
                    49,496,736
                    
                    
                    $
                    0.02
                    
                    
                    $
                    12,741,856
                    
                    
                    
                    53,130,903
                    
                    
                    $
                    0.24




(o)
              Investments
  As of
December 31, 2009 and 2008, the Company maintained certain cost-method
investments aggregating $973,965 and $1,031,033, respectively, which are
included in “Other assets, net” in the accompanying consolidated balance sheets.
During 2009
and 2008, the Company recognized impairment charges of $57,068 and $65,424,
respectively, related to certain of its cost-method investments as a result of
other-than-temporary declines in market value related to certain of these
investments. These charges are included in “Interest and other (loss) income,
net” in the accompanying consolidated statements of operations.
  (p)
              Treasury
      Stock
  The
Company accounts for treasury stock under the cost method and includes treasury
stock as a component of stockholders’ equity.
  (q)
              New
      Accounting Pronouncements
  In
January 2010, the FASB issued authoritative guidance that requires reporting
entities to make new disclosures about recurring or nonrecurring
fair-value measurements including significant transfers into and out of Level 1
and Level 2 fair value measurements, and information
on purchases, sales, issuances, and settlements on a gross basis
in the reconciliation of Level 3 fair value measurements. The guidance is
effective for annual reporting periods beginning after December 15, 2009,
except for Level 3 reconciliation disclosures, which are effective for
annual periods
beginning after December 15, 2010.The Company plans on providing
the additional required disclosures in its future consolidated financial
statements.
  56
 Table of Contents
  In October 2009, the FASB
issued authoritative guidance related to the recognition of revenue for
multiple-deliverable arrangements. Under the authoritative guidance, revenue may
be allocated to the different elements in an arrangementbased on
relative selling price using the best estimate of selling price if
vendor-specific or other third-party evidence of value is not available. This
authoritative guidance will be effective prospectively for revenue arrangements
entered into or materially modified in fiscal years beginning on or after
June 15, 2010. Early adoption is permitted. The Company is still assessing
the potential impact of adopting the new authoritative guidance.
  In
October 2009, the FASB issued authoritative guidance altering the scope of
revenue recognition guidance for software deliverables to exclude items sold
that include hardware with software that is essential to the hardware's
functionality. This authoritative guidance will be effective prospectively for
revenue arrangements entered into or materially modified in fiscal years
beginning on or after June 15, 2010. Early adoption is permitted. The
Company is still assessing the potential impact of adopting the new
authoritative guidance.
  In June 2009, the FASB
issued authoritative guidance to amend the manner in which entities evaluate
whether consolidation is required for variable interest entities (“VIE”). The amended
authoritative guidance determines whether an entity is a VIE and requires
a company to perform an analysis to determine whether the company’s variable
interest or interests give it a controlling financial interest in a VIE. The
amended authoritative guidance determines whether a company is required to
consolidate an entity based on, among other things, an entity’s purpose and
design and a company’s ability to direct the activities of the entity that most
significantly impact the entity’s economic performance. The authoritative
guidance will be effective for annual reporting periods beginning after November
15, 2009. The Company is currently evaluating the impact, if any, the adoption
of the amended authoritative guidance will have on its consolidated financial
statements.
  In June
2009, the FASB issued authoritative guidance related to the FASB Accounting
Standards Codification ("Codification"), as the single source of authoritative
non-governmental
generally accepted accounting principles (“GAAP”) in the United States of
America. All existing accounting standard documents, such as FASB, American
Institute of Certified Public Accountants, Emerging Issues Task Force and other
related literature, excluding guidance from the Securities and Exchange
Commission (“SEC”), have been superseded by the Codification. All other
non-grandfathered, non-SEC accounting literature not included in the
Codification has become non-authoritative. The
Codification did not change GAAP, but instead introduced a new structure that
combines all authoritative standards into a comprehensive, topically organized
online database. The Codification waseffective for interim or
annual periods ending after September 15, 2009, andthe Company
adopted the Codification during the quarter ended September 30, 2009. The
adoption of the Codification did not have an impact on the Company’s financial
condition or results of operations, but does impact the Company’s financial
reporting process by eliminating all references to pre-codification
standards.
  In May
2009, the FASB issued authoritative guidance establishing general standards for
accounting for and disclosures of events that occur after the balance sheet date
but before financial statements are issued or are available to be issued. This
authoritative guidance, among other things, sets forth the period after the
balance sheet date during which management should evaluate events or
transactions that may occur for potential recognition or disclosure in the
financial statements, the circumstances under which an entity should recognize
events or transactions occurring after the balance sheet date in its financial
statements, and the disclosures an entity should make about events or
transactions that occurred after the balance sheet date. The Company adopted the
authoritative guidance during the quarter ended June 30, 2009, and the adoption
did not have any impact on the Company’s consolidated financial
position.
  (r)
              Reclassifications
  Certain
reclassifications
have been made to the prior periods consolidated financial statements to conform
to the current period’s presentation.
  57
 Table of Contents
  (2)
                Property
      and Equipment
  Property
and equipment consist of the following:
  December
      31,
                  
                  
                  December
      31,2009
                  
                  
                  2008Computer
      hardware and software
                  
                  $
                  22,529,719
                  
                  
                  $
                  24,110,190Furniture
      and equipment
                  
                  
                  626,909
                  
                  
                  
                  566,598Leasehold
      improvements
                  
                  
                  1,812,772
                  
                  
                  
                  1,615,304Automobile
                  
                  
                  13,008
                  
                  
                  
                  13,00824,982,408
                  
                  
                  
                  26,305,100Less
      accumulated depreciation
                  
                  
                  (17,380,681
                  )
                  
                  
                  (18,342,081
                  )$
                  7,601,727
                  
                  
                  $
                  7,963,019
  During
the year ended December 31, 2009, the Company wrote off approximately $5.2
million of fully depreciated assets and related accumulated depreciation, for
book purposes only. Depreciation expense was $4,690,385, $4,467,118, and
$3,565,116 in 2009, 2008, and 2007, respectively.
  (3)
                Marketable
      Securities
  The
Company’s marketable securities consist of available-for-sale securities, which
are carried at fair value, with unrealized gains and losses reported as a
separate component of stockholders’ equity.  Unrealized gains and
losses are computed on the specific identification method. Realized gains,
realized losses and declines in value judged to be other-than-temporary, are
included in interest and other income, net. The cost of available-for-sale
securities sold is based on the specific identification method and interest
earned is included in interest and other income.
  The cost
and fair values of the Company’s available-for-sale marketable securities as of
December 31, 2009, are as follows:
  Aggregate
                    Fair Value
                  
                  
                  Cost
                    Basis
                  
                  
                  Net
      Unrealized
                    Gains / (loss)Auction
      rate securities
                  
                  $
                  1,077,466
                  
                  
                  $
                  1,360,000
                  
                  
                  $
                  (282,534
                  )Government
      securities
                  
                  
                  18,494,044
                  
                  
                  
                  18,440,506
                  
                  
                  
                  53,538Corporate
      debt securities
                  
                  
                  6,458,922
                  
                  
                  
                  6,438,616
                  
                  
                  
                  20,306$
                  26,030,432
                  
                  
                  $
                  26,239,122
                  
                  
                  $
                  (208,690
                  )
  The cost
and fair values of the Company’s available-for-sale marketable securities as of
December 31, 2008, are as follows:
  Aggregate
                    Fair Value
                  
                  
                  Cost
                    Basis
                  
                  
                  Net
      Unrealized
                    Gains / (loss)Auction
      rate securities
                  
                  $
                  1,166,945
                  
                  
                  $
                  1,500,000
                  
                  
                  $
                  (333,055
                  )Government
      securities
                  
                  
                  13,760,507
                  
                  
                  
                  13,600,725
                  
                  
                  
                  159,782Corporate
      debt securities
                  
                  
                  5,518,503
                  
                  
                  
                  5,592,253
                  
                  
                  
                  (73,750
                  )$
                  20,445,955
                  
                  
                  $
                  20,692,978
                  
                  
                  $
                  (247,023
                  )
  58
 Table of Contents
  The cost
basis and fair value of available-for-sale securities by contractual maturity as
of December 31, 2009, were as follows:
  Fair
                      Value
                    
                    
                    CostDue
      within one year
                    
                    $
                    17,393,280
                    
                    
                    $
                    17,317,659Due
      after one year
                    
                    
                    8,637,152
                    
                    
                    
                    8,921,462$
                    26,030,432
                    
                    
                    $
                    26,239,122
  (4)
                    Fair
      Value Measurements
  The
Company measures its cash equivalents and marketable securities at fair value.
Fair value is an exit price, representing the amount that would be received on
the sale of an asset or that would be paid to transfer a liability in an orderly
transaction between market participants. As a basis for considering such
assumptions, a three-tier fair value hierarchy, which prioritizes the inputs
used in the valuation methodologies in measuring fair value:
  Fair
Value Hierarchy
  The
methodology for measuring fair value specifies a hierarchy of valuation
techniques based upon whether the inputs to those valuation techniques reflect
assumptions other market participants would use based upon market data obtained
from independent sources (observable inputs) or reflect the Company’s own
assumptions of market participant valuation (unobservable inputs). As a result,
observable and unobservable inputs have created the following fair value
hierarchy:
  ·
                      Level 1 – Quoted prices
      in active markets that are unadjusted and accessible at the measurement
      date for identical, unrestricted assets or liabilities. The Level 1
      category includes money market funds, which at December 31, 2009 and
      December 31, 2008 totaled $6.4 million and $15.1 million, respectively,
      which are included within cash and cash equivalents and marketable
      securities in the consolidated balance
sheets.
  ·
                      Level 2 –Quoted prices
      for identical assets and liabilities in markets that are not active,
      quoted prices for similar assets and liabilities in active markets or
      financial instruments for which significant inputs are observable, either
      directly or indirectly. The Level 2 category at December 31, 2009 includes
      government securities and corporate debt securities totaling $27.3
      million. The Level 2 category at December 31, 2008 included commercial
      paper totaling $0.8 million, and government securities and corporate debt
      securities totaling $19.3 million, which are included within cash and cash
      equivalents and marketable securities in the consolidated balance
      sheets.
  ·
                      Level 3 – Prices or valuations that
      require inputs that are both significant to the fair value measurement and
      unobservable. The Level 3 category includes auction rate securities, which
      at December 31, 2009 and December 31, 2008 totaled $1.1 million and $1.2
      million, respectively, which are included within long-term marketable
      securities in the consolidated balance
sheets.
  Measurement
of Fair Value
  The
Company measures fair value as an exit price using the procedures described
below for all assets and liabilities measured at fair value. When available, the
Company uses unadjusted quoted market prices to measure fair value and
classifies such items within Level 1. If quoted market prices are not available,
fair value is based upon financial models that use, when possible, current
market-based or independently-sourced market parameters such as interest rates
and currency rates. Items valued using financial generated models are
classified according to the lowest level input or value driver that is
significant to the valuation. Thus, an item may be classified in Level 3 even
though there may be inputs that are readily observable. If quoted market prices
are not available, the valuation model used generally depends on the specific
asset or liability being valued. The determination of fair value considers
various factors including interest rate yield curves and time value underlying
the financial instruments.
  59
 Table of Contents
  As of
each December 31, 2009 and 2008, the Company held certain assets that are
required to be measured at fair value on a recurring basis. Included within the
Company’s marketable securities portfolio are investments in auction rate
securities, which are classified as available-for-sale securities and are
reflected at fair value. However, due to events in the U.S. credit markets, the
auction events for these securities held by the Company failed commencing in the
first quarter of 2008, and continued to fail throughout both 2008 and 2009.
Therefore, the fair values of these securities are estimated utilizing a
discounted cash flow analysis and other type of valuation model as of both
December 31, 2009 and December 31, 2008. These analyses consider, among other
items, the collateral underlying the security, the creditworthiness of the
issuer, the timing of the expected future cash flows, including the final
maturity, and an assumption of when the next time the security is expected to
have a successful auction. These securities were also compared, when possible,
to other observable and relevant market data, which is limited at this
time.
  As of December 31, 2009, the Company
recorded $40,000 cumulatively as an other-than-temporary impairment and a
cumulative temporary decline in fair value of approximately $282,534 in
accumulated other comprehensive loss. As of December 31, 2008, the losses
related to the Company’s auction rate securities recorded in accumulated other
comprehensive loss totaled $333,055. During the first quarter of 2009, the
Company determined that a decline in the fair value of one of its particular
investments was the result of a downgrade in the credit rating of certain
underlying subordinate securities within the auction rate security. As a result,
the Company determined a portion of the overall decline in fair value of the
auction rate security to be other-than-temporary due to the creditworthiness of
the underlying securities, and accordingly recorded $40,000 in
other-than-temporary impairments on this auction rate security. Accordingly, any
future fluctuation in the fair value related to any of the auction rate
securities that the Company deems to be temporary, including any recoveries of
previous write-downs, would be recorded in accumulated other comprehensive loss,
net of tax. In addition, during the fourth quarter of 2009, $100,000 of the
Company’s auction rate securities were called by the issuer at par value.
Finally, with the exception of the creditworthiness of one of the auction rate
securities, the Company believes that the remaining temporary declines in fair
value are primarily due to liquidity concerns and not to the creditworthiness of
the remaining underlying assets, because the majority of the underlying securities are almost
entirely backed by the U.S. Government. However, if at any time in
the future a determination that a valuation adjustment is other-than-temporary,
the Company will record a charge to earnings in the period of
determination.
  Items
Measured at Fair Value on a Recurring Basis
 
 The
following table presents the Company’s assets that are measured at fair value on
a recurring basis at December 31, 2009:
  Fair Value Measurements at Reporting Date
      UsingQuoted
      Prices in
                        
                        
                        
                        
                        
                        SignificantActive
      Markets for
                        
                        
                        Significant
      other
                        
                        
                        UnobservableIdentical
      Assets
                        
                        
                        Inputs
                        
                        
                        InputsTotal
                        
                        
                        (Level 1)
                        
                        
                        (Level 2)
                        
                        
                        (Level 3)Cash
      equivalents:Money
      market funds
                        
                        $
                        6,405,104
                        
                        
                        $
                        6,405,104
                        
                        
                        $
                        -
                        
                        
                        $
                        -Corporate
      debt and government securities
                        
                        
                        2,372,660
                        
                        
                        
                        -
                        
                        
                        
                        2,372,660
                        
                        
                        
                        -Marketable
      securities:Corporate
      debt and government securities
                        
                        
                        24,952,966
                        
                        
                        
                        -
                        
                        
                        
                        24,952,966
                        
                        
                        
                        -Auction
      rate securities
                        
                        
                        1,077,466
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,077,466Total
      assets measured at fair value
                        
                        $
                        34,808,196
                        
                        
                        $
                        6,405,104
                        
                        
                        $
                        27,325,626
                        
                        
                        $
                        1,077,466
  60
 Table of Contents
  The
following table presents the Company’s assets that are measured at fair value on
a recurring basis at December 31, 2008:
  Fair Value Measurements at Reporting Date
      UsingQuoted
      Prices in
                    
                    
                    
                    
                    
                    SignificantActive
      Markets for
                    
                    
                    Significant
      other
                    
                    
                    UnobservableIdentical
      Assets
                    
                    
                    Inputs
                    
                    
                    InputsTotal
                    
                    
                    (Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)Cash
      equivalents:Money
      market funds
                    
                    $
                    15,088,465
                    
                    
                    $
                    15,088,465
                    
                    
                    $
                    -
                    
                    
                    $
                    -Commercial paper
                    
                    
                    799,920
                    
                    
                    
                    -
                    
                    
                    
                    799,920
                    
                    
                    
                    -Marketable
      securities:Corporate
      debt and government securities
                    
                    
                    19,279,010
                    
                    
                    
                    -
                    
                    
                    
                    19,279,010
                    
                    
                    
                    -Auction
      rate securities
                    
                    
                    1,166,945
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,166,945Total
      assets measured at fair value
                    
                    $
                    36,334,340
                    
                    
                    $
                    15,088,465
                    
                    
                    $
                    20,078,930
                    
                    
                    $
                    1,166,945




Based on
market conditions, the Company changed its valuation methodology for auction
rate securities to a discounted cash flow analysis and other type of valuation
model during the first quarter of 2008. Accordingly, these securities changed
from Level 1 to Level 3 within the three-tier fair value hierarchy,
which prioritizes the inputs used in the valuation methodologies in measuring
fair value. The following table presents the Company’s assets measured at fair
value on a recurring basis using significant unobservable inputs
(Level 3) as of each of the years ended December 31, 2009 and
2008:




Fair
      Value Measurements UsingSignificant
      Unobservable Inputs(Level 3)Auction Rate SecuritiesDecember
      31, 2009
              
              
              December
      31, 2008Beginning
      Balance
              
              $
              1,166,945
              
              
              $
              -Transfers
      to Level 3
              
              
              -
              
              
              
              1,500,000Total
      unrealized gains (losses) in accumulatedother
      comprehensive loss
              
              
              50,521
              
              
              
              (333,055
              )Total
      realized losses in other income
              
              
              (40,000
              )
              
              
              -Securities
      called by issuer
              
              
              (100,000
              )
              
              
              -Ending
      Balance
              
              $
              1,077,466
              
              
              $
              1,166,945






61
 Table of Contents




(5)
              Accrued
      Expenses
  Accrued
expenses are
comprised of the following:
  December
      31,
              
              
              December
      31,2009
              
              
              2008Accrued
      compensation
              
              $
              2,920,802
              
              
              $
              3,708,523Accrued
      consulting and professional fees
              
              
              968,713
              
              
              
              957,527Accrued
      marketing and promotion
              
              
              10,777
              
              
              
              107,393Other
      accrued expenses
              
              
              1,704,500
              
              
              
              1,684,077Accrued
      income taxes
              
              
              309,936
              
              
              
              441,380Accrued
      other taxes
              
              
              1,515,654
              
              
              
              522,562Accrued
      hardware purchases
              
              
              736,591
              
              
              
              502,864Accrued
      and deferred rent
              
              
              287,770
              
              
              
              364,406$
              8,454,743
              
              
              $
              8,288,732
 
 (6)
              Income
      Taxes
  Information
pertaining to the Company’s (loss) income before income taxes and the applicable
(benefit) provision for income taxes is as follows:
  December
      31,2009
                
                
                2008
                
                
                2007Income
      before income taxes:Domestic
      (loss) income
                
                $
                (8,349,257
                )
                
                $
                1,238,431
                
                
                $
                7,788,284Foreign
      income
                
                
                1,873,491
                
                
                
                1,462,016
                
                
                
                641,536Total
      (loss) income before income taxes:
                
                $
                (6,475,766
                )
                
                $
                2,700,447
                
                
                $
                8,429,820Provision
      (benefit) for income taxes:Current:Federal
                
                $
                111,000
                
                
                $
                1,905,083
                
                
                $
                4,421,578State
      and local
                
                
                (13,988
                )
                
                
                336,363
                
                
                
                802,074Foreign
                
                
                778,129
                
                
                
                382,056
                
                
                
                301,794875,141
                
                
                
                2,623,502
                
                
                
                5,525,446Deferred:Federal
                
                $
                (4,039,825
                )
                
                $
                (1,466,080
                )
                
                $
                (8,843,575
                )State
      and local
                
                
                (189,116
                )
                
                
                77,941
                
                
                
                (696,490
                )Foreign
                
                
                (29,261
                )
                
                
                262,272
                
                
                
                (297,417
                )(4,258,202
                )
                
                
                (1,125,867
                )
                
                
                (9,837,482
                )Total
      (benefit) provision for income taxes:
                
                $
                (3,383,061
                )
                
                $
                1,497,635
                
                
                $
                (4,312,036
                )






62
 Table of Contents




During
2009, the Company recorded a tax benefit of $3,383,061 related to federal, state
and local and foreign taxes.  In addition, the Company recorded a
deferred provision of $14,302 as a component of other comprehensive income
relating to unrealized gains on available-for-sale securities.
  During
2008, the Company recorded a tax provision of $1,497,635 related to federal,
state and local and foreign taxes. In addition, the Company recorded a deferred
tax benefit of $135,198 as a component of other comprehensive income relating to
unrealized losses on available-for-sale securities.
  During
2007, the Company recorded a tax benefit of $4,312,036, related to a provision
for state, local and foreign taxes offset by net benefits for the reversal of a
portion of the valuation allowance for certain deferred tax assets. In addition,
the Company recorded a deferred provision of $43,037 as a component of other
comprehensive income relating to unrealized gains on available-for-sale
securities.
  Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
for income tax purposes. Significant components of the Company’s deferred tax
assets and liabilities are as follows:
  December
      31,2009
                
                
                2008Deferred
      Tax Assets and Liabilities:Allowance
      for receivables
                
                $
                2,799,390
                
                
                $
                3,161,447Deferred
      revenue
                
                
                2,177,914
                
                
                
                1,914,460Share-based
      compensation
                
                
                5,505,648
                
                
                
                3,277,771Accrued
      expenses and other liabilities
                
                
                526,219
                
                
                
                459,349Local
      net operating loss carryforwards
                
                
                87,412
                
                
                
                94,494Foreign
      net operating loss carryforwards
                
                
                630,223
                
                
                
                787,124Tax
      credit carryforwards
                
                
                1,994,690
                
                
                
                866,320AMT
      tax credit carryforwards
                
                
                503,798
                
                
                
                482,648Capital
      loss carryforwards
                
                
                677,722
                
                
                
                663,454Fixed
      assets
                
                
                267,847
                
                
                
                (234,588
                )Intangibles
                
                
                473,292
                
                
                
                333,535Sub-total
                
                
                15,644,155
                
                
                
                11,806,014Valuation
      allowance
                
                
                (1,624,523
                )
                
                
                (1,770,522
                )Net
      Deferred Tax Asset
                
                $
                14,019,632
                
                
                $
                10,035,492




During
the year ended December 31, 2009, the Company’s deferred tax asset valuation
allowance decreased by $0.1 million. The decrease in the valuation allowance was
primarily attributable to the current year utilization of net operating losses
in China for which no tax benefit was previously recognized.
  As of
December 31, 2009, the deferred tax asset valuation allowance of $1.6 million
relates to: (i) capital loss carryforwards and write-down of investments of $0.7
million; (ii) net operating losses related to excess share-based compensation
expense deductions of $0.1 million; (iii) foreign tax credits of $0.2 million;
and (iv) certain foreign net operating losses of $0.6 million. If the remaining
valuation allowance were to be reversed, approximately $0.1 million would be
allocated to additional paid-in-capital as such amounts are attributable to the
tax effects of excess compensation deductions from exercises of employee and
consultant stock options. The reversal of the remainder of the valuation
allowance of approximately $1.5 million would reduce income tax
expense.
  As of
December 31, 2009, the Company had approximately $2.5 million of various tax
credit carryforwards, of which, approximately $1.8 million related to research
and development tax credit carryforwards. The research and development tax
credits may be carried forward 20 years for federal tax purposes and are set to
expire at various dates beginning in 2020 through 2029, if not
utilized.
  63
 Table of Contents
  As of
December 31, 2008, the deferred tax asset valuation allowance of $1.8 million
relates to: (i) capital loss carry forwards of $0.7 million; (ii) net operating
losses related to excess share-based compensation expense deductions of $0.1
million; (iii) foreign tax credits of $0.2 million; and (iv) certain foreign net
operating losses of $0.8 million. If the remaining valuation allowance were to
be reversed, approximately $0.1 million would be allocated to additional
paid-in-capital as such amounts are attributable to the tax effects of excess
compensation deductions from exercises of employee and consultant stock options.
The reversal of the remainder of the valuation allowance of approximately $1.7
million would reduce income tax expense.
  The
Company has not provided for the United States income or the foreign withholding
taxes on the undistributed earnings of its subsidiaries operating outside of the
United States, with the exception of China.  It is the Company’s
intention to reinvest those earnings permanently, and accordingly, it is not
practicable to estimate the amount of tax that might be payable.
  The
effective tax rate before income taxes varies from the current statutory federal
income tax rate as follows:
  December
      31,2009
                
                
                2008
                
                
                2007Tax
      at Federal statutory rate
                
                $
                (2,266,518
                )
                
                $
                945,156
                
                
                $
                2,950,437Increase
      (reduction) in income taxes resulting from:State
      and local taxes
                
                
                (226,341
                )
                
                
                119,963
                
                
                
                461,823Non-deductible
      expenses
                
                
                92,857
                
                
                
                (25,076
                )
                
                
                169,310Shared-based
      payment compensation
                
                
                336,882
                
                
                
                728,760
                
                
                
                811,659Net
      effect of foreign operations
                
                
                145,310
                
                
                
                (52,755
                )
                
                
                154,888Research
      and development credit
                
                
                (1,413,087
                )
                
                
                (446,033
                )
                
                
                (227,421
                )Change
      in tax rates
                
                
                -
                
                
                
                203,717
                
                
                
                283,585Change
      in valuation allowance
                
                
                (52,163
                )
                
                
                23,903
                
                
                
                (8,916,317
                )$
                (3,383,061
                )
                
                $
                1,497,635
                
                
                $
                (4,312,036
                )
  A
reconciliation of the beginning and ending amount of unrecognized tax benefits,
excluding interest and penalties, is as follows:
  2009
                  
                  
                  2008Balance
      at January 1,
                  
                  $
                  4,985,445
                  
                  
                  $
                  4,399,914Increases
      in tax positions for prior years
                  
                  
                  -
                  
                  
                  
                  452,365Decreases
      in tax positions for prior years
                  
                  
                  (436,196
                  )
                  
                  
                  -Increase
      in tax positions for current year
                  
                  
                  121,473
                  
                  
                  
                  133,166Settlements
                  
                  
                  (3,318
                  )
                  
                  
                  -Balance
      at December 31,
                  
                  $
                  4,667,404
                  
                  
                  $
                  4,985,445
  Of the
amounts reflected in the table above at December 31, 2009, the entire amount if
recognized would reduce the Company’s annual effective tax rate. As of December
31, 2009, the Company had approximately $85,352 of accrued interest and
penalties.  The
Company does not expect its unrecognized tax benefits to change significantly
over the next 12 months.
  The
Company files federal, state, and foreign
income tax returns in jurisdictions with varying statutes of limitations. The
2006 through 2009 tax years generally remain subject to examination by federal
and most state tax authorities. In addition to the U.S., the Company’s major
taxing jurisdictions include China, Taiwan, France, Germany and
Korea.
  64
 Table of Contents
  (7)
                  Stockholders’
      Equity
 
 Stock
Repurchase Activity
 
 At
various times from October 2001 through February 2009, the Company’s Board of
Directors has authorized the repurchase of up to 14 million shares of the
Company’s outstanding common stock in the aggregate. 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, 2009, the Company repurchased 1,181,185 shares of
our common stock in open market purchases at an aggregate purchase price of
$3,988,011. During the year ended December 31, 2008, the Company repurchased
5,639,950 shares of our common stock in open market purchases at an aggregate
purchase price of $33,874,504. Since October 2001, the Company has repurchased a
total of 8,005,235 shares at an aggregate purchase price of $46,916,339. As of
December 31, 2009, the Company had the authorization to repurchase an additional
5,994,765 shares of its common stock based upon its judgment and market
conditions.
  Preferred
Stock
 
 The
Company is authorized to issue two million shares of $0.001 par value Preferred
Stock. No preferred stock has been issued or outstanding for any period
presented.
 
 (8)
                  Share-Based
      Payment Arrangements
 
 On May 1, 2000, the Company adopted the
FalconStor Software, Inc., 2000 Stock Option Plan (the “2000 Plan”). The 2000
Plan isadministered by the Board of Directors and, as amended, provides
for the grant of options to purchase up to 14,162,296 shares of Company common
stock to employees, consultants and non-employee directors. Options may be
incentive (“ISO”) or non-qualified. ISOs granted must have exercise prices at
least equal to the fair value of the common stock on the date of grant, and have
terms not greater than ten years, except those to an employee who owns stock
with greater than 10% of the voting power of all classes of stock of the
Company, in which case they must have an option price at least 110% of the fair
value of the stock, and expire no later than five years from the date of grant.
Non-qualified options granted must have exercise prices not less than eighty
percent of the fair value of the common stock on the date of grant, and have
terms not greater than ten years. All options granted under the 2000 Plan must
be granted before May 1, 2010. As of December 31, 2009, there were 322,758
shares available for grant under the 2000 Plan.
  On May 17, 2006, the Company adopted
the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006
Plan”).  The 2006 Plan was amended on May 8, 2007 and on May 8, 2008.
The 2006 Plan is administered by the Board of Directors and provides for the
grant of incentive and nonqualified stock options, shares of restricted stock,
and restricted stock units to employees, officers, consultants and advisors of
the Company. The number of shares available for grant or issuance under the 2006
Plan, as amended, is determined as follows:  If, on July 1st of any
calendar year in which the 2006 Plan is in effect, the number of shares
of stock as to which options, restricted shares and restricted stock units may
be granted under the 2006 Plan is less than five percent (5%) of the number of
outstanding shares of stock, then the number of shares of stock available for
issuance under the 2006 Plan is automatically increased so that the number
equals five percent (5%) of the shares of stock outstanding. In no event shall
the number of shares of stock subject to the 2006 Plan in the aggregate exceed
twenty million shares, subject to adjustment as provided in the 2006 Plan. On
July 1, 2009, the total number of outstanding shares of the Company’s common
stock totaled 44,680,318. Pursuant to the 2006 Plan, as amended, the total
shares available for issuance under the 2006 Plan thus increased by 2,080,367
shares to 2,234,016 shares available for issuance as of July 1, 2009. Exercise
prices of the options must be equal to the fair market value of the common stock
on the date of grant. Options granted have terms of not greater than ten years.
All options, shares of restricted stock, and restricted stock units granted
under the 2006 Plan must be granted before May 17, 2016. As of December 31,
2009, there were 1,304,047 shares available for grant under the 2006
Plan.
  On May 8,
2007, the Company adopted the FalconStor Software, Inc. 2007 Outside Directors
Equity Compensation Plan (the “2007 Plan”). The 2007 Plan was amended on May 8,
2008. The 2007 Plan is administered by the Board of Directors and provides for
the issuance of up to 300,000 shares of Company common stock upon the vesting of
options or upon the grant of shares with such restrictions as determined by the
Board of Directors to the non-employee directors of the
Company. Exercise prices of the options must be equal to the fair market value
of the common stock on the date of grant. Options granted have terms of ten
years. Shares of restricted stock have the terms and conditions set by the Board
of Directors and are forfeitable until the terms of the grant have been
satisfied. As of December 31, 2009, there were no shares available for grant
under the 2007 Plan.
  65
 Table of Contents
  As of
December 31, 2009, options to purchase 125,500 and 250,000 shares remain
outstanding from the Company’s 1994 Outside Directors Stock Option
Plan (the “1994 Plan”) and 2004 Outside Directors Stock Option Plan (the “2004
Plan”), respectively. Options granted under both Plans have terms of ten years,
and no additional options are available for grant under each of the 1994 Plan
and 2004 Plan, respectively.
  A summary
of the Company’s stock
option activity for 2009 is as follows:
  WeightedWeighted
                    
                    
                    AverageAverage
                    
                    
                    Remaining
                    
                    
                    AggregateNumber
      of
                    
                    
                    Exercise
                    
                    
                    Contractual
                    
                    
                    IntrinsicOptions
                    
                    
                    Price
                    
                    
                    Life (Years)
                    
                    
                    ValueOptions
      Outstanding at December 31, 2008
                    
                    
                    9,675,145
                    
                    
                    $
                    6.41Granted
                    
                    
                    3,399,700
                    
                    
                    $
                    3.00Exercised
                    
                    
                    (102,571
                    )
                    
                    $
                    0.35Canceled
                    
                    
                    (193,799
                    )
                    
                    $
                    8.01Forfeited
                    
                    
                    (240,137
                    )
                    
                    $
                    6.49Options
      Outstanding at December 31, 2009
                    
                    
                    12,538,338
                    
                    
                    $
                    5.51
                    
                    
                    
                    6.31
                    
                    
                    $
                    8,254,348Options
      Exercisable at December 31, 2009
                    
                    
                    7,422,272
                    
                    
                    $
                    6.22
                    
                    
                    
                    4.43
                    
                    
                    $
                    3,633,175Options Expected to Vest after
      December 31, 2009(1)
                    
                    
                    4,128,255
                    
                    
                    $
                    4.38
                    
                    
                    
                    9.06
                    
                    
                    $
                    -(1)
      Options expected to vest after December 31, 2009 reflect an estimated
      forfeiture rate
  Stock
option exercises are fulfilled with new shares of common stock. The total cash
received from stock option exercises for the years ended December 31, 2009, 2008
and 2007 was $35,520, $821,282 and $10,007,174, respectively. The total
intrinsic value of stock options exercised during the years ended December 31,
2009, 2008 and 2007 was $358,495, $2,091,768 and $14,398,460,
respectively.
 
 The Company
realized share-based compensation expense for all awards issued under the
Company’s stock plans in the following line items in the consolidated statement
of operations:
  Years
      ended December 31,2009
                      
                      
                      2008
                      
                      
                      2007Cost
      of maintenance, software services and other revenue
                      
                      $
                      1,534,208
                      
                      
                      $
                      1,449,065
                      
                      
                      $
                      1,034,424Software
      development costs
                      
                      
                      3,057,145
                      
                      
                      
                      3,240,711
                      
                      
                      
                      3,279,065Selling
      and marketing
                      
                      
                      3,107,877
                      
                      
                      
                      3,531,375
                      
                      
                      
                      2,615,503General
      and administrative
                      
                      
                      1,128,211
                      
                      
                      
                      863,365
                      
                      
                      
                      1,008,531$
                      8,827,441
                      
                      
                      $
                      9,084,516
                      
                      
                      $
                      7,937,523
 
 TheCompany recognized approximately $388,000, $506,000 and $1,025,000 of tax
benefits related to share-based compensation expense during the years ended
December 31, 2009, 2008 and 2007, respectively.
  66
 Table of Contents
  The
Company began issuing restricted stock in 2006 and restricted stock units in
2008. The fair value of the restricted stock awards and restricted stock units
are expensed at either (i) the fair value per share at date of grant (outside
directors, officers and employees), or (ii) the fair value per share as
of each reporting period (non-employee consultants).  A summary of the
total stock-based compensation expense related to restricted stock awards and
restricted stock units, which is included
in the Company’s total share-based compensation expense for each respective
year, is as
follows:
  Years
      ended December 31,2009
                      
                      
                      2008
                      
                      
                      2007Outside
      directors, officers and employees
                      
                      $
                      2,667,745
                      
                      
                      $
                      2,284,800
                      
                      
                      $
                      912,619Non-employee
      consultants
                      
                      
                      123,249
                      
                      
                      
                      177,824
                      
                      
                      
                      123,860$
                      2,790,994
                      
                      
                      $
                      2,462,624
                      
                      
                      $
                      1,036,479
  As of
December 31, 2009, an aggregate of 2,178,854 shares of restricted stock have
been issued, of which, 622,425 have vested and 393,180 have been
forfeited. As
of December 31, 2008, an aggregate of 1,140,000 shares of restricted stock have
been issued, of which, 306,410 have vested and 390,500 have been forfeited. As
of December 31, 2007, an aggregate of 598,000 shares of restricted stock have
been issued, of which, 75,350 have vested and 25,000 have been
forfeited.
 
 As of
December 31, 2009, an
aggregate of 90,412 restricted stock units have been issued, of which none had
vested or been forfeited.  As of December 31, 2008, an aggregate of
45,750 restricted stock units have been issued, of which none had vested or been
forfeited.


Number
      of RestrictedStock
      Awards / UnitsNon-Vested
      at December 31, 2008
              
              
              488,840Granted
              
              
              1,083,516Vested
              
              
              (316,015)Forfeited
              
              
              (2,680)Non-Vested
      at December 31, 2009
              
              
              1,253,661




Restricted
stock and restricted stock units are fulfilled with new shares of common stock.
The total intrinsic value of restricted stock for which the restrictions lapsed
during the years ended December 31, 2009, 2008 and 2007 was $1,405,901,
$1,542,308 and $767,756, respectively.
  Options granted to non-employee
consultants have exercise prices equal to the fair market value of the stock on
the date of grant and a contractual term of ten years. Restricted stock awards
granted to non-employee consultants have a contractual term equal to the
lapse of restriction(s) of each specific award. Vesting periods for share-based
awards granted to non-employee consultants range from immediate vesting to three
years depending on service requirements. A summary of the total stock-based
compensation expense related to share-based awards granted to non-employee
consultants, which is included in the Company’s total share-based compensation
expense for each respective year, is as follows:
  Years
      ended December 31,2009
                
                
                2008
                
                
                2007Non-qualified
      stock options
                
                $
                152,231
                
                
                $
                (36,849
                )
                
                $
                85,358Restricted
      stock awards
                
                
                123,249
                
                
                
                177,824
                
                
                
                123,860$
                275,480
                
                
                $
                140,975
                
                
                $
                209,218
  67
 Table of Contents
  During
the first quarter of 2008, the Company issued restricted stock awards to certain
executives and other officers, which vested over three-year terms dependent upon
the Company achieving certain performance targets for the full-year 2008. During
the first and second quarters of 2008, the Company recorded the related
compensation costs associated with the performance awards. During the third
quarter of 2008, the Company determined the performance criteria to be
improbable of achievement and accordingly reversed compensation cost of
approximately $606,000 previously recognized within its consolidated statement
of operations.
  During
the third quarter of 2008, certain executives and other officers of the Company
voluntarily forfeited 1,505,046 shares of previously granted stock option awards
(the “awards”). No replacement stock option awards were made, nor did the
Company enter into any agreements for future replacement awards for the
voluntary forfeiture. The voluntarily forfeited awards were fully vested as of
the date of forfeiture, therefore, no adjustment to stock based compensation
expense was recorded.
  The
Company estimates the fair value of share-based payments using the Black-Scholes
option-pricing model. The Company believes that this valuation technique and the
approach utilized to develop the underlying assumptions are appropriate in
estimating the fair value of the Company’s share-based payments granted during
the years ended December 31, 2009, 2008, and 2007. Estimates of fair value are
not intended to predict actual future events or the value ultimately realized by
the employees who receive equity awards.
  The per share weighted average fair
value of share-based payments granted during the years ended December 31, 2009,
2008, and 2007 was $1.77, $3.91 and $7.79, respectively. In addition to
the exercise and grant date prices of the awards, certain weighted average
assumptions that were used to estimate the fair value of share-based payment
grants in the respective periods are listed in the table below:
  Years
      ended December 31,2009
                
                2008
                
                2007Expected
      dividend yield
                
                0%
                
                0%
                
                0%Expected
      volatility
                
                51
      - 60%
                
                48
      -58%
                
                54
      - 57%Risk-free
      interest rate
                
                1.8
      -3.9%
                
                1.7
      - 4.0%
                
                3.4
      - 5.0%Expected
      term (years)
                
                5.5
                
                5.5
                
                6Discount
      for post-vesting restrictions
                
                N/A
                
                N/A
                
                N/A
  Options
granted to officers, employees and directors during fiscal 2009, 2008, and 2007
have exercise prices equal to the fair market value of the stock on the date of
grant, a contractual term of ten years, and a vesting period generally of three
years. Based on each respective group’s historical vesting experience and
expected trends, the estimated forfeiture rate for officers, employees, and
directors, as adjusted, was 11%, 24% and 9%, respectively.
  The
Company estimates expected volatility based primarily on historical daily
volatility of the Company’s stock and other factors, if applicable. The
risk-free interest rate is based on the United States treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued since January 1, 2008, was determined
based upon an estimate of the expected term of “plain vanilla” options as
prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110. The
expected term of the awards issued prior to January 1, 2008, was determined
using the“simplified method” prescribed in SAB No. 107.
  As of
December 31, 2009, there was approximately $10,304,924 of total unrecognized
compensation cost related to the Company’s unvested stock options, restricted
stock and restricted stock unit awards granted under the Company’s stock plans.
The unrecognized compensation cost is expected to be recognized over a
weighted-average period of 2.03 years.
  As of
December 31, 2009, the Company has 15,418,804 shares of common stock reserved
for issuance upon the exercise of stock options, restricted stock and restricted
stock units.
  68
 Table of Contents
  (9)
                  Acquisitions
  On July 1, 2008,
the Company acquired certain assets of World Venture Limited (“World Venture”),
a network storage software business based in Hong Kong, at an aggregate purchase
price of $1.7 million including transaction costs. The Company accounted for the
acquisition under the purchase method of accounting and the assets acquired have
been included in our condensed consolidated financial statements at fair value,
including acquired intangible assets with estimated useful lives of three years.
The excess of the purchase price over the fair value of the net assets acquired
was classified as goodwill on the Company’sconsolidated balance sheets.
  The
following table summarizes the allocation of the purchase price of World Venture
on July 1, 2008. The Company obtained a valuation of certain acquired tangible
and intangible assets and has finalized the allocations below to reflect such
valuations. In
addition, net assets acquired have been finalized to reflect all adjustments
identified during the year of acquisition.
  Value
      atJuly
      1, 2008Purchase
      price, including transaction costs
                    
                    $
                    1,716,000Net
      assets acquired
                    
                    
                    (23,000
                    )Intellectual
      property (estimated useful life, 3 years)
                    
                    
                    (467,000
                    )Customer
      contracts (estimated useful life, 3 years)
                    
                    
                    (589,000
                    )Goodwill,
      including transaction costs (indefinite lived)
                    
                    $
                    637,000
  The
Company’s identifiable intangible assets, customer contracts and intellectual
property, have a weighted average useful life of three years. During the year
ended December 31, 2009, the Company recorded amortization expense of $155,734
and $196,200 for intellectual property and customer contracts, respectively.
During the year ended December 31, 2008, the Company recorded amortization
expense of $77,867 and $98,100 for intellectual property and customer contracts,
respectively. Goodwill is not amortized for book or tax purposes.
  The
results of operations for World Venture have been included in the Company’s
consolidated financial statements commencing in the third quarter of 2008. The
results of operations for periods prior to the acquisition were not material to
the Company’s consolidated financial statements and, accordingly, pro forma
information has not been presented.
  
 (10)
                    Commitments
      and Contingencies
 
 The
Company has an operating lease covering its primary office facility that expires
in February 2012. The Company also has several operating leases related to
offices in both the United States and foreign countries.  The
expiration dates for these leases range from 2010 through 2012. The following is
a schedule of future minimum lease payments for all operating leases as of
December 31, 2009:
  Year ending December 31,2010
                      
                      $
                      2,541,2072011
                      
                      
                      1,875,3762012
                      
                      
                      522,3534,938,936
 These
leases require the Company to pay its proportionate share of real estate taxes
and other common charges.  Total rent expense for operating leases was
$2,630,544, $2,512,346, and $2,177,927 for the years ended December 31, 2009,
2008 and 2007, respectively.
  69
 Table of Contents
  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 the authoritative guidance issued by the FASB on 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
the authoritative guidance issued by the FASB on contingencies. As of December
31, 2009, there were no claims outstanding under such indemnification
provisions.
  The
Company is subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, the Company believes that
such matters will not have a material adverse effect on its financial condition
or liquidity. The Company expenses legal costs related to contingencies when
incurred.
  On
December 31, 2007, the Company entered into an Employment Agreement (“Employment
Agreement”) with ReiJane Huai. Pursuant to the Employment Agreement, the Company
agreed to continue to employ Mr. Huai as President and Chief Executive Officer
of the Company effective January 1, 2008 through December 31, 2010, at annual
salaries of $310,000, $341,000 and $375,100 for calendar years 2008, 2009 and
2010, respectively. The Employment Agreement also provides for the potential
payment of annual bonuses to Mr. Huai, in the form of restricted shares of the
Company’s common stock, based on the Company’s operating income (or “bonus
targets” as defined in the Employment Agreement) and for certain other
contingent benefits set forth in the Employment Agreement. Pursuant to the
Employment Agreement, any annual bonus of restricted stock due to Mr. Huai shall
be issued within seventy-five (75) days of the end of the fiscal year, assuming
the bonus targets are achieved. The restricted stock is subject to a three-year
vesting period commencing from the date of grant. During both the years ended
December 31, 2009 and 2008, the bonus targets set forth in the Employment
Agreement were not met, therefore, no annual bonus were awarded to Mr. Huai.
  On
December 1, 2005, the Company adopted the 2005 FalconStor Software, Inc., Key
Executive Severance Protection Plan, as amended (“Severance Plan”). Pursuant to
the Severance Plan, the Company’s Chief Executive Officer, Chief Financial
Officer and certain other key personnel are entitled to receive certain
contingent benefits, as set forth in the Severance Plan, including lump sum
payments and acceleration of stock option vesting, each in certain
circumstances.
  
 (11)
                    Derivative
      Financial Instruments
 
 The
Company commenced the use of derivative financial instruments during the second
quarter of 2009 and continues to use such derivative financial instruments, such
as foreign currency forward contracts, as economic hedges to reduce exchange
rate risks arising
from the change in fair value of certain foreign currency denominated assets and
liabilities (i.e., receivables and payables).  The purpose of the
Company’s foreign currency risk management program is to reduce
volatility in earnings caused byexchange rate
fluctuations.In accordance with the authoritative guidance
issued by the FASB on derivatives and hedging, companies are required to
recognize all of the derivative financial instruments as either assets or
liabilities at fair value in the consolidated balance
sheets. The Company’s derivative instruments do not meet the
criteria for hedge accounting within the authoritative guidance. Therefore, the
foreign currency forward contracts are recorded at fair value, with the gain or
loss on these transactions recorded in the consolidated statements of operations
within “interest and other income, net” in the period in which they occur. The
Company does not use derivative financial instruments for trading or speculative
purposes.
  As of
December 31,
2009, the Company had no foreign currency forward contracts outstanding. During
the year ended December 31, 2009, the Company recorded approximately $0.8
million of losses related to its foreign currency forward contracts. The Company
did not utilize foreign currency forward contracts or any other derivative
financial instruments during the year ended December 31, 2008.
  70
 Table of Contents
  (12)
                      Employee
      Benefit Plans
  Defined
Contribution Plan
 
 Effective
July 2002, the Company established a voluntary savings and defined contribution
plan (the “Plan”) under Section 401(k) of the Internal Revenue Code. This Plan
covers all U.S. employees meeting certain eligibility requirements and allows
participants to contribute a portion of their annual compensation. Employees are
100% vested in their own contributions. For the years ended December 31, 2009,
2008, and 2007, the Company did not make any contributions to the
Plan.
  Effective
July 1, 2007, the Company, in accordance with the labor pension system in
Taiwan, contributes 6% of salaries to individual pension accounts managed by the
Bureau of Labor Insurance. The Plan covers all Taiwan employees that elect the
new pension system and all employees hired after July 1, 2005. For the years
ended December 31, 2009, 2008, and 2007, the Company contributed $127,000,
$117,000, and $76,000, respectively.
 
 Defined
Benefit Plan
 
 The
Company has a defined benefit plan covering employees in Taiwan. The Company
accounts for its defined benefit plan in accordance with the authoritative
guidance issued by the FASB on retirement benefits, which requires the Company
to recognize the funded status of its defined benefit plan in the accompanying
consolidated balance sheet, with the corresponding adjustment to accumulated
other comprehensive income, net of tax.
  At
December 31, 2009 and 2008, $192,803 and $141,953, respectively, is included in
accumulated other comprehensive income for amounts that have not yet been
recognized in net periodic pension cost. These amounts include the following:
unrecognized transition obligation of $47,858 and $52,233 at December 31, 2009
and 2008, respectively, and unrecognized actuarial losses of $144,946 and
$89,720 at December 31, 2009 and 2008, respectively. During 2009, the total
amount recorded in other comprehensive income related to the pension plan was
$55,226 (net of tax), which consisted of an actuarial gain of $50,850 and the
recognition of $4,376 of transition obligations recognized during 2009 as a
component of net periodic pension cost. The transition obligation and actuarial
loss included in accumulated other comprehensive loss and expected to be
recognized in net periodic pension cost for the year ended December 31, 2010, is
$5,196 and $5,815 respectively.
  Pension
information for the years ended December 31, 2009 and 2008, is as
follows:
 2009
                        
                        
                        2008Accumulated
      benefit obligation
                        
                        $
                        170,312
                        
                        
                        $
                        128,038Changes
      in projected benefit obligation:Projected
      benefit obligation at beginning of year
                        
                        
                        247,779
                        
                        
                        
                        284,686Interest
      cost
                        
                        
                        6,157
                        
                        
                        
                        8,068Actuarial
      (gain)/loss
                        
                        
                        56,034
                        
                        
                        
                        (47,409
                        )Benefits
      paid
                        
                        
                        -
                        
                        
                        
                        -Service
      cost
                        
                        
                        2,982
                        
                        
                        
                        3,452Currency
      translation and other
                        
                        
                        5,800
                        
                        
                        
                        (1,018
                        )Projected
      benefit obligation at end of year
                        
                        $
                        318,752
                        
                        
                        $
                        247,779Changes
      in plan assets:Fair
      value of plan assets at beginning of year
                        
                        $
                        48,456
                        
                        
                        $
                        33,592Actual
      return on plan assets
                        
                        
                        930
                        
                        
                        
                        971Benefits
      paid
                        
                        
                        -
                        
                        
                        
                        -Employer
      contributions
                        
                        
                        11,854
                        
                        
                        
                        14,808Currency
      translation and other
                        
                        
                        1,174
                        
                        
                        
                        (915
                        )Fair
      value of plan assets at end of year
                        
                        $
                        62,414
                        
                        
                        $
                        48,456Funded
      status
                        
                        $
                        256,338
                        
                        
                        $
                        199,323Components
      of net periodic pension cost:Interest
      cost
                        
                        $
                        6,157
                        
                        
                        $
                        8,068Expected
      return on plan assets
                        
                        
                        (1,205
                        )
                        
                        
                        (951
                        )Amortization
      of net loss
                        
                        
                        8,988
                        
                        
                        
                        14,703Service
      cost
                        
                        
                        2,982
                        
                        
                        
                        3,452Net
      periodic pension cost
                        
                        $
                        16,922
                        
                        
                        $
                        25,272
  
 71
 Table of Contents
  The
Company makes contributions to the plan so that minimum contribution
requirements, as determined by government regulations, are met. Company
contributions of approximately $12,000 are expected to be made during 2010.
Benefit payments of approximately $269,000 are expected to be paid in 2015
through 2019.
 
 The
Company utilized the following assumptions in computing the benefit obligation
at December 31, 2009 and 2008 as follows:
  December 31, 2009
                          
                          December 31, 2008Discount
      Rate
                          2.25%
                          
                          2.50%Rate
      of increase in compensation levels
                          3.00%
                          
                          3.00%Expected
      long-term rate of return on plan assets
                          2.25%
                          
                          2.50%
 (13)
                        Segment
      Reporting and Concentrations
 
 The
Company is organized in a single operating segment for purposes of making
operating decisions and assessing performance. Revenues from the United States
to customers in the following geographical areas for the years ended December
31, 2009, 2008 and 2007, and the location of long-lived assets as of December
31, 2009, 2008, and 2007, are summarized as follows:
  2009
                          
                          
                          2008
                          
                          
                          2007Revenues:United
      States
                          
                          $
                          53,306,365
                          
                          
                          $
                          52,540,234
                          
                          
                          $
                          51,078,007Asia
                          
                          
                          15,140,444
                          
                          
                          
                          14,143,622
                          
                          
                          
                          12,329,395Europe,
      Middle East, Australia and other
                          
                          
                          21,012,372
                          
                          
                          
                          20,341,004
                          
                          
                          
                          13,991,820Total
      revenues
                          
                          $
                          89,459,181
                          
                          
                          $
                          87,024,860
                          
                          
                          $
                          77,399,222Long-lived
      assets (includes all non-current assets):United
      States
                          
                          $
                          24,295,603
                          
                          
                          $
                          20,682,794
                          
                          
                          $
                          18,483,890Asia
                          
                          
                          1,505,856
                          
                          
                          
                          1,869,963
                          
                          
                          
                          1,720,098Europe,
      Middle East, Australia and other
                          
                          
                          508,577
                          
                          
                          
                          386,981
                          
                          
                          
                          499,632Total
      long-lived assets
                          
                          $
                          26,310,036
                          
                          
                          $
                          22,939,738
                          
                          
                          $
                          20,703,620
 
 72
 Table of Contents
  For the
year ended December 31, 2009, the Company had two customers that together
accounted for 26% of revenues. For the year ended December 31, 2008, the Company
had two customers that together accounted for a total of 33% of revenues. For
the year ended December 31, 2007, the Company had two customers that together
accounted for a total of 38% of revenues. As of December 31, 2009, there were no
customers with accounts receivables balances greater than 10% of the gross
accounts receivable balance. As of December 31, 2008, the Company had two
customers with accounts receivable balances greater than 10%, which totaled 22%
of the gross accounts receivable balance.
 
 (14)
                          Valuation
      and Qualifying Accounts – Allowance for Returns and Doubtful
      Accounts
 
 Period Ended
                          
                          Balance at
                            Beginning
                            ofPeriod
                          
                          
                          Additions
                              chargedto
      Expense
                          
                          
                          Deductions
                          
                          
                          Balance at
                            End
      of
                            PeriodDecember
      31, 2009
                          
                          $
                          8,474,428
                          
                          
                          $
                          3,163,697
                          
                          
                          $
                          4,134,787
                          
                          
                          $
                          7,503,338December
      31, 2008
                          
                          $
                          8,780,880
                          
                          
                          $
                          4,088,575
                          
                          
                          $
                          4,395,027
                          
                          
                          $
                          8,474,428December
      31, 2007
                          
                          $
                          6,016,298
                          
                          
                          $
                          5,041,216
                          
                          
                          $
                          2,276,634
                          
                          
                          $
                          8,780,880
 
 (15)
                          Quarterly
      Financial Data (Unaudited)
 
 The
following is a summary of selected quarterly financial data for the years ended
December 31, 2009 and 2008:
  Fiscal
      QuarterFirst
                            
                            
                            Second
                            
                            
                            Third
                            
                            
                            Fourth2009Revenue
                            
                            $
                            21,021,085
                            
                            
                            $
                            24,468,620
                            
                            
                            $
                            21,540,169
                            
                            
                            $
                            22,429,307Net
      (loss) income
                            
                            $
                            (850,961
                            )
                            
                            $
                            1,266,714
                            
                            
                            $
                            (2,031,405
                            )
                            
                            $
                            (1,477,053
                            )Basic
      net (loss) income per share
                            
                            $
                            (0.02
                            )
                            
                            $
                            0.03
                            
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.03
                            )Diluted
      net (loss)   income per share
                            
                            $
                            (0.02
                            )
                            
                            $
                            0.03
                            
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.03
                            )Basic
      weighted average common shares outstanding
                            
                            
                            44,974,677
                            
                            
                            
                            44,662,246
                            
                            
                            
                            44,803,379
                            
                            
                            
                            44,690,260Diluted
      weighted average common shares outstanding
                            
                            
                            44,974,677
                            
                            
                            
                            45,886,221
                            
                            
                            
                            44,803,379
                            
                            
                            
                            44,690,260
  73
 Table of Contents
  2008Revenue
                              
                              $
                              21,806,660
                              
                              
                              $
                              22,226,946
                              
                              
                              $
                              19,611,493
                              
                              
                              $
                              23,379,761Net
      income (loss)
                              
                              $
                              1,333,757
                              
                              
                              $
                              793,211
                              
                              
                              $
                              (1,562,244
                              )
                              
                              $
                              638,088Basic
      net income (loss) per share
                              
                              $
                              0.03
                              
                              
                              $
                              0.02
                              
                              
                              $
                              (0.03
                              )
                              
                              $
                              0.01Diluted
      net income (loss) per share
                              
                              $
                              0.03
                              
                              
                              $
                              0.02
                              
                              
                              $
                              (0.03
                              )
                              
                              $
                              0.01Basic
      weighted average common shares outstanding
                              
                              
                              49,590,008
                              
                              
                              
                              48,066,451
                              
                              
                              
                              47,522,085
                              
                              
                              
                              46,277,252Diluted
      weighted average common shares outstanding
                              
                              
                              51,690,245
                              
                              
                              
                              50,249,824
                              
                              
                              
                              47,522,085
                              
                              
                              
                              46,866,381




The sum
of the quarterly net income (loss) per share amounts do not necessarily equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each period.
  74
 Table of Contents




Item9.
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
 
 None.
 Item9A.
                  Controls
      and Procedures
 Disclosure Controls and
Procedures
 The
Company maintains “disclosure controls and procedures,” as such term is defined
in Rules 13a-15e and 15d-15e of the Securities and Exchange Act of 1934, as
amended (the “Exchange Act”), that are designed to ensure that information
required to be disclosed in its reports, pursuant to the Exchange Act, is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms, and that such information is accumulated and
communicated to its management, including its Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding the
required disclosures. In designing and evaluating the disclosure controls and
procedures, management has recognized that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurances of
achieving the desired control objectives, and management necessarily is required
to apply its judgment in evaluating the cost benefit relationship of possible
controls and procedures.
 
 The
Company’s Chief Executive Officer (its principal executive officer) and Chief
Financial Officer (its principal finance officer and principal accounting
officer) have evaluated the effectiveness of its “disclosure controls and
procedures” as of the end of the period covered by this Annual Report on Form
10-K. Based on their evaluation, the principal executive officer and principal
financial officer concluded that its disclosure controls and procedures are
effective at a reasonable assurance level at the end of the period covered by
this report.
 
 Internal Control Over
Financial Reporting
 
 Management’s Report on
Internal Control Over Financial Reporting
 
 The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting for the Company; as such term is
defined in Rules 13a-15(f). To evaluate the effectiveness of the Company’s
internal control over financial reporting, the Company’s management uses the
Integrated Framework adopted by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”).
 
 The
Company’s management has assessed the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2009, 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.
 
 There
were no changes in the Company’s internal controls over financial reporting
during the Company’s last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, the Company’s internal control over
financial reporting.
 
 The
registered public accounting firm that audited the financial statements included
in this annual report has issued an attestation report on the Company’s internal
control over financial reporting.
 Item9B.
                  Other
      Information
 None
  75
 Table of Contents
  PARTIII
 Item10.
                    Directors,
      Executive Officers and Corporate
  Governance
 Information
      called for by Part III, Item 10, regarding the Registrant’s directors will
      be included in our Proxy Statement relating to our annual meeting of
      stockholders scheduled to be held in May 2010, and is incorporated herein
      by reference. The information appears in the Proxy Statement under the
      captions “Election of Directors”, “Management”, “Executive Compensation”,
      “Section 16 (a) Beneficial Ownership Reporting Compliance”, and
      “Committees of the Board of Directors.” The Proxy Statement will be filed
      within 120 days of December 31, 2009, our
  year-end.
 Item11.
                    Executive
      Compensation
 Information
called for by Part III, Item 11, will be included in our Proxy Statement
relating to our annual meeting of stockholders scheduled to be held in May 2010,
and is incorporated herein by reference. The information appears in the Proxy
Statement under the captions “Executive Compensation”, “Director Compensation”,
“Compensation Committee Interlocks and Insider Participation”, Compensation
Committee Report” and “Committees of the Board of Directors.” The Proxy
Statement will be filed within 120 days of December 31, 2009, our
year-end.
  Item12.
                    Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder
Matters
 Information
      regarding Securities Authorized for Issuance Under Equity Compensation
      Plans is included in Item 4 and is incorporated herein by reference. All
      other information called for by Part III, Item 12, will be included in our
      Proxy Statement relating to our annual meeting of stockholders scheduled
      to be held in May 2010, and is incorporated herein by reference. The
      information appears in the Proxy Statement under the caption “Beneficial
      Ownership of Shares.” The Proxy Statement will be filed within 120 days of
      December 31, 2009, our year-end.
  Item13.
                    Certain
      Relationships and Related Transactions, and Director
      Independence
 Information
      regarding our relationships and related transactions will be included in
      our Proxy Statement relating to our annual meeting of stockholders
      scheduled to be held in May 2010, 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, 2009, our
  year-end.
  Item14.
                    Principal
      Accountant Fees and
Services
 Information
      called for by Part III, Item 14, will be included in our Proxy Statement
      relating to our annual meeting of stockholders scheduled to be held in May
      2010, 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, 2009, our year-end.




76
 Table of Contents




PARTIV
 
  Item15.
                      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
 
 3.1
              Restated
      Certificate of Incorporation, incorporated herein by reference to Exhibit
      3.1 to the Registrant’s registration statement on Form S-1 (File no.
      33-79350), filed on April 28, 1994.
  3.2
              Bylaws,
      incorporated herein by reference to Exhibit 3.2 to the Registrant’s
      quarterly report on form 10-Q for the period ended March 31, 2000, filed
      on May 10, 2000.
  3.3
              Certificate
      of Amendment to the Certificate of Incorporation, incorporated herein by
      reference to Exhibit 3.3 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 1998, filed on March 22,
    1999.
  3.4
              Certificate
      of Amendment to the Certificate of Incorporation, incorporated herein by
      reference to Exhibit 3.4 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 2001, filed on March 27,
    2002.
  3.5
              Amendment
      to By-Laws of FalconStor Software, Inc., dated August 6, 2007,
      incorporated herein by reference to Exhibit 3.1 to the Registrant’s
      quarterly report on Form 10-Q for the period ended June 30, 2007, filed on
      August 8, 2007.
  4.1
              2000
      Stock Option Plan, incorporated herein by reference to Exhibit 4.1 of the
      Registrant’s registration statement on Form S-8, filed on September 21,
      2001.
  4.2
              2000
      Stock Option Plan, as amended May 15, 2003, incorporated herein by
      reference to Exhibit 99 to the Registrant’s quarterly report on Form 10-Q
      for the period ended June 30, 2003, filed on August 14,
    2003.
  4.3
              2000
      Stock Option Plan, as amended May 14, 2004, incorporated herein by
      reference to Exhibit 4.3 to the Registrant’s Annual Report on Form 10-K
      for the year ended December 31, 2004, filed on March 16,
    2005.
  4.4
              1994
      Outside Directors Stock Plan, as amended May 17, 2002 incorporated herein
      by reference to Exhibit 4.2 to the Registrant’s annual report on Form 10-K
      for the year ended December 31, 2002, filed on March 17,
    2003.
  4.5
              2004
      Outside Directors Stock Option Plan, incorporated herein by reference to
      Exhibit 4.5 to the Registrant’s Annual Report on Form 10-K for the year
      ended December 31, 2004, filed on March 16,
  2005.
  4.6
              Amended
      and Restated 2006 Incentive Stock Plan incorporated herein by reference to
      Exhibit 4.1 to the Registrant’s quarterly report on Form 10-Q for the
      quarter ended March 31, 2007 , filed on May 9,
  2007.
  4.7
              2007
      Outside Directors Equity Compensation Plan, as amended May 8,
      2008,  incorporated herein by reference to Exhibit 99.2 to the
      Registrant’s quarterly report on Form 10-Q for the quarter ended June 30,
      2008, filed on August 11, 2008.
  77
 Table of Contents
  4.8
              Form
      of Restricted Stock Letter Agreement for Executive Officers, incorporated
      herein by reference to Exhibit 99.1 to the Registrant’s quarterly report
      on Form 10-Q for the period ended March 31, 2008, filed May 9,
      2008.
  10.1
              Agreement
      of lease between Huntington Quadrangle 2, LLC, and FalconStor Software,
      Inc., dated August 2003, incorporated herein by reference to Exhibit 99.1
      to the Registrant’s quarterly report on Form 10-Q for the period ended
      September 30, 2003, filed on November 14,
2003.
  10.2
              Employment
      Agreement dated December 31, 2007 between Registrant and ReiJane Huai,
      incorporated herein by reference to Exhibit 10.1 to the Registrant’s
      Current Report on Form 8-K, dated December 31,
  2007.
  10.3
              FalconStor
      Software, Inc., 2005 Key Executive Severance Protection Plan, as amended
      August 6, 2007, incorporated herein by reference to Exhibit 10.2 to
      Registrant’s quarterly report on Form 10-Q for the period ended June 30,
      2007, filed on August 8, 2007.
  10.4
              Amended
      and Restated FalconStor Software, Inc., 2005 Key Executive Severance
      Protection Plan, incorporated herein by reference to Exhibit 10.3 to
      Registrant’s annual report on Form 10-K for the year ended December 31,
      2005, filed on March 15, 2006.
  21.1
              Subsidiaries
      of Registrant – FalconStor, Inc., FalconStor AC, Inc., FalconStor Software
      (Korea), Inc.
  23.1
              *Consent
      of KPMG LLP
  31.1
              *Certification
      of the Chief Executive Officer
  31.2
              *Certification
      of the Chief Financial Officer
  32.1
              *Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 (18 U.S.C. § 1350)
  32.2
              *Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 (18 U.S.C. § 1350)
  *-
      filed herewith.
   78
 Table of Contents




SIGNATURES
 
 Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized in Melville, State of New York on March 12, 2010.
 
 FALCONSTOR
      SOFTWARE, INC.By:
              /s/ ReiJane Huai
              
              Date:
              March
      12, 2010ReiJane
      Huai, President, Chief Executive
                Officer
      of FalconStor Software, Inc.
 
 
 POWER
OF ATTORNEY
 FalconStor Software, Inc. and each of
the undersigned do hereby appoint ReiJane Huai and James Weber, and each of them
severally, its or his true and lawful attorney to execute on behalf of
FalconStor Software, Inc. and the undersigned any and all amendments to this
Annual Report on Form 10-K and to file the same with all exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission; each of such attorneys shall have the power to act hereunder with or
without the other.
 
 Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
date indicated.
  By:
                /s/ ReiJane Huai
                
                March 12, 2010ReiJane
      Huai, President, Chief Executive Officer andChairman
      of the Board(Principal
      Executive Officer)
                
                DateBy:
                /s/ James Weber
                
                March
      12, 2010James
      Weber, Chief Financial Officer, Vice Presidentand
      Treasurer
                  (Principal
      Financial Officer and Principal Accounting Officer)
                
                DateBy:
                /s/
      Steven L. Bock
                
                March
      12, 2010Steven
      L. Bock, Director
                
                DateBy:
                /s/
      Patrick B. Carney
                
                March
      12, 2010Patrick
      B. Carney, Director
                
                DateBy:
                /s/
      Lawrence S. Dolin
                
                March
      12, 2010Lawrence
      S. Dolin, Director
                
                DateBy:
                /s/ Steven R. Fischer
                
                March
      12, 2010Steven
      R. Fischer, Director
                
                DateBy:
                /s/ Alan W. Kaufman
                
                March
      12, 2010Alan
      W. Kaufman, Director
                
                DateBy:
                /s/ Irwin Lieber
                
                March
      12, 2010Irwin
      Lieber, Director
                
                DateBy:
                /s/ Eli Oxenhorn
                
                March
      12, 2010Eli
      Oxenhorn, Director
                
                DateBy:
                /s/ Barry Rubenstein
                
                March
      12, 2010Barry
      Rubenstein, Director
                
                Date
 
 79