**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(MarkOne)**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended June 30, 2007**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from               to               **

**CommissionFile Number: 000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                    | **94-3342784**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |

 

**9405 SW Gemini Drive,Beaverton, Oregon 97008**

(Address of principalexecutive offices) (Zip Code)

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act:

| Title of Each Class        | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------|------------|-----------------------------------------------|
| Common Stock,              |       | The Nasdaq Stock  Market                      |
| $0.001 Par Value Per Share |       |                                          |

 

Securities registered pursuant to Section 12(g) ofthe Act:

**NONE**

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

 

|  | Large accelerated  filer o | Accelerated filer x | Non-accelerated filer o |
|--|---------------------------------|---------------------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in rule 12b-2of the Exchange Act). Yes o  No x

As of July 31, 2007, there were 21,608,076 sharesof the registrant’s common stock, par value $0.001 per share, outstanding.

 

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**Tableof Contents**
| **PART I FINANCIAL  INFORMATION** |                                                                                                                        | 3      |   |
|----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.                           | Financial  Statements:                                                                                                      |   | 3      |   |
|                                   | Consolidated  Balance Sheets as of June 30, 2007 and December 31,  2006 (Unaudited)                          |   | 3      |   |
|                                   | Consolidated  Statements of Operations for the three- and six-months ended June 30, 2007  and 2006 (Unaudited)    |   | 4      |   |
|                                   | Consolidated  Statements of Stockholders’ Equity as of June 30, 2007 and  December 31, 2006 (Unaudited) |   | 5      |   |
|                                   | Consolidated  Statements of Cash Flows for the six-months ended June 30, 2007 and  2006 (Unaudited)               |   | 6      |   |
|                                   | Notes  to Consolidated Financial Statements (Unaudited)                                                                     |   | 7      |   |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                 |   | 25     |   |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                                                 |   | 45     |   |
| Item 4.                                | Controls  and Procedures                                                                                                    |   | 45     |   |
| **PART II  OTHER INFORMATION**    |                                                                                                                        | 46     |   |
| Item 1.                                | Legal  Proceedings                                                                                                          |   | 46     |   |
| Item 1A.                               | Risk Factors                                                                                                                |   | 47     |   |
| Item 4.                                | Submission  of Matters to a Vote of Security Holders                                                                        |   | 58     |   |
| Item 6.                                | Exhibits                                                                                                                    |   | 59     |   |
| **SIGNATURES**                         |                                                                                                                        | 60     |   |

 

2

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**PART I.**   FINANCIALINFORMATION

**Item 1.**                        FinancialStatements.

**DIGIMARC CORPORATIONCONSOLIDATED BALANCE SHEETS(In thousands, except share data) (UNAUDITED)**

| ** **                                                                                                                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2007**          | ** ** | **2006(1)**           | ** ** |
| **ASSETS**                                                                                                                              |       |              |       |                  |       |   |   |
| Current assets:                                                                                                                         |       |              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                               |       | $                 | 17,581     |                  |       | $ | 23,135 |   |   |
| Restricted cash                                                                                                                         |       | —            |       |                  | 378        |   |   |
| Short-term investments                                                                                                                  |       | 1,715             |       |                  | —     |   |   |
| Trade accounts receivable, net                                                                                                          |       | 16,358            |       |                  | 14,403     |   |   |
| Inventory, net                                                                                                                          |       | 7,030             |       |                  | 6,600      |   |   |
| Other current assets                                                                                                                    |       | 2,605             |       |                  | 2,273      |   |   |
| Total current assets                                                                                                                    |       | 45,289            |       |                  | 46,789     |   |   |
| Restricted cash                                                                                                                         |       | 9,560             |       |                  | 9,560      |   |   |
| Property and  equipment, net                                                                                                            |       | 66,465            |       |                  | 61,898     |   |   |
| Intangibles, net                                                                                                                        |       | 14,391            |       |                  | 15,374     |   |   |
| Other assets, net                                                                                                                       |       | 956               |       |                  | 1,010      |   |   |
| Total assets                                                                                                                            |       | $                 | 136,661    |                  |       | $ | 134,631 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                           |       |              |       |                  |       |   |   |
| Current liabilities:                                                                                                                    |       |              |       |                  |       |   |   |
| Accounts payable                                                                                                                        |       | $                 | 5,850      |                  |       | $ | 5,708 |   |   |
| Accrued payroll and related costs                                                                                                       |       | 2,007             |       |                  | 3,894      |   |   |
| Deferred revenue                                                                                                                        |       | 6,078             |       |                  | 5,050      |   |   |
| Other current liabilities                                                                                                               |       | 1,666             |       |                  | 2,258      |   |   |
| Total current liabilities                                                                                                               |       | 15,601            |       |                  | 16,910     |   |   |
| Long-term  deferred revenue, net of current portion                                                                                     |       | 6,968             |       |                  | 5,345      |   |   |
| Other long-term  liabilities                                                                                                            |       | 1,090             |       |                  | 885        |   |   |
| Total liabilities                                                                                                                       |       | 23,659            |       |                  | 23,140     |   |   |
| Commitments and  contingencies (Note 5)                                                                                                 |       |              |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                              |       |              |       |                  |       |   |   |
| Common stock  (21,627,455 and 21,191,918 shares issued and outstanding at June 30,  2007 and December 31, 2006, respectively) |       | 22                |       |                  | 22         |   |   |
| Additional  paid-in capital                                                                                                             |       | 213,955           |       |                  | 211,072    |   |   |
| Accumulated other  comprehensive income                                                                                                 |       | 137               |       |                  | 137        |   |   |
| Accumulated  deficit                                                                                                                    |       | (101,112          | )          |                  | (99,740    | ) |   |
| Total stockholders’ equity                                                                                                         |       | 113,002           |       |                  | 111,491    |   |   |
| Total liabilities  and stockholders’ equity                                                                                        |       | $                 | 136,661    |                  |       | $ | 134,631 |   |   |

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(1)          Derived from the Company’sDecember 31, 2006 audited consolidated financial statements

See Notes to Unaudited Consolidated Financial Statements.

3

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(UNAUDITED)**

| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                        | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                          |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | $                                | 22,538     |                           | $          | 20,519 |   | $ | 43,837 |   | $ | 42,809 |   |
| Product and subscription                          |       | 4,826                            |       | 4,388                          |       | 10,373 |   | 9,291 |   |
| Total revenue                                     |       | 27,364                           |       | 24,907                         |       | 54,210 |   | 52,100 |   |
| Cost of revenue:                                  |       |                             |       |                           |       |   |   |   |   |
| Service                                           |       | 15,089                           |       | 15,002                         |       | 29,804 |   | 32,101 |   |
| Product and subscription                          |       | 1,988                            |       | 1,675                          |       | 4,088 |   | 4,224 |   |
| Total cost of revenue                             |       | 17,077                           |       | 16,677                         |       | 33,892 |   | 36,325 |   |
| Gross profit                                      |       | 10,287                           |       | 8,230                          |       | 20,318 |   | 15,775 |   |
| Operating expenses:                               |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                               |       | 4,365                            |       | 4,685                          |       | 8,642 |   | 9,224 |   |
| Research, development and engineering             |       | 1,883                            |       | 2,994                          |       | 3,925 |   | 6,230 |   |
| General and administrative                        |       | 3,809                            |       | 4,172                          |       | 7,907 |   | 9,382 |   |
| Amortization of intangibles                       |       | 509                              |       | 550                            |       | 1,009 |   | 1,123 |   |
| Intellectual property                             |       | 476                              |       | 481                            |       | 975 |   | 912 |   |
| Restructuring charges, net                        |       | —                           |       | 547                            |       | — |   | 547 |   |
| Total operating expenses                          |       | 11,042                           |       | 13,429                         |       | 22,458 |   | 27,418 |   |
| Operating income (loss)                           |       | (755                             | )          | (5,199                         | )          | (2,140 | ) | (11,643 | ) |
| Other income (expense):                           |       |                             |       |                           |       |   |   |   |   |
| Interest income                                   |       | 362                              |       | 341                            |       | 774 |   | 666 |   |
| Interest expense                                  |       | 4                                |       | (28                            | )          | (15 | ) | (44 | ) |
| Other                                             |       | 36                               |       | (5                             | )          | 25 |   | 43 |   |
| Total other income, net                           |       | 402                              |       | 308                            |       | 784 |   | 665 |   |
| Income (loss)  before provision for income taxes  |       | (353                             | )          | (4,891                         | )          | (1,356 | ) | (10,978 | ) |
| (Provision)  benefit for income taxes             |       | (142                             | )          | 22                             |       | (161 | ) | (63 | ) |
| Net income (loss)                                 |       | $                                | (495       | )                              | $          | (4,869 | ) | $ | (1,517 | ) | $ | (11,041 | ) |
| Net income (loss)  per share—basic           |       | $                                | (0.02      | )                              | $          | (0.24 | ) | $ | (0.07 | ) | $ | (0.54 | ) |
| Net income (loss)  per share—diluted         |       | $                                | (0.02      | )                              | $          | (0.24 | ) | $ | (0.07 | ) | $ | (0.54 | ) |
| Weighted average shares outstanding—basic    |       | 20,898                           |       | 20,627                         |       | 20,847 |   | 20,617 |   |
| Weighted average  shares outstanding—diluted |       | 20,898                           |       | 20,627                         |       | 20,847 |   | 20,617 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

4

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**

| ** **                                          | ** ** | **Common stock** | ** ** | **Additional  paid-in** | ** ** | **Deferred  stock** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Accumulated** | ** ** | **Total  stockholders’** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------|------------|---------------------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                          | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**         | ** ** | **compensation**                      | ** ** | **income**      | ** ** | **Deficit**                   | ** ** | **equity** | ** ** |
| **BALANCE AT DECEMBER 31,   2005**             |       | 20,808,994            |       |                    | $          | 21                  |       |                                  |       | $               | 209,337    |                          |       |   | $ | (1,519 | ) |   |   | $ | 137 |   |   |   | $ | (88,000 | ) |   |   | $ | 119,976 |   |   |
| Initial adjustment to adopt SFAS 123R               |       | —                |       |                    | —     |                |       |                                  | (1,519     | )               |       |                          | 1,519      |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Exercise of stock   options                         |       | 44,584                |       |                    | 1          |                |       |                                  | 201        |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 202 |   |   |
| Issuance of employee stock purchase plan shares     |       | 52,957                |       |                    | —     |                |       |                                  | 248        |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 248 |   |   |
| Issuance of restricted common stock                 |       | 312,365               |       |                    | —     |                |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and retirement of common stock   |       | (26,982               | )          |                    | —     |                |       |                                  | (208       | )               |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | (208 | ) |   |
| Stock-based compensation   expense                  |       | —                |       |                    | —     |                |       |                                  | 3,013      |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 3,013 |   |   |
| Net loss                                            |       | —                |       |                    | —     |                |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | (11,740 | ) |   |   | (11,740 | ) |   |
| **BALANCE AT DECEMBER 31,   2006**             |       | 21,191,918            |       |                    | 22         |                |       |                                  | 211,072    |            |       |                          | —     |   |   |   | 137 |   |   |   | (99,740 | ) |   |   | 111,491 |   |   |
| Initial adjustment to adopt FIN 48   (Note 10) |       | —                |       |                    | —     |                |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | 145 |   |   |   | 145 |   |   |
| Exercise of stock   options                         |       | 97,399                |       |                    | —     |                |       |                                  | 588        |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 588 |   |   |
| Issuance of employee stock purchase plan shares     |       | 54,119                |       |                    | —     |                |       |                                  | 423        |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 423 |   |   |
| Issuance of restricted common stock                 |       | 309,490               |       |                    | —     |                |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase and retirement of common stock   |       | (25,471               | )          |                    | —     |                |       |                                  | (140       | )               |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | (140 | ) |   |
| Stock-based compensation   expense                  |       | —                |       |                    | —     |                |       |                                  | 2,012      |            |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | 2,012 |   |   |
| Net loss                                            |       | —                |       |                    | —     |                |       |                                  | —     |            |       |                          | —     |   |   |   | — |   |   |   | (1,517 | ) |   |   | (1,517 | ) |   |
| **BALANCE  AT JUNE 30, 2007**             |       | 21,627,455            |       |                    | $          | 22                  |       |                                  |       | $               | 213,955    |                          |       |   | $ | — |   |   |   | $ | 137 |   |   |   | $ | (101,112 | ) |   |   | $ | 113,002 |   |   |

 

See Notes to Unaudited Consolidated Financial Statements.

5

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**DIGIMARC CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(UNAUDITED)**

| ** **                                                                                 | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30,  2007**        | ** ** | **June 30,  2006** | ** ** |
| Cash flows from  operating activities:                                                     |       |                           |       |   |   |
| Net loss                                                                                   |       | $                              | (1,517     | ) | $ | (11,041 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                              |       | 7,801                          |       | 7,652 |   |
| Stock-based compensation expense                                                           |       | 2,012                          |       | 1,576 |   |
| Increase (decrease) in allowance for doubtful  accounts                                    |       | 1                              |       | (164 | ) |
| Other non-cash charges                                                                     |       | (50                            | )          | (73 | ) |
| Changes in  operating assets and liabilities:                                              |       |                           |       |   |   |
| Restricted cash                                                                            |       | 378                            |       | (4,204 | ) |
| Trade accounts receivable, net                                                             |       | (1,996                         | )          | 1,765 |   |
| Inventory, net                                                                             |       | (430                           | )          | 1,102 |   |
| Other current assets                                                                       |       | (332                           | )          | 232 |   |
| Other assets, net                                                                          |       | 54                             |       | 69 |   |
| Accounts payable                                                                           |       | 142                            |       | 155 |   |
| Accrued payroll and related costs                                                          |       | (1,887                         | )          | (250 | ) |
| Deferred revenue                                                                           |       | 2,651                          |       | 985 |   |
| Other liabilities                                                                          |       | (116                           | )          | (321 | ) |
| Net cash provided by (used in) operating activities                                        |       | 6,711                          |       | (2,517 | ) |
| Cash flows from  investing activities:                                                     |       |                           |       |   |   |
| Purchase of property and equipment, including  capitalized labor costs, and intangibles    |       | (11,109                        | )          | (3,437 | ) |
| Sale or maturity of short-term investments                                                 |       | 76,807                         |       | 62,713 |   |
| Purchase of short-term investments                                                         |       | (78,522                        | )          | (62,975 | ) |
| Net cash provided by (used in) investing activities                                        |       | (12,824                        | )          | (3,699 | ) |
| Cash flows from  financing activities:                                                     |       |                           |       |   |   |
| Issuance of common stock                                                                   |       | 1,011                          |       | 264 |   |
| Purchase of common stock                                                                   |       | (140                           | )          | — |   |
| Principal payments under capital lease obligations                                         |       | (312                           | )          | (314 | ) |
| Net cash provided by (used in) financing activities                                        |       | 559                            |       | (50 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | (5,554                         | )          | (6,266 | ) |
| Cash and cash equivalents at beginning of period                                           |       | 23,135                         |       | 23,964 |   |
| Cash and cash equivalents at end of period                                                 |       | $                              | 17,581     |   | $ | 17,698 |   |
| Supplemental  disclosure of cash flow information:                                         |       |                           |       |   |   |
| Cash paid for interest                                                                     |       | $                              | 38         |   | $ | 44 |   |
| Cash paid for income taxes                                                                 |       | $                              | 323        |   | $ | 111 |   |
| Summary of non-cash  investing and financing activities:                                   |       |                           |       |   |   |
| Equipment  acquired or exchanged under capital lease obligations                           |       | $                              | 244        |   | $ | 582 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

6

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share data) (UNAUDITED)**

**1.**                 TheCompany, Basis of Presentation

*Description ofBusiness*

Digimarc Corporation (“Digimarc”or “the Company”) is a supplier of secure identity solutions and advancedtechnologies for use in media management. The Company’s solutions enablegovernments and businesses around the world to deter counterfeiting and piracy,enhance traffic safety and national security, combat identity theft and fraud,facilitate the effectiveness of voter identification programs, improve themanagement of media content, and support new digital media distribution modelsthat provide consumers with more choice and access to media content.

*Principles ofConsolidation*

The consolidated financialstatements include the accounts of Digimarc and its wholly-owned subsidiaries.All significant intercompany transactions and balances have been eliminated.

*Interim FinancialStatements*

The accompanying consolidated financial statementshave been prepared from the Company’s records without audit and, in management’sopinion, include all adjustments (consisting of only normal recurringadjustments) necessary to fairly reflect the financial condition and theresults for the periods presented. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States (the “U.S.”) havebeen condensed or omitted under the rules and regulations of theSecurities and Exchange Commission (the “SEC”).

These consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006, which was filed with the SEC on March 8,2007. The results of operations for the interim periods presented in theseconsolidated financial statements are not necessarily indicative ofthe results for the full year.

*Use of Estimates*

The preparation ofconsolidated financial statements in accordance with accounting principlesgenerally accepted in the U.S. requires Digimarc to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenue andexpenses, and related disclosure of contingent assets and liabilities. Certainof the Company’s accounting policies require higher degrees of judgment thanothers in their application. These include revenue recognition on long-termservice contracts, impairments and estimation of useful lives of long-livedassets, inventory valuation, reserves for uncollectible accounts receivable,inputs for stock-based compensation calculations, and contingencies andlitigation. Digimarc bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

7

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Reclassifications*

Certain amounts in the2006 consolidated financial statements and notes thereon have been reclassifiedto conform to the current period presentation. These reclassifications had nomaterial effect on the results of operations or financial position for anyperiod presented.

**2.**                 NetIncome (Loss) Per Share Computation

Net income (loss) per share (or earnings per share (“EPS”))is calculated in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 128, *Earnings per Share*,which provides that basic and diluted net income (loss) per share for allperiods presented are to be computed using the weighted average number ofcommon shares outstanding during each period, with diluted net income (loss)per share including the effect of potentially dilutive common shares.

Thefollowing table shows the reconciliation of weighted average basic shares toweighted average diluted shares outstanding: 

| ** **                                       | ** ** | **Three Months Ended**        | ** ** | **Six Months Ended**          | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **June 30,**                       | ** ** | **June 30,**                       | ** ** |
| ** **                                       | ** ** | **2007**                                | ** ** | **2006**                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** |
| **Basic  EPS**                                   | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Weighted average shares   outstanding            |       |                                    | 20,898     | ** **                              |       |   | 20,627 | ** ** |   |   | 20,847 | ** ** |   |   | 20,617 | ** ** |   |
| **Effect of Dilutive Securities**                | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Options                                          |       |                                    | —     | ** **                              |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| Restricted stock  and performance vesting shares |       |                                    | —     | ** **                              |       |   | — | ** ** |   |   | — | ** ** |   |   | — | ** ** |   |
| **Diluted EPS**                                  | ** ** |                                    | ** ** | ** **                              |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Weighted  average shares   outstanding           |       |                                    | 20,898     | ** **                              |       |   | 20,627 | ** ** |   |   | 20,847 | ** ** |   |   | 20,617 | ** ** |   |

 

Common stock equivalents related to stock options of4,429 and 4,366 were excluded from diluted net loss per share calculations forthe three- and six-month periods ended June 30, 2007, respectively, astheir exercise price was higher than the average market price of the underlyingcommon stock for the period and therefore their impact would be anti-dilutive.In addition, common stock equivalents related to stock options and restrictedstock of 1,550  and 1,565 for the three-and six-month periods ended June 30, 2007, respectively, were excludedfrom diluted net loss per share as the Company was in a loss position and theinclusion would be anti-dilutive.

The effect of 5,632 and5,324 outstanding stock options for the three- and six-months periods ended June 30,2006, respectively, were excluded from the calculation of diluted net loss pershare because their exercise price was higher than the average market price ofthe underlying common stock for the period and therefore their inclusion wouldbe anti-dilutive. In addition, common stock equivalents related to stock 

8

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

optionsand restricted stock of 759 and 821 for the three- and six-months periods endedJune 30, 2006, respectively, were excluded from diluted net loss per shareas the Company was in a loss position and their inclusion would beanti-dilutive.

**3.**                 Stock-BasedCompensation

Stock-based compensation includes expense charges forall stock-based awards to employees and directors. Such awards include optiongrants, restricted stock awards, and shares expected to be purchased under anemployee stock purchase plan. On January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123(R), *Share-Based Payment (Revised 2004)*, which requires themeasurement and recognition of compensation for all stock-based awards made toemployees and directors including stock options and employee stock purchasesunder a stock purchase plan based on estimated fair values. SFAS 123(R) supersedesprevious accounting under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*, for periodsbeginning in fiscal 2006. In March 2005, the SEC issued Staff AccountingBulletin No. 107 relating to application of SFAS 123(R). The Company hasapplied the provisions of Staff Accounting Bulletin (“SAB”) 107 in the adoptionof SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of its 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the three- and six-month periods ended June 30, 2007 and2006 is based on the value of the portion of the stock-based award that willvest during the period, adjusted for expected forfeitures. Stock-basedcompensation recognized in the Company’s consolidated financial statements inthe three- and six-month periods ended June 30, 2007 and 2006 includescompensation cost for stock-based awards granted prior to, but not fully vestedas of, December 31, 2005 and stock-based awards granted subsequent to December 31,2005. The compensation cost for awards granted prior to January 1, 2006 isbased on the grant date fair value estimated in accordance with the pro formaprovisions of SFAS 123 while awards granted on or after January 1, 2006follow the provisions of SFAS 123(R) to determine the grant date fairvalue and compensation cost. Compensation cost for all stock-based awards isrecognized using the straight-line method.

Upon adoption ofSFAS 123(R), the Company continued to use the Black-Scholes option pricingmodel as its method of valuation for stock-based awards. The Company’sdetermination of the fair value of stock-based awards on the date of grantusing an option pricing model is affected by the Company’s stock price as wellas assumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to, the expected life of theaward, the Company’s expected stock price volatility over the term of the awardand actual and projected exercise behaviors. Although the fair value ofstock-based awards is determined in accordance with SFAS 123(R) and SAB107, the Black-Scholes option pricing model requires the input of highlysubjective assumptions, and other reasonable assumptions could providediffering results.

9

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

***Determining Fair Value Under SFAS 123(R)***

*Stock Options*

*Valuationand Amortization Method.**  **The Company estimates the fair value ofstock-based awards granted using the Black-Scholes option valuation model. TheCompany amortizes the fair value of all awards on a straight-line basis overthe requisite service periods, which are generally the vesting periods.*The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model.

*ExpectedLife.*   The expected life ofawards granted represents the period of time that they are expected to beoutstanding. The Company determines the expected life based on historicalexperience with similar awards, giving consideration to the contractual terms,vesting schedules and pre-vesting and post-vesting forfeitures. Stockoptions granted during the three- and six-months ended June 30, 2007 and2006 generally vest over four years and have contractual terms of ten years.

*ExpectedVolatility.*   The Company estimatesthe volatility of its common stock at the date of grant based on the historicalvolatility of its common stock. The volatility factor the Company uses in theBlack-Scholes option valuation model is based on its historical stock pricesover the most recent period commensurate with the estimated expected life ofthe award. This historical period excludes portions of time when unusualtransactions occurred, such as a significant acquisition.

*Risk-FreeInterest Rate.**  *TheCompany bases the risk-free interest rate used in the Black-Scholes optionvaluation model on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent remaining term approximately equal to theexpected life of the award.

*ExpectedDividend Yield.**  *TheCompany has never paid any cash dividends on its common stock and does notanticipate paying any cash dividends in the foreseeable future. Consequently,the Company uses an expected dividend yield of zero in the Black-Scholes optionvaluation model.

*ExpectedForfeitures.**  *TheCompany uses relevant historical data to estimate pre-vesting optionforfeitures. The Company records stock-based compensation only for those awardsthat are expected to vest.

A summary of theweighted average assumptions and results for options granted during the periodspresented is as follows:

| ** **               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **               | ** ** | **2007**                                   | ** ** | **2006**                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected life (in years) |       | 5.8                                        |       | 6.0                                      |       | 5.8 |   | 6.0 |   |
| Expected volatility      |       | 44                                         | %          | 53                                       | %          | 44 | % | 53 | % |
| Risk-free interest rate  |       | 4.7                                        | %          | 4.7                                      | %          | 4.7 | % | 4.7 | % |
| Expected dividend yield  |       | 0                                          | %          | 0                                        | %          | 0 | % | 0 | % |
| Expected forfeiture rate |       | 16                                         | %          | 14                                       | %          | 16 | % | 14 | % |
| Fair value               |       | $                                          | 4.76       |                                     | $          | 3.80 |   | $ | 4.36 |   | $ | 3.57 |   |
|                          |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |

 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Employee StockPurchase Plans*

The Company also recognizes stock-based compensation in connection withits 1999 Employee Stock Purchase Plan. The plan allowed employees to purchaseshares of Digimarc common stock through payroll deductions of up to 15% oftheir base compensation during each six-month plan period, up to a maximum deductionof $10.6 for each plan period, not to exceed $21 per year. Plan periods weregenerally from December 1 to May 31 and from June 1 to November 30.The price an employee paid for the shares was 85% of the lower of (i) thefair market value of Digimarc common stock at the beginning of the plan periodor (ii) the fair market value at the end of the plan period. There were52,957 shares purchased under the Company’s stock purchase plan during thethree- and six-month periods ended June 30, 2006. The plan was suspendedeffective June 1, 2006.

An amended plan was reinstated effective November 2,2006 which slightly modified the earlier plan. The changes included changingthe plan periods from six to three months and the maximum deduction to $5.3 foreach plan period. The plan periods are generally from December 1 to February 28,March 1 to May 31, June 1 to August 31 and from September 1to November 30. Employees purchased 28,742 shares and 54,119 shares underthe plan during the three- and six-month periods ended June 30, 2007,respectively.

*Restricted Stockand Performance Vesting Shares*

During 2007 and 2006 the Compensation Committee of theBoard of Directors awarded restricted stock shares under the Company’s 1999Stock Incentive Plan, as amended, to certain officers, employees and directors.The shares subject to the restricted stock awards vest over a certain period,usually one to four years, following the date of the grant. In addition theCompensation Committee awarded performance vesting shares under the 1999 StockIncentive Plan, as amended, to certain officers and employees. The performancevesting shares vest in full (or terminate) based on the achievement ofspecified performance goals. Specific terms of the restricted stock awards andperformance vesting share awards are governed by restricted stock agreementsand performance vesting share agreements between the Company and the awardrecipients.

The fair value of restricted stock awards granted isbased on the fair market value of the Company’s common stock on the date of thegrant (measurement date), and is recognized over the vesting period of therelated restricted stock using the straight-line method.

The fair value of performance vesting shareawards granted is based on a Monte Carlo valuation model that results in afactor applied to the fair market value of the Company’s common stock on thedate of the grant (measurement date), and is recognized over the derivedservice period using the straight-line method.

11

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

***Stock-based Compensation Under FAS 123(R)***

The following tablesummarizes stock-based compensation expense related to stock-based awards underSFAS 123(R) for the three- and six-month periods ended June 30, 2007and 2006, which was incurred as follows:

| ** **                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                            | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stock-based compensation:             |       |                                            |       |                                          |       |   |   |   |   |
| Cost of revenue                       |       | $                                               | 109        |                                          | $          | 84 |   | $ | 215 |   | $ | 138 |   |
| Sales and marketing                   |       | 185                                             |       | 134                                           |       | 392 |   | 256 |   |
| Research, development and engineering |       | 101                                             |       | 76                                            |       | 173 |   | 190 |   |
| General and administrative            |       | 599                                             |       | 478                                           |       | 1,207 |   | 974 |   |
| Intellectual property                 |       | 13                                              |       | 10                                            |       | 25 |   | 18 |   |
| Total stock-based compensation        |       | $                                               | 1,007      |                                          | $          | 782 |   | $ | 2,012 |   | $ | 1,576 |   |

 

At June 30, 2007, the Company had1.5 million non-vested stock options that had a weighted average grantdate price of $7.10. As of June 30, 2007, the Company had$9.1 million of total unrecognized compensation cost related to non-vestedstock-based awards granted under all equity compensation plans, includingoptions, restricted stock, and employee stock purchase plan. Total unrecognizedcompensation cost will be adjusted for any future changes in estimatedforfeitures. The Company expects to recognize this cost over a weighted averageperiod of 1.45 years.

*Stock Option Activity*

As of June 30, 2007, under all of the Company’s stock-basedcompensation plans, options to purchase an aggregate of 7.2 million shareswere outstanding, and options to purchase an additional 7.2 million shareswere authorized for future grants under the plans. The Company issues newshares upon option exercises.

Options granted,exercised, canceled and expired under the Company’s stock option plans aresummarized as follows:

| **Three-months ended June 30, 2007:** | ** ** | ** ** | ** ** | **Options** | ** ** | **Weighted**Average Exercise Price | ** ** | **Weighted**Average Remaining  Contractual Life | ** **      |
|-----------------------------------------------------------|------------|------------|------------|-------------|------------|------------------------------------|------------|-------------------------------------------------|-----------------|
| Outstanding at March 31, 2007                        |       | 7,278,888  |       |        | $          | 13.53                              |       |                                            |            |   |
| Options granted                                           |       | 85,025     |       |        | 9.87       |                               |       |                                            |            |
| Options exercised                                         |       | (33,045    | )          |        | 6.00       |                               |       |                                            |            |
| Options canceled                                          |       | (94,660    | )          |        | 10.13      |                               |       |                                            |            |
| Options expired                                           |       | —     |       |        | —     |                               |       |                                            |            |
| Outstanding at June 30, 2007                         |       | 7,236,208  |       |        | $          | 13.56                              |       |                                            | 6.08 years |   |
| Exercisable at June 30, 2007                         |       | 5,689,784  |       |        | $          | 15.32                              |       |                                            | 5.35 years      |   |

 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

 

| **Six-months ended June 30, 2007:** | ** ** | ** ** | ** ** | **Options** | ** ** | **Weighted**Average Exercise Price | ** ** | **Weighted**Average Remaining  Contractual Life | ** **      |
|---------------------------------------------------------|------------|------------|------------|-------------|------------|------------------------------------|------------|-------------------------------------------------|-----------------|
| Outstanding at December 31, 2006                   |       | 7,045,751  |       |        | $          | 13.67                              |       |                                            |            |   |
| Options granted                                         |       | 452,975    |       |        | 9.04       |                               |       |                                            |            |
| Options exercised                                       |       | (97,399    | )          |        | 6.03       |                               |       |                                            |            |
| Options canceled                                        |       | (165,119   | )          |        | 10.20      |                               |       |                                            |            |
| Options expired                                         |       | —     |       |        | —     |                               |       |                                            |            |
| Outstanding at June 30, 2007                       |       | 7,236,208  |       |        | $          | 13.56                              |       |                                            | 6.08 years |   |
| Exercisable at June 30, 2007                       |       | 5,689,784  |       |        | $          | 15.32                              |       |                                            | 5.35 years      |   |

 

The following tablesummarizes information about stock options outstanding at June 30, 2007:

| ** **                                      | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices**     | ** ** | ** **                   | ** ** | **Number**Outstanding        | ** ** | **Remaining**Contractual Life  (Years) | ** ** | **Weighted**Average Price | ** ** | **Number**Exercisable | ** ** | **Weighted**Average Price | ** ** |
| $  0.50 - $  5.96 |       |                         | 823,763    |                         |       |   | 7.28 |   |   |   | $ | 5.06 |   |   | 452,235 |   |   | $ | 4.41 |   |   |
| $  6.00 - $  6.15 |       |                         | 477,773    |                         |       |   | 7.99 |   |   |   | $ | 6.07 |   |   | 222,101 |   |   | $ | 6.05 |   |   |
| $  6.16 - $  6.99 |       |                         | 530,140    |                         |       |   | 8.61 |   |   |   | $ | 6.49 |   |   | 176,371 |   |   | $ | 6.49 |   |   |
| $  7.02 - $  8.97 |       |                         | 783,647    |                         |       |   | 8.45 |   |   |   | $ | 8.42 |   |   | 319,442 |   |   | $ | 8.28 |   |   |
| $  9.00 - $12.23            |       |                         | 888,843    |                         |       |   | 6.98 |   |   |   | $ | 10.93 |   |   | 787,593 |   |   | $ | 11.07 |   |   |
| $12.40 - $13.25                       |       |                         | 578,220    |                         |       |   | 5.60 |   |   |   | $ | 12.82 |   |   | 578,220 |   |   | $ | 12.82 |   |   |
| $13.38 - $14.13                       |       |                         | 786,500    |                         |       |   | 3.65 |   |   |   | $ | 14.07 |   |   | 786,500 |   |   | $ | 14.07 |   |   |
| $14.40 - $15.24                       |       |                         | 562,295    |                         |       |   | 5.47 |   |   |   | $ | 15.10 |   |   | 562,295 |   |   | $ | 15.10 |   |   |
| $15.25 - $17.00                       |       |                         | 672,877    |                         |       |   | 5.43 |   |   |   | $ | 16.24 |   |   | 672,877 |   |   | $ | 16.24 |   |   |
| $17.88 - $26.25                       |       |                         | 757,900    |                         |       |   | 3.91 |   |   |   | $ | 21.03 |   |   | 757,900 |   |   | $ | 21.03 |   |   |
| $27.50 - $53.94                       |       |                         | 374,250    |                         |       |   | 2.68 |   |   |   | $ | 46.74 |   |   | 374,250 |   |   | $ | 46.74 |   |   |
| $  0.50 - $53.94            |       |                         | 7,236,208  |                         |       |   | 6.08 |   |   |   | $ | 13.56 |   |   | 5,689,784 |   |   | $ | 15.32 |   |   |
|                                                 |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006, 5,559,602 options wereexercisable at a weighted average price of $15.62.

At June 30, 2007,the aggregate intrinsic value of outstanding and exercisable stock options was$8,646 and $4,471, respectively. The aggregate intrinsic value is based on theCompany’s closing price of $9.81 on June 29, 2007, which would have beenreceived by the optionees had all of the options with exercise prices less than$9.81 been exercised on that date.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Restricted Stockand Performance Vesting Shares Activity*

Thefollowing table reconciles the unvested balance of restricted and performanceshares:

| ** **                                              | ** ** | **Number of  Shares** | ** ** |
|---------------------------------------------------------|------------|----------------------------|------------|
| ***Three-months ended June 30,  2007:*** | ** ** |                       | ** ** | ** ** |   |
| Unvested balance,  March 31, 2007                  |       |                       | 686,062    |   |   |
| Granted                                                 |       |                       | 24,000     |   |   |
| Vested                                                  |       |                       | (19,200    | ) |   |
| Canceled                                                |       |                       | (7,779     | ) |   |
| Unvested balance,  June 30, 2007                   |       |                       | 683,083    |   |   |

 

| ** **                                            | ** ** | **Number of  Shares** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| ***Six-months ended June 30,  2007:*** | ** ** |                       | ** ** | ** ** |   |
| Unvested balance,  December 31, 2006             |       |                       | 444,032    |   |   |
| Granted                                               |       |                       | 309,490    |   |   |
| Vested                                                |       |                       | (59,660    | ) |   |
| Canceled                                              |       |                       | (10,779    | ) |   |
| Unvested balance,  June 30, 2007                 |       |                       | 683,083    |   |   |

 

**4.**                 SegmentInformation

*GeographicInformation*

The Company derives its revenue from a singlereporting segment: secure identification and media management solutions.Revenue is generated in this segment through licensing and subscription of itsvarious products and the delivery of contracted and consulting services relatedto these products. The Company markets its products in the United States and innon-U.S. countries through its sales personnel and its subsidiaries. TheCompany’s management evaluates resource allocation decisions and theperformance of the Company based upon revenue by the geographic regions of thesegment and does not receive discrete financial information about assetallocation and expense allocation on a disaggregated basis.

Revenueby geographic areas is as follows: 

| ** **    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Domestic      |       | $                                               | 21,219     |                                          | $          | 21,112 |   | $ | 41,739 |   | $ | 41,307 |   |
| International |       | 6,145                                           |       | 3,795                                         |       | 12,471 |   | 10,793 |   |
| Total         |       | $                                               | 27,364     |                                          | $          | 24,907 |   | $ | 54,210 |   | $ | 52,100 |   |

 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

*Major Customers*

No single customeraccounted for more than 10% of total revenue for the three- and six-monthperiods ended June 30, 2007. One customer accounted for approximately 11%of total revenue in the three-month period ended June 30, 2006 and approximately10% of total revenue in the six-month period ended June 30, 2006.

**5.**                 Commitments andContingencies

Beginning in September 2004,three purported class action lawsuits were filed in the U.S. District Court forthe District of Oregon against the Company and certain of its current andformer directors and officers on behalf of purchasers of the Company’ssecurities during the period April 17, 2002 to July 28, 2004. Theselawsuits were later consolidated into one action for all purposes. The amendedcomplaint, which sought unspecified damages, asserted claims under the federalsecurities laws relating to the Company’s restatement of its financialstatements for 2003 and the first two quarters of 2004 and alleged that theCompany issued false and misleading financial statements and issued misleadingpublic statements about the Company’s operations and prospects. On August 4,2006, the court granted the Company’s motion to dismiss the lawsuit withprejudice and entered judgment in the Company’s favor. Plaintiffs have filed anotice of appeal in the Ninth Circuit Court of Appeals. The appeal was stayedpending the recent U.S. Supreme Court’s determination in another case of issuesrelating to the Private Securities Litigation Reform Act, and briefing isscheduled to be completed by the end of the year. The Company anticipates oralargument and a decision in 2008. However, due to the inherent uncertainties oflitigation, the Company cannot accurately predict the ultimate timing oroutcome of the matter.

On or about October 19,2004, two purported shareholder derivative lawsuits were filed against certainof the Company’s officers and directors, naming the Company as a nominaldefendant, in the Superior Court of the State of California for the County ofSan Luis Obispo. These lawsuits were consolidated into one action for allpurposes on March 14, 2005. This suit claims that certain of theseofficers and directors breached their fiduciary duties to the Company’sshareholders and to the Company. The complaint is derivative in nature and doesnot seek relief from the Company. The Board of Directors appointed anindependent committee to investigate the claims asserted in this derivativelawsuit. On July 19, 2005, the court granted the Company’s motion to staythese consolidated actions in favor of a shareholder derivative action to befiled by plaintiffs in the Circuit Court of the State of Oregon for the Countyof Washington. On August 25, 2005, the California plaintiffs filed two newderivative lawsuits in the United States District Court for the District ofOregon. On October 17, 2005, defendants filed a motion to dismiss thesecomplaints for lack of subject matter jurisdiction and failure to state aclaim. In May of 2006, the Board committee, after completing its investigation,concluded that pursuit of the allegations would not be in the best interests ofDigimarc or its shareholders. On August 24, 2006, the court granteddefendants’ motion and dismissed the lawsuit with prejudice. Plaintiffs filed anotice of appeal on September 22, 2006. The briefs to the Ninth Circuitwere completed in June, and the Company anticipates oral argument and adecision in 2008. However, due to the inherent uncertainties of litigation, theCompany cannot accurately predict the ultimate timing or outcome of the matter.

Beginning in May 2001,a number of substantially identical class action complaints alleging violationsof the federal securities laws were filed in the United States District Courtfor the Southern District of 

15

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

New Yorknaming approximately 300 companies, including Digimarc, certain of its officersand directors, and certain underwriters of the Company’s initial publicoffering as defendants. The complaints have since been consolidated into asingle action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-marketsubsequent to the Company’s initial public offering. The Company and certain ofits officers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),however, were dismissed. In June 2003, a committee of the Company’s boardof directors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval. The settlement would haveprovided, among other things, a release of the Company and of the individualdefendants for the alleged wrongful conduct in the amended complaint inexchange for a guarantee from the Company’s insurers regarding recovery fromthe underwriter defendants and other consideration from the Company regardingits underwriters, including agreeing to assign away, not assert, or releasecertain potential claims the Company may have against its underwriters. Theplaintiffs have continued to litigate against the underwriter defendants. Thedistrict court directed that the litigation proceed within a number of “focuscases” rather than in all of the 310 cases that have been consolidated. TheCompany’s case is not one of these focus cases. On October 13, 2004, thedistrict court certified the focus cases as class actions. The underwriterdefendants appealed that ruling, and on December 5, 2006, the Court ofAppeals for the Second Circuit reversed the district court’s classcertification decision. On April 6, 2007, the Second Circuit deniedplaintiffs’ petition for rehearing. In light of the Second Circuit opinion, theCompany has informed the district court that this settlement cannot be approvedbecause the defined settlement class, like the litigation class, cannot becertified. The Company cannot predict whether the Company will be able torenegotiate a settlement that complies with the Second Circuit’s mandate. Dueto the inherent uncertainties of litigation, the Company cannot accuratelypredict the ultimate outcome of the matter.

The Company’s contracts for driver license and other identificationissuance systems and their related products typically include provisionsimposing (i) development, delivery and installation schedules andmilestones, (ii) customer acceptance and testing requirements and (iii) otherperformance requirements. Such provisions are common in large scale governmentcontracts at the state and federal levels. To the extent these provisionsinvolve performance over extended periods of time, there may be increased riskof noncompliance. The Company from time to time experiences delays inidentification system implementation, timely acceptance for identificationsystems programs, concerns regarding identification 

16

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

systemprogram performance, and other contractual disputes. Customers have asserted from time totime, and may in the future assert, claims for compensatory or liquidateddamages or breach of contract, or other claims alleging that the Company hasfailed to meet timing or other delivery requirements and milestones pursuant tothe terms of such contracts. Management believes that these assertionsare often part of the resolution process involving commercial disagreementsover the terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. However,the Company’s failure to meet contractual milestones or other performancerequirements as promised, or to successfully resolve customer disputes, couldresult in the Company incurring liability for damages, as well as increasedcosts, lower margins, or compensatory obligations in addition to other losses,such as harm to the Company’s reputation. Such circumstances could have amaterial adverse effect on the Company’s business and financial results. TheCompany anticipates that future contracts will continue to have such provisionsunless and until industry practices change.

In addition to the Company’snormal price-per-card issuance contracts, the Company occasionally enters intofixed price contracts. Fixed price contracts typically consist of agreements tosell entire systems or portions of a system for an agreed upon price. Thesecontracts normally do not have clauses that allow for recovery of costoverruns. Under fixed price contracts, the Company provides specific tasks fora specific price and are typically paid on a milestone basis. The Company hasexperienced low margins or losses on such contracts in the recent past. Suchcontracts involve greater financial risks because the Company bears the risk ifactual project costs exceed the amounts the Company is paid under thecontracts. A material percentage of the Company’s revenues are derived fromfixed price contracts and the Company’s reliance on fixed price contracts maygrow.

A significant portion of the Company’s business depends on a limitednumber of large, public-sector contracts, which are generally subject totermination for convenience, as determined by the subject agency, or for lackof budgetary appropriation provided for the subject agency. Some governmentcontracts also may be one-time events, such as in the case of some personalidentification systems in non-U.S. markets involving voter registrationprograms. In such cases, the Company may generate substantial revenue that maynot be subject to future renewal. Further, the Company may face competitivebids for a number of the Company’s major accounts in 2007 and 2008. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards.

Certain of the Company’sproduct license and services agreements include an indemnification provisionfor claims from third parties relating to the Company’s intellectual property.Such indemnification provisions are accounted for in accordance with SFAS No. 5,*Accounting for Contingencies*. Todate, there have been no law suits filed or amounts payable under suchindemnification provisions, but from time to time, in the normal course ofbusiness, potential claims may be raised with and reviewed by the Company.

The Company is subjectfrom time to time to other legal proceedings and claims arising in the ordinarycourse of business.Although the ultimate outcome of these matters cannot be determined, managementbelieves that, as of June 30, 2007, the final disposition of theseproceedings will not have a material adverse effect on the consolidatedfinancial position, results of operations, or liquidity of the 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

Company.No accrual has been recorded because the amounts are not probable or reasonablyestimatable in accordance with SFAS No. 5, *Accountingfor Contingencies*.

A portion of the Company’srevenue each year is generated from licensing of technology. In the competitiveenvironment in which the Company operates, product generation, development andmarketing processes relating to technology are uncertain and complex, requiringaccurate prediction of demand as well as successful management of variousdevelopment risks inherent in technology development. In light of thesedependencies, it is possible that failure to successfully manage future changesin technology with respect to the Company’s technology could have a long-termimpact on the Company’s growth and results of operations.

*Performance Bonds*

Some governmentalauthorities require performance bonds that the Company is obligated to maintainduring the life of the contract. Often, the terms of these bonds require thatthe Company obtain letters of credit to secure the Company’s obligations underthe bonds. The letters of credit may in turn require us to maintain largerestricted cash reserves as security, reducing the Company’s ability to usethese funds for the Company’s other business purposes. Even with theavailability of such cash reserve guarantees, the Company may not be able toobtain such performance bond underwriting at a favorable rate or at all. TheCompany’s failure to be able to provide such performance bonds may preclude us from bidding on new government contracts ormaintaining the Company’s existing contracts for their full terms. In addition,these performance bonds may provide for security interests covering theCompany’s receivables or other assets, which could cause additional financingto be more difficult or more expensive to obtain. The size, nature and purposeof, and the risks and uncertainties associated with, public sector contractscan potentially cause the Company’s quarterly results to fluctuate andanticipated revenue to decrease significantly.

**6.**                 Recent AccountingPronouncements

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,*which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair value. Thisstatement does not require any new fair value measurements, but providesguidance on how to measure fair value by providing a fair value hierarchy usedto classify the source of the information. SFAS No. 157 is effective forfirst fiscal year beginning after November 15, 2007. The Company iscurrently assessing the potential impact that adoption of this standard willhave on the Company’s financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Option for theFinancial Assets and Financial Liabilities,*which permits entitiesto choose to measure certain financial assets and liabilities at fair value.SFAS No. 159 is effective for first fiscal year beginning after November 15,2007. The Company has not determined whether it will adopt the fair valueoption method permitted by SFAS No. 159.

**7.**                 RevenueRecognition

The Company’s revenue is comprised of service revenue fromits government-issued credentials systems and related maintenance, installationand system integration services as well as product and 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

subscription revenue,including hardware and software sales, royalties and revenues from thelicensing of digital watermarking products and related authentication services.The Company’s revenue recognition policy follows SEC SAB No. 104 *“Revenue Recognition”,*Statement of Position (“SOP”) No. 97-2,*“Software Revenue Recognition,”*asamended by SOP No. 98-9, *“Modification of SOP No. 97-2,Software Recognition, With Respect to Certain Transactions,”*SOP 81-1*“Accounting for the Performance of Construction Type and CertainProduction-Type Contracts,”*and Emerging Issues Task Force (“EITF”)Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables.*

Certain customer arrangements encompass multiple deliverables, such as software, hardware sales, consumables sales,maintenance fees, and software development fees. The Company accounts for thesearrangements in accordance with EITF Issue No. 00-21, *Revenue Arrangements with Multiple Deliverables*. If thedeliverables meet the criteria in EITF Issue No. 00-21, thedeliverables are divided into separate units of accounting and revenue isallocated to the deliverables based on their relative fair values. The criteriaspecified in EITF Issue No. 00-21 are as follows (i) thedelivered item has value to the customer on a stand-alone basis, (ii) thereis objective and reliable evidence of the fair value of the undelivered item,and (iii) if the arrangement includes a general right of return relativeto the delivered item, delivery or performance of the undelivered item isconsidered probable and substantially in the control of the vendor. For theCompany’s purposes, fair value is generally defined as the price at which acustomer could purchase each of the elements independently from other vendorsor as the price that the Company has sold the element separately to anothercustomer. Management applies judgment to ensure appropriate application of EITFIssue No. 00-21, including value allocation among multiple deliverables, determination of whether undelivered elements areessential to the functionality of delivered elements and timing of revenuerecognition, among others.

AICPA SOP No. 98-9 requires that revenue berecognized using the “residual method” in circumstances when vendor specificobjective evidence (“VSOE”) exists only for undelivered elements. Under theresidual method, revenue is recognized as follows: (1) the total fair valueof undelivered elements, as indicated by vendor specific objective evidence, isdeferred and subsequently recognized in accordance with the relevant sectionsof AICPA SOP No. 97-2, and (2) the difference between the totalarrangement fee and the amount deferred for the undelivered elements isrecognized as revenue related to the delivered elements.

Applicable revenuerecognition criteria is considered separately for each separate unit ofaccounting as follows:

·       Revenuefrom the Company’s government-issued credential systems is generally billed andrecognized on a per card produced basis. The Company recognizes revenue onthese contracts based on the actual monthly production, if available, and inlimited situations on estimated volume information. When actual productioninformation becomes available, typically within one month, the Company billsthe customer accordingly and any differences from the estimates are recognizedin the month the billing occurs. Differences to date have not been significant.

·       Revenuerelated to an enhancement of, or upgrade to, an existing system is generallydeferred and recognized over the remaining life of the contract. However, ifVSOE can be established for the 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

delivered items andtitle passes to those items and all obligations are completed, then the Companyrecognizes revenue at acceptance.

·       Revenuefor sales of consumables and equipment not related to a driver licenseproduction contract is recognized when the products have been shipped,ownership has been transferred, evidence of an arrangement exists, the salesprice is fixed and determinable, and collectibility is reasonably assured. Whensignificant obligations remain after products are delivered, such as for systemintegration or customer acceptance, revenue and related costs are deferreduntil such obligations are fulfilled.

·       Revenuefrom professional services arrangements is generally determined based on timeand material or a cost plus a profit margin measure. Revenue for professionalservices is recognized as the services are performed. Progress towardscompletion is measured using costs incurred compared to the budgeted amountscontained in the contract. Losses on contracts, if any, are provided for in theperiod in which the loss becomes determinable. Billing for services renderedgenerally occurs within one month following when the services are provided.

·       Maintenancerevenue is recognized when the maintenance amounts owed to the Company havebeen earned, are determinable, and collection is probable. Maintenancecontracts are, at times, paid in advance and revenue is recognized ratably on astraight-line basis over the term of the service period.

·       Royaltyrevenue is recognized when the royalty amounts owed to the Company have beenearned, are determinable, and collection is probable. Subscriptions are paid inadvance and revenue is recognized ratably over the term of the subscription.These revenues include the licensing of digital watermarking products andservices for use in authenticating documents, detecting fraudulent documentsand deterring unauthorized duplication or alteration of high-value documents,for use in communicating copyright, asset management and business-to-businessimage commerce solutions, and for use in connecting analog media to a digital environment.

·       Softwarerevenue is recognized in accordance with AICPA SOP No. 97-2, asamended by AICPA SOP No. 98-9, *Modificationof SOP 97-2*, *With Respectto Certain Transactions*. Revenue for licenses of the Company’ssoftware products is recognized upon the Company meeting the followingcriteria: persuasive evidence of an arrangement exists; delivery has occurred;the vendor’s fee is fixed or determinable; and collectibility is probable.Software revenue is recognized over the term of the license or upon deliveryand acceptance if the Company grants a perpetual license with no furtherobligations.

·       TheCompany records revenue from certain customers upon cash receipt as a result ofcollectibility not being reasonably assured.

·       Revenueearned which has not been invoiced is classified as unbilled trade receivables,which is included in the balance of trade accounts receivable, net in theconsolidated balance sheets. Billing for services rendered generally occurswithin one month following when the services are provided.

·       Deferred revenue consistsof billings and/or payments received in advance for professional services,subscriptions and hardware for which revenue has not been earned.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

**8.**                 Trade AccountsReceivable

Tradeaccounts receivable are recorded at the invoiced amount and do not bearinterest. Revenue earned that has not been invoiced is classified as unbilledtrade receivables in the consolidated balance sheets.

| ** **                       | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Billed trade  receivables        |       | $                       | 9,795      |                        |       | $ | 8,990 |   |   |
| Unbilled trade  receivables      |       | 6,750                   |       |                        | 5,599      |   |   |
| Trade accounts  receivable       |       | 16,545                  |       |                        | 14,589     |   |   |
| Allowance for  doubtful accounts |       | (187                    | )          |                        | (186       | ) |   |
| Trade accounts  receivable, net  |       | $                       | 16,358     |                        |       | $ | 14,403 |   |   |

 

Trade accounts receivable, net includes $1.5 millionat June 30, 2007 and $2.2 million at December 31, 2006 of deferredrevenue, billed in accordance with the provisions of the contracts with theCompany’s customers.

The allowance for doubtfulaccounts is the Company’s best estimate of the amount of probable credit lossesin the Company’s existing accounts receivable. The Company determines theallowance based on historical write-off experience and current information. TheCompany reviews its allowance for doubtful accounts monthly. Account balancesare charged off against the allowance after all means of collection have beenexhausted and the potential for recovery is considered remote. The Company doesnot have an off-balance sheet credit exposure related to its customers.

*Major Customers*

No single customer accountedfor more than 10% of the Company’s trade and unbilled accounts receivable, netat June 30, 2007 and at December 31, 2006.

**9.**                 Inventory

Inventoryconsists primarily of the consumable materials used to manufactureidentification cards, such as inks, card stock, laminates, and adhesives(considered raw material), equipment held for sale (considered finished goods)and deferred contract costs (considered either finished goods or in-process).Inventories are valued on a first-in, first-out basis at the lower of cost ormarket value (net realizable value).

| ** **                                  | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Equipment and  deferred contract costs      |       |                    | $          | 1,599                       |       |   |   | $ | 1,046 |   |   |
| Consumable  materials                       |       |                    | 5,545      |                        |       |   | 5,654 |   |   |
| Inventory                                   |       |                    | 7,144      |                        |       |   | 6,700 |   |   |
| Reserve for slow  moving and obsolete items |       |                    | (114       | )                           |       |   | (100 | ) |   |
| Inventory, net                              |       |                    | $          | 7,030                       |       |   |   | $ | 6,600 |   |   |

 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

While the Company does notcurrently expect to be able to sell or otherwise use the reserved inventory onhand based upon the Company’s forecast and backlog, it is possible that acustomer or customers will decide in the future to purchase a portion of thereserved inventory.

**10.**          IncomeTaxes

*Provision for IncomeTaxes.*   The provision for income taxes reflectsexpected tax expense in certain foreign jurisdictions. The Company has recordeda full valuation allowance against the Company’s domestic net deferred taxassets at June 30, 2007 due to the uncertainty of realization of theCompany’s domestic net operating losses. The Company did record a foreigndeferred tax asset of $124 at March 31, 2007 that it believes is morelikely than not to be realized. The Company will continue to evaluate therealizability of the Company’s domestic and other foreign net deferred taxassets and may record additional benefits in future earnings if the Companydetermines the realization of these assets is more likely than not.

The Company adopted theprovisions of FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement 109*(“FIN 48”), on January 1, 2007. The Company’s consolidated financialstatements for 2007 reflect the impact of FIN 48, but the consolidated financialstatements for 2006 have not been restated to reflect, and do not include, theimpact of FIN 48.

As a result of theimplementation of FIN 48, the Company recognized a $145 reduction in theCompany’s net liability for uncertain tax positions previously recorded, whichwas accounted for as an adjustment to the January 1, 2007 retainedearnings balance. As part of the FIN 48 implementation, the Company adopted apolicy to record accrued interest and penalties associated with uncertain taxpositions in income tax expense in the accompanying consolidated statements ofoperations. On initial adoption of FIN 48, the Company recognized an additional$52 of accrued interest and penalties associated with uncertain tax positionsin prior years, which reduced the overall adjustment to the January 1,2007 retained earnings.

Asummary reconciliation of the Company’s uncertain tax positions is listedbelow:

| Beginning balance  at January 1, 2007                           |   | $    | 289    |   |
|----------------------------------------------------------------------|--------|------|--------|--------|
| Additions for tax  positions of prior years (interest and penalties) |   | 52   |   |
| Reductions for  net tax positions of prior years                     |   | (197 | )      |
| Revised balance at  January 1, 2007                             |   | $    | 144    |   |

 

The Company’s tax yearsfor its foreign jurisdictions are subject to review for up to seven years afterfiling tax returns. Federal, state and foreign loss carryforwards and creditscan generally be adjusted by taxing authorities at any time in the future. Theentire amount of the uncertain tax positions if recognized would affect theeffective tax rate.

**11.**          Software DevelopmentCosts

Under SFAS No. 86, *Accounting for the Cost of Computer Software to Be Sold, Leased, orOtherwise Marketed,*software development costs are to be capitalizedbeginning when a product’s technological feasibility has been established andending when a product is made available for general release to 

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

customers. To date, theestablishment of technological feasibility of the Company’s products hasoccurred shortly before general release and, therefore, software developmentcosts qualifying for capitalization have been immaterial. Accordingly, theCompany has not capitalized any software development costs and has charged allsuch costs to research and development expense.

Internal use softwaredevelopment costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred inthe preliminary project stage are expensed as incurred and costs incurred inthe application development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years. Costs incurred in thepost-implementation stage are expensed as incurred. Internal use softwaredevelopment projects that have been capitalized to date relate to cardmanufacturing and control systems software.

**12.**          Related PartyTransactions

During the three- andsix-month periods ended June 30, 2007, the Company recognized revenue of$232 and $454, respectively, from a holder of common stock pursuant to alicense agreement. In addition the Company recognized revenue of $120 and $245for the three- and six-month periods ended June 30, 2006, respectively,from this stockholder. Net accounts receivable from this customer was $94 at June 30,2007 and $329 at December 31, 2006. Deferred revenue from this customerwas $188 at June 30, 2007 and $288 at December 31, 2006.

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**DIGIMARC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except share and per share data) (UNAUDITED)**

**13.**          Quarterly SelectedFinancial Information

Thefollowing table shows the quarterly reported numbers. 

| **Quarter ended:**                   | ** **   | ** ** | ** **   | **March 31** | ** ** | **June 30** | ** **   | **September 30** | ** **   | **December 31** | ** ** |
|-------------------------------------------|--------------|------------|--------------|-------------------|------------|------------------|--------------|-----------------------|--------------|----------------------|------------|
| ***2007***                                | *** *** |       | *** *** | *** ***      |       | *** ***     | *** *** |                  | *** *** | *** ***         |       |   | *** *** | *** *** |   |
| Total revenue                             |         |       | $            | 26,846            |       |             | 27,364       |                  |         |                 |       |   |   |   |   |   |
| Total cost of  revenue                    |         |       | 16,815       |              |       | 17,077           |         |                  |         |                 |       |   |   |   |   |
| Gross profit                              |         |       | 10,031       |              |       | 10,287           |         |                  |         |                 |       |   |   |   |   |
| Sales and  marketing                      |         |       | 4,277        |              |       | 4,365            |         |                  |         |                 |       |   |   |   |   |
| Research,  development and engineering    |         |       | 2,042        |              |       | 1,883            |         |                  |         |                 |       |   |   |   |   |
| General and  administrative               |         |       | 4,098        |              |       | 3,809            |         |                  |         |                 |       |   |   |   |   |
| Amortization of  intangibles              |         |       | 500          |              |       | 509              |         |                  |         |                 |       |   |   |   |   |
| Intellectual  property                    |         |       | 499          |              |       | 476              |         |                  |         |                 |       |   |   |   |   |
| Restructuring  charges, net               |         |       | —       |              |       | —           |         |                  |         |                 |       |   |   |   |   |
| Operating income  (loss)                  |         |       | (1,385       | )                 |       | (755             | )            |                  |         |                 |       |   |   |   |   |
| Net income (loss)                         |         |       | (1,022       | )                 |       | (495             | )            |                  |         |                 |       |   |   |   |   |
| Net income (loss)  per share—basic   |         |       | (0.05        | )                 |       | (0.02            | )            |                  |         |                 |       |   |   |   |   |
| Net income (loss)  per share—diluted |         |       | (0.05        | )                 |       | (0.02            | )            |                  |         |                 |       |   |   |   |   |
| ***2006***                                | *** *** |       | *** *** | *** ***      |       | *** ***     | *** *** |                  | *** *** | *** ***         |       |   | *** *** | *** *** |   |
| Total revenue                             |         |       | $            | 27,193            |       |             | $            | 24,907                |         |                 | $          | 26,733 |   |   |   | $ | 25,414 |   |   |
| Total cost of  revenue                    |         |       | 19,648       |              |       | 16,677           |         |                  | 16,719       |                 |       |   | 15,725 |   |   |
| Gross profit                              |         |       | 7,545        |              |       | 8,230            |         |                  | 10,014       |                 |       |   | 9,689 |   |   |
| Sales and  marketing                      |         |       | 4,539        |              |       | 4,685            |         |                  | 3,440        |                 |       |   | 3,691 |   |   |
| Research,  development and engineering    |         |       | 3,236        |              |       | 2,994            |         |                  | 2,158        |                 |       |   | 1,881 |   |   |
| General and  administrative               |         |       | 5,210        |              |       | 4,172            |         |                  | 3,684        |                 |       |   | 4,418 |   |   |
| Amortization of  intangibles              |         |       | 573          |              |       | 550              |         |                  | 537          |                 |       |   | 511 |   |   |
| Intellectual  property                    |         |       | 431          |              |       | 481              |         |                  | 460          |                 |       |   | 402 |   |   |
| Restructuring charges,  net               |         |       | —       |              |       | 547              |         |                  | —       |                 |       |   | — |   |   |
| Operating income  (loss)                  |         |       | (6,444       | )                 |       | (5,199           | )            |                  | (265         | )                    |       |   | (1,214 | ) |   |
| Net income (loss)                         |         |       | (6,172       | )                 |       | (4,869           | )            |                  | 213          |                 |       |   | (912 | ) |   |
| Net income (loss)  per share—basic   |         |       | (0.30        | )                 |       | (0.24            | )            |                  | 0.01         |                 |       |   | (0.04 | ) |   |
| Net income (loss) per  share—diluted |         |       | (0.30        | )                 |       | (0.24            | )            |                  | 0.01         |                 |       |   | (0.04 | ) |   |
|                                           |              |            |              |                   |            |                  |              |                       |              |                      |            |  |  |  |  |  |  |  |  |  |  |

 

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

*The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements relating to future events or thefuture financial performance of Digimarc, which involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements. Please see the discussionregarding forward-looking statements included in this quarterly report on Form 10-Qunder the caption “Safe Harbor Statement under the Private SecuritiesLitigation Reform Act of 1995.”*

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readersare also urged to carefully review and consider the various disclosures made byus which attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made in Item 1A (RiskFactors) of this Form 10-Q and in the audited consolidated financialstatements and related notes included in our Annual Report on Form 10-K forthe year ended December 31, 2006 filed on March 8, 2007, and otherreports and filings made with the Securities and Exchange Commission (“SEC”).*

**Overview**

Digimarc (“Digimarc,” “the Company,” “our” or “we”) isa supplier of secure identification documents (“IDs”) and digital watermarkingtechnology for use in media management. Our secure ID solutions enablegovernments and businesses around the world to enhance traffic safety andnational security, combat identity theft and fraud and facilitate theeffectiveness of voter identification programs. We are also a pioneer andleading owner of intellectual property in a signal processing technologyinnovation known as “digital watermarking,” which allows imperceptible digital information to be embedded in allforms of digitally designed, produced or distributed media content, includingpersonal identification documents, financial instruments, photographs, movies,music, television and product packages. The embedded data within various typesof media content can be detected and read by software or hardware detectors inpersonal computers and other digital devices.

The majority of ourrevenue is generated pursuant to long-term contracts (normally five or moreyears) with government agencies—primarily state government agencies responsiblefor driver license issuance, a consortium of central banks, and nationalgovernments of foreign countries. These customers rely on our expertise insystems design, integration and materials science, and proprietary technologiessuch as digital watermarking, to implement issuance systems and processes thatimprove the security of identity documents and banknotes. The remainder of ourrevenue is generated through commercial applications of our digitalwatermarking and related technologies, primarily from patent and technology licensefees paid by business partners.

*Secure ID Solutions*

We issue more than 60 million IDs annually and are theleading supplier of government-issued citizen IDs in North America, producingmore than two-thirds of all driver licenses issued in the United States (the “U.S.”). We have also provided secure IDsolutions to approximately 25 foreign governments.

In North America, most of our revenue is generatedthrough the issuance of state driver licenses and other IDs and is paid in theform of a fixed price per credential issued. In North America, we are generallya prime contractor, providing full issuance systems to federal, state, and provincialdepartments of motor vehicles or other government issuing authorities. Thesesystems typically include hardware (including specialized cameras, printers,personal computers and servers), software, consumable supplies (such asribbons, blank or preprinted card materials and laminated and relatedconsumables) and ongoing support services. These systems may also involve softwareand/or hardware development, integration services, and implementation services.When we provide a full issuance system to a customer, we generally retain titleto 

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all equipment, softwareand consumables associated with the system and are responsible for maintainingthe system over the contractual period.

In the United States, Federal legislation, such as thefederal legislation passed in May 2005 known as the REAL ID Act (the “REALID Act”) imposes certain federal requirements for State-issued driver licenses.These requirements will increase the security of driver licenses, requirevalidation of applicants prior to issuance, and mandate certain changes inbusiness processes relating to security and the sharing and storage of data.

The Company’s strategy regarding the anticipatedopportunities relating to the REAL ID Act is to provide solutions that embodythe key elements of the REAL ID Act: identity verification; document scanningand archiving; individual background checking; data and image sharing; andmigration to and production of REAL ID Act compliant driver license documents.These solutions are available to customers as upgrades or complete issuancesystems. Digimarc will also offer the States program management assistance tosafely migrate to REAL ID Act compliance.

In markets outside of North America, we generallyprovide driver license, national identification and voter identificationsystems, services, and components in partnership with local card producers,security printers, system integrators and others. In these markets, we mayserve as prime contractor or sub-contractor, depending on the circumstances. Asa sub-contractor, we generally are responsible for delivering hardware,software, or consumables, and some degree of integration services to the primecontractor; whereas as a prime contractor, we are responsible for integratingall components of the system to the customer’s specifications.

Outside of North America, our revenues are typicallygenerated from sales of equipment, software and/or consumables to governmentagencies or their prime contractors. These sales may occur at irregularintervals, carry relatively low margins and cause variations in quarterlyrevenue and gross profit trends. We enter into low margin contracts and transactionsfrom time to time to maintain market presence and build relationships withcustomers and business partners, and often transition to more profitabledigital technologies over time. Due to the nature of such internationalprograms and customers, the timing of these sales is less predictable than ourservice revenues provided by domestic customers and, consequently,international sales can occur unevenly during the course of a year.

*Seasonality.**  *We have observed seasonality in our U.S. driverlicense issuance revenues, with larger revenues in the second and third quarterof the year, and generally lower revenues in the first and fourth quarters. Thefourth quarter is usually the lowest quarter each year. We use the straightline method of depreciation and amortization for program-related assets. Thecombination of the seasonality of our revenues and straight-line depreciationand amortization can cause significant variations in quarterly gross margintrends, generally increasing margins in the second and third quarters when ourissuance revenues are higher and decreasing margins in the first and fourthquarters when our issuance revenues are typically lower.

*Variabilityof Capitalized and Deferred Costs.**  *Ourdriver license and ID issuance programs generally require significant cost todevelop, build and deploy new systems. These new systems may be sold outrightupon completion or used in generating recurring revenue in the future. Certainlabor and other costs relating to these new systems may be deferred andexpensed upon completion, or capitalized and amortized over the life of therelevant contract, rather than expensed in the quarter in which they areincurred. We may experience variability in our operating income, depending onthe extent to which we are able to capitalize or defer these costs. If we areable to win new business, our capitalized or deferred costs and operatingincome may increase as a result of an increased allocation of labor resourcesto capitalized or deferred items. On the other hand, if we experience delays orreductions in new business, our capitalized or deferred costs may decrease,which may result in an increase in operating expenses for the relevant quarterand a decrease in operating income.

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*Depreciation.**  *Starting January 1, 2006, we changed our policyfor depreciating fixed assets that were specifically used to provide servicesunder long-term contracts to the shorter of the original contract term plus2.75 years or estimated useful life. Through December 31, 2005, wedepreciated these assets over the shorter of the original contract term orestimated useful life. This change in estimate was supported by an analysis wecompleted during the first quarter of 2006 which showed that historically 95%of contracts were extended beyond the original contract term, that the averagecontract had at least two contract extensions during its life and that theseextensions added on average 2.75 years to the length of the contracts’ originalterms.

Since contract-specificprogram assets are tracked on a contract basis, the finding that contracts areroutinely extended beyond the original term and that these extensions are notgenerally accompanied by significant incremental capital investment indicatesthat the useful life of contract-related assets is generally longer than theoriginal term of the contract. Given these findings, we concluded that it wasappropriate to change the estimated useful lives of these assets for purposesof depreciation. In addition, the change in useful lives achieves a bettermatching of the utility of these assets with the resulting revenues. For theyear ended December 31, 2006, we performed an updated analysis on contractspecific assets which resulted in no change to our previous conclusions. Wewill continue to analyze the useful lives of contract specific assets in futureperiods.

*Backlog*

Based on projected government-issued credentialproduction volumes and other commitments we have for the periods under contractwith our respective customers, we anticipate our current contracts as of June 30,2007 will generate approximately $225 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectmore than $40 million of this amount to be recognized as revenue during theremainder of 2007. This amount includes production volumes reasonably expectedto be achieved under currently effective contracts and government orders thatare firm but not yet funded.

Some factors thatlead to increased backlog are:

·       competitivebid wins,

·       renewalswith current customers,

·       add-onsales to current customers, and

·       contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Some factors thatlead to decreased backlog are:

·       recognitionof revenue associated with backlog currently in place,

·       lowbid activity,

·       contractswith shorter contractual periods replacing contracts with longer contractualperiods, and

·       therevenue model utilized for a particular customer (e.g., a “price-per-card”model with a large associated backlog vs. a “hardware and consumables” modelwith a small associated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period.

Over the next few years, we anticipate several Statesto request bids on their driver license issuance system programs. This periodof expected high bid activity could lead to additional backlog if we aresuccessful with our bids. Another factor that could affect backlog in this periodis the revenue model utilized for a particular customer. From time to time, wehave sales to our customers that are not made on 

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a price-per-card basis,but instead include hardware and consumable sales. Although these types ofrevenue models are positive growth indicators for our business, they can leadto lower reported backlog.

There is no assurance thatour backlog will result in actual revenue in any particular period, because theorders, awards and contracts included in our backlog may be subject tomodification, cancellation or suspension. We may not realize revenue on certaincontracts, orders or awards included in our backlog or the timing of suchrealization may change.

*Restructuring*

During the last half of2005 and continuing during 2006, the Company restructured its operations toimprove productivity and reduce fixed costs. During the second quarter of 2006we accelerated those activities significantly, resulting in a reduction of ourworkforce by nearly 20%. Overall, our workforce was reduced by over 30% sincemid 2005. Our actions included the redeployment and reallocation of resourcesto better align with our operating strategies.

**AdditionalInformation**

A more detailed discussionof our business is contained in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2006.

**Critical AccountingPolicies and Estimates**

The preparation of consolidated financial statementsin accordance with accounting principles generally accepted in the UnitedStates of America requires us to make estimates and judgments that affect thereported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to bad debts, inventories,intangible assets, income taxes, restructuring, long-term service contracts,warranties, investments, contingencies and litigation, and inputs related tostock-based compensation calculations. We base our estimates on historicalexperience and on various other assumptions we believe to be reasonable underthe circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions.

Certain of our accounting policies require higherdegrees of judgment than others in their application. These include revenuerecognition on long-term service contracts, impairments and estimation ofuseful lives of long-lived assets, inventory valuation, reserves foruncollectible accounts receivable, contingencies and litigation, and inputs relatedto stock-based compensation calculations. We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our consolidated financial statements:

**Revenuerecognition on long-term service contracts:****  **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.These amounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting our financial results,our practice is to compare the actual production volumes to estimatedproduction volumes and adjust revenue amounts as necessary. Any estimatedamounts are included in unbilled receivables on the balance sheet until the actualproduction information is available and the billing occurs. Any estimationprocess involves inherent risk. We reduce the inherent risk relating toproduction estimation through our approval and 

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monitoring processesrelated to accounting estimates. We also evaluate contracts for multipleelements and account for these items under the appropriate accountingliterature.

Revenue from professional services arrangements isgenerally determined based on time and material or a cost plus a profit marginmeasure. Revenue for professional services is recognized as the services areperformed. Losses on contracts, if any, are provided for in the period in whichthe loss becomes determinable. Billing for services rendered generally occurswithin one month following when the services are provided. Revenue earned whichhas not been invoiced is classified as unbilled trade receivables in theconsolidated balance sheets.

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically assess long-lived assetsfor impairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable, in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets.* This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised values,depending on the nature of the asset. Also, we periodically review the usefullives of long-lived assets whenever events or changes in circumstances indicatethat the useful life may have changed. If the estimated useful lives of suchassets do change, we adjust the depreciation or amortization period to a shorteror longer period, based on the circumstances identified.

**Inventoryvaluation:****  **Inventoryconsists primarily of consumable supplies that are used in the production ofdriver licenses and products held for resale to customers. We value inventoryat the lower of cost or market value (which lower amount is the net realizablevalue). We reduce the value of our inventory for estimated obsolescence orunmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand andmarket conditions. If actual market conditions are less favorable than thoseprojected by management, additional inventory write-downs may berequired.

**Reservesfor uncollectible accounts receivable:****  **We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust whenappropriate, our allowance for doubtful accounts on at least a quarterly basis.If the financial condition of our customers were to deteriorate, resulting inan impairment of their ability to make payments, additional allowances may berequired.

**Contingencies and Litigation:**   We periodically evaluate all pending orthreatened contingencies or commitments, if any, that are reasonably likely tohave a material adverse effect on our operations or financial position. Weassess the probability of an adverse outcome and determine if it is remote,reasonably possible or probable as defined in accordance with the provisions ofSFAS No. 5, *Accounting for Contingencies*. Ifinformation available prior to the issuance of our financial statementsindicates that it is probable that an asset has been impaired or a liabilityhas been incurred at the date of our financial statements, and the amount ofthe loss, or the range of probable loss can be reasonably estimated, then suchloss is accrued and charged to operations. If no accrual is made for a losscontingency because one or both of the conditions pursuant to SFAS No. 5are not met, but the probability of an adverse outcome is at least reasonablypossible, we will disclose the nature of the 

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contingency and provide an estimate of the possible loss or range ofloss, or state that such an estimate cannot be made.

**Stock-Based Compensation:**   We account for stock-based compensationin accordance with SFAS 123(R), *Share-Based Payment(Revised 2004)*, which requires the measurement and recognition ofcompensation for all stock-based awards made to employees and directorsincluding stock options and employee stock purchases under a stock purchaseplan based on estimated fair values. We use the Black-Scholes option pricingmodel as our method of valuation for stock options and employee stockpurchases. Our determination of the fair value of these stock-based awardson the date of grant using an option pricing model is affected by our stockprice as well as assumptions regarding a number of highly complex andsubjective variables. These variables include, but are not limited to, theexpected life of the award, our expected stock price, volatility over the termof the award and actual and projected exercise behaviors. Although the fairvalue of these stock-based awards is determined in accordance with SFAS 123(R),the Black-Scholes option pricing model requires the input of highly subjectiveassumptions, and other reasonable assumptions could provide differing results. Thefair value of restricted stock awards granted is based on the fair market valueof the Company’s common stock on the date of the grant (measurement date), andis being recognized over the vesting period of the related restricted stockusing the straight-line method. The fair value of performance vesting share awardsgranted is based on a Monte Carlo valuation model that resulted in a factorapplied to the fair market value of the Company’s common stock on the date ofthe grant (measurement date), and is being recognized over the derived serviceperiod using the straight-line method.

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**Results ofOperations**

Thefollowing table presents our consolidated statements of operations data for theperiods indicated as a percentage of total revenue. Unless otherwise indicated,all references to the three and six-month periods relate to the three- andsix-month periods ended June 30, 2007 and all changes discussed withrespect to such period reflect changes as compared to the three- and six-monthperiods ended June 30, 2006.

| ** **                                       | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2007**                                              | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue:                                         |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                  | 82         | %                                                   |       |   | 82 | % |   |   | 81 | % |   |   | 82 | % |   |
| Product and subscription                         |       |                                                  | 18         |                                                |       |   | 18 |   |   |   | 19 |   |   |   | 18 |   |   |
| Total revenue                                    |       |                                                  | 100        |                                                |       |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                                                  | 55         |                                                |       |   | 60 |   |   |   | 55 |   |   |   | 62 |   |   |
| Product and subscription                         |       |                                                  | 7          |                                                |       |   | 7 |   |   |   | 8 |   |   |   | 8 |   |   |
| Total cost of revenue                            |       |                                                  | 62         |                                                |       |   | 67 |   |   |   | 63 |   |   |   | 70 |   |   |
| Gross profit                                     |       |                                                  | 38         |                                                |       |   | 33 |   |   |   | 37 |   |   |   | 30 |   |   |
| Operating  expenses:                             |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                                                  | 16         |                                                |       |   | 19 |   |   |   | 15 |   |   |   | 17 |   |   |
| Research, development and engineering            |       |                                                  | 7          |                                                |       |   | 12 |   |   |   | 7 |   |   |   | 12 |   |   |
| General and administrative                       |       |                                                  | 14         |                                                |       |   | 17 |   |   |   | 15 |   |   |   | 18 |   |   |
| Amortization of intangibles                      |       |                                                  | 2          |                                                |       |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |
| Intellectual property                            |       |                                                  | 2          |                                                |       |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |
| Restructuring charges, net                       |       |                                                  | 0          |                                                |       |   | 2 |   |   |   | 0 |   |   |   | 1 |   |   |
| Total operating expenses                         |       |                                                  | 41         |                                                |       |   | 54 |   |   |   | 41 |   |   |   | 52 |   |   |
| Operating income (loss)                          |       |                                                  | (3         | )                                                   |       |   | (21 | ) |   |   | (4 | ) |   |   | (22 | ) |   |
| Other income  (expense):                         |       |                                                  |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                  |       |                                                  | 1          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                 |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Other                                            |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Total other income, net                          |       |                                                  | 1          |                                                |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                                                  | (2         | )                                                   |       |   | (20 | ) |   |   | (3 | ) |   |   | (21 | ) |   |
| Provision for  income taxes                      |       |                                                  | 0          |                                                |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                                                  | (2         | )%                                                  |       |   | (20 | )% |   |   | (3 | )% |   |   | (21 | )% |   |

 

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Revenue

| ** **                        | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|----------------------------|------------|--------------|------------|--------------|------------|
| ** **                        | ** ** | **June 30,**            | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**          | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                        | ** ** | **2007**                     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**             | ** ** | **2007**     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                        | ** ** | **(in 000’s)**     | ** ** |
| Revenue:                          |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | $                            | 22,538     |         | $          | 20,519         |       |                       | $          | 2,019        |       |         |       | 10 | % |   | $ | 43,837 |   | $ | 42,809 |   |   | $ | 1,028 |   |   |   | 2 | % |   |
| Product and subscription          |       | 4,826                        |       | 4,388        |       |           | 438        |                       |       |         | 10         | %            |       | 10,373 |   | 9,291 |   |   | 1,082 |   |   |   | 12 | % |   |
| Total                             |       | $                            | 27,364     |         | $          | 24,907         |       |                       | $          | 2,457        |       |         |       | 10 | % |   | $ | 54,210 |   | $ | 52,100 |   |   | $ | 2,110 |   |   |   | 4 | % |   |
| Revenue (as % of total  revenue): |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                           |       | 82                           | %          | 82           | %          |           |       |                       |       |         |       |         |       | 81 | % | 82 | % |   |   |   |   |   |   |   |   |
| Product and subscription          |       | 18                           | %          | 18           | %          |           |       |                       |       |         |       |         |       | 19 | % | 18 | % |   |   |   |   |   |   |   |   |
| Total                             |       | 100                          | %          | 100          | %          |           |       |                       |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

*Service.*   Service revenue consists primarilyof:

·       cardproduction on a price-per-card basis,

·       softwaredevelopment services, and

·       hardwareand software maintenance.

The majority of service revenue arrangements aretypically structured as price-per-card product agreements, time and materialsconsulting agreements, or fixed price consulting agreements.

Service revenue increased for the three-month periodended June 30, 2007 compared to the corresponding three-month period endedJune 30, 2006 primarily due to increased service revenue from our Mexicooperation, which experienced a production hiatus during the 2006 nationalelections, and higher production revenues in our Canada operations from theimplementation of services to several provinces under our Atlantic Canadacontract which was signed in 2006. Offsetting these increases were lowerrevenues due to a combination of price and volume mix from various states.

The increase in service revenue for the six-monthperiod ended June 30, 2007 compared to the corresponding six-month periodended June 30, 2006 was due primarily to increased project work from theconsortium of central banks, increased revenue following the hiatus in ourMexico plant. These increases were offset by lower production volumes fromHaiti’s voter identification project and lower revenue from Latvia, both ofwhich were non-recurring in nature, and the negative impact of the change incertain states’ driver license renewal periods.

*Productand subscription.  *Product revenue consistsprimarily of the sale of equipment and consumables related to identificationcard production systems and software licenses that are variable in nature andoccur from time to time. Subscription revenue consists primarily of royaltyrevenue from our intellectual property licenses and the sale of our web-basedsubscriptions related to various software products, both of which are morerecurring in nature. Revenues from our licensing products have minimalassociated costs and are nearly all margin.

Product and subscription revenue increased for thethree-month period ended June 30, 2007 compared to the correspondingthree-month period ended June 30, 2006 primarily due to increased salesfrom the District of Columbia, Russia and Mozambique. These increases wasoffset by lower revenues from other international customers that occur fromtime to time.

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The increase in productand subscription revenue between the six-month period ended June 30, 2007and the corresponding six-month period ended June 30, 2006 was dueprimarily to additional payments from a cash basis customer and a net increasein non-recurring sales to various international customers.

Revenueby Geography

| ** **                        | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|-----------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|----------------------------|------------|--------------|------------|--------------|------------|
| ** **                        | ** ** | **June 30,**            | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**          | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                        | ** ** | **2007**                     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**             | ** ** | **2007**     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                        | ** ** | **(in 000’s)**     | ** ** |
| Revenue by geography:             |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                          |       | $                            | 21,219     |         | $          | 21,112         |       |                       | $          | 107          |       |         |       | 1 | % |   | $ | 41,739 |   | $ | 41,307 |   |   | $ | 432 |   |   |   | 1 | % |   |
| International                     |       | 6,145                        |       | 3,795        |       |           | 2,350      |                       |       |         | 62         | %            |       | 12,471 |   | 10,793 |   |   | 1,678 |   |   |   | 16 | % |   |
| Total                             |       | $                            | 27,364     |         | $          | 24,907         |       |                       | $          | 2,457        |       |         |       | 10 | % |   | $ | 54,210 |   | $ | 52,100 |   |   | $ | 2,110 |   |   |   | 4 | % |   |
| Revenue (as % of total  revenue): |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Domestic                          |       | 78                           | %          | 85           | %          |           |       |                       |       |         |       |         |       | 77 | % | 79 | % |   |   |   |   |   |   |   |   |
| International                     |       | 22                           | %          | 15           | %          |           |       |                       |       |         |       |         |       | 23 | % | 21 | % |   |   |   |   |   |   |   |   |
| Total                             |       | 100                          | %          | 100          | %          |           |       |                       |       |         |       |         |       | 100 | % | 100 | % |   |   |   |   |   |   |   |   |

 

The increase in domestic revenue for the three-monthperiod ended June 30, 2007 as compared to the corresponding three-monthperiod ended June 30, 2006 was due primarily to increased payments from acash basis customer. The increase was offset by lower revenues from acombination of price and volume mix from various states.

The increase in domestic revenue for the six-monthperiod ended June 30, 2007 as compared to the corresponding six-monthperiod ended June 30, 2006 was due primarily to increased payments from acash basis customer and increased project work from the consortium of centralbanks. These increases were offset by lower revenues from a combination ofprice and volume mix from various states.

The increase in international revenue for thethree-month period ended June 30, 2007 as compared to the correspondingthree-month period ended June 30, 2006 was due primarily to increasedrevenue from our operation in Mexico following a hiatus there during the 2006national elections, increased sales of consumables to Russia, increasedproduction revenues in Canada and increased product sales to Mozambique.

The increase in international revenue for thesix-month period ended June 30, 2007 as compared to the correspondingsix-month period ended June 30, 2006 was due primarily to increasedrevenue from our operation in Mexico following a hiatus there during the 2006national elections and increased product sales to Ghana. These increases wereoffset by lower production volumes from Haiti’s voter identification projectand lower revenue from Latvia, both of which were non-recurring in nature.

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*Cost of Revenue*

| ** **                                             | ** ** | **Three Months**        | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months**          | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                             | ** ** | **Ended June 30,** | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **Ended June 30,** | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                             | ** ** | **2007**                     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**               | ** ** | **2007**     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                             | ** ** | **(in 000’s)**     | ** ** |
| Cost of Revenue:                                       |       |                         |       |         |       |           |       |                         |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                |       | $                            | 15,089     |         | $          | 15,002         |       |                         | $          | 87           |       |         |       | 1 | % |   | $ | 29,804 |   | $ | 32,101 |   |   | $ | (2,297 | ) |   |   | (7 | )% |   |
| Product and subscription                               |       | 1,988                        |       | 1,675        |       |           | 313        |                         |       |         | 19         | %            |       | 4,088 |   | 4,224 |   |   | (136 | ) |   |   | (3 | )% |   |
| Total                                                  |       | $                            | 17,077     |         | $          | 16,677         |       |                         | $          | 400          |       |         |       | 2 | % |   | $ | 33,892 |   | $ | 36,325 |   |   | $ | (2,433 | ) |   |   | (7 | )% |   |
| Cost of Revenue  (as % of related revenue components): |       |                         |       |         |       |           |       |                         |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                                |       | 67                           | %          | 73           | %          |           |       |                         |       |         |       |         |       | 68 | % | 75 | % |   |   |   |   |   |   |   |   |
| Product and  subscription                              |       | 41                           | %          | 38           | %          |           |       |                         |       |         |       |         |       | 39 | % | 45 | % |   |   |   |   |   |   |   |   |

 

*Service.*   Cost of service revenue primarilyincludes:

·       costsof consumables used in delivering a service,

·       compensationfor software developers, quality assurance personnel, product managers, fieldoperations personnel, and outside contractors,

·       depreciationcharges for machinery, equipment, software and capitalized labor,

·       deploymentcosts used specifically for service delivery,

·       provisionsfor obsolete and excess inventories,

·       travelcosts directly attributable to service and development contracts,

·       stock-basedcompensation expense, and

·       chargesfor infrastructure and centralized costs.

Cost of servicerevenue increased for the three-month period ended June 30, 2007 comparedto the corresponding three-month period ended June 30, 2006 primarily dueto:

·       increasein consumables inventory costs of $1.0 million related to increased revenues,offset by

·       decreasedemployee compensation-related expenses of $0.9 million as part of therestructuring initiative.

Cost of servicerevenue decreased for the six-month period ended June 30, 2007 compared tothe corresponding six-month period ended June 30, 2006 primarily due to:

·       decreasedemployee compensation-related expenses of $1.5 million as part of therestructuring initiative,

·       decreasedcontract and temporary labor of $0.5 million as part of the cost cuttinginitiative under which a number of contractors were converted to employees atlower average costs,

·       decreasedcosts of approximately $1.1 million related to resource allocations (forexample, in 2006 resources were allocated to projects that were of an operatingexpense nature and in 2007 resources were allocated to capital projects),offset by

·       increaseddepreciation expense of $0.3 million related to programs completed in the laterhalf of 2006 or implemented during the quarter, and

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*·**      *increased allocated infrastructureand centralized costs of $0.4 million primarily due to the redeployment ofresources to program activities as part of our restructuring initiative duringthe prior year.

*Productand subscription.*   Cost of product and subscription revenue primarilyincludes costs of equipment and consumables related to our ID productionsystems, as well as Internet service provider connectivity charges and imagesearch data fees to support the services offered to our subscription customers.

Cost of product and subscription revenue increased forthe three-month period ended June 30, 2007 compared to the correspondingthree-month period ended June 30, 2006 primarily due to higher materialcosts of $0.3 million relating to hardware sales to both domestic andinternational customers.

Cost of product andsubscription revenue slightly decreased for the six-month period ended June 30,2007 compared to the corresponding six-month period ended June 30, 2006primarily due to lower material costs of $0.5 million related to consumablesales, offset by higher hardware costs.

The costs included in ourcost of revenue fall under three categories as described below:

Costof Revenue Components

| ** **                                 | ** ** | **Three Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**    | ** ** | **Six Months  Ended** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|--------------------------------------------|------------|------------------------------|------------|--------------|------------|----------------|------------|----------------------------|------------|--------------|------------|--------------|------------|
| ** **                                 | ** ** | **June 30,**            | ** ** | **Increase** | ** ** | **Increase**   | ** ** | **June 30,**          | ** ** | **Increase** | ** ** | **Increase** | ** ** |
| ** **                                 | ** ** | **2007**                     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)**             | ** ** | **2007**     | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                 | ** ** | **(in 000’s)**     | ** ** |
| Cost of revenue:                           |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                   |       | $                            | 7,771      |         | $          | 6,454          |       |                       | $          | 1,317        |       |         |       | 20 | % |   | $ | 15,382 |   | $ | 14,771 |   |   | $ | 611 |   |   |   | 4 | % |   |
| Fixed field support and manufacturing |       | 6,586                        |       | 7,595        |       |           | (1,009     | )                          |       |         | (13        | )%           |       | 13,025 |   | 16,338 |   |   | (3,313 | ) |   |   | (20 | )% |   |
| Program depreciation                       |       | 2,720                        |       | 2,628        |       |           | 92         |                       |       |         | 4          | %            |       | 5,485 |   | 5,216 |   |   | 269 |   |   |   | 5 | % |   |
| Total                                      |       | $                            | 17,077     |         | $          | 16,677         |       |                       | $          | 400          |       |         |       | 2 | % |   | $ | 33,892 |   | $ | 36,325 |   |   | $ | (2,433 | ) |   |   | (7 | )% |   |
| Cost of revenue  (as % of total revenue):  |       |                         |       |         |       |           |       |                       |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable                                   |       | 28                           | %          | 26           | %          |           |       |                       |       |         |       |         |       | 29 | % | 28 | % |   |   |   |   |   |   |   |   |
| Fixed field support and manufacturing |       | 24                           | %          | 30           | %          |           |       |                       |       |         |       |         |       | 24 | % | 32 | % |   |   |   |   |   |   |   |   |
| Program depreciation                       |       | 10                           | %          | 11           | %          |           |       |                       |       |         |       |         |       | 10 | % | 10 | % |   |   |   |   |   |   |   |   |
| Total                                      |       | 62                           | %          | 67           | %          |           |       |                       |       |         |       |         |       | 63 | % | 70 | % |   |   |   |   |   |   |   |   |

 

*Variable.  *Variablecosts include:

·       theprice of materials and labor to produce an identification card,

·       directcosts of hardware and software, and related labor, delivered, and

·       othercosts that are variable in nature.

The increase in variable costs for the three-monthperiod ended June 30, 2007 as compared to the corresponding three-monthperiod ended June 30, 2006 was primarily due to increased material costsin Mexico related to increased revenues and higher hardware and material coststo certain international customers, including Mozambique and Russia thatexperienced higher revenues in 2007. The higher variable costs as a percent ofrevenues in 2007 is primarily attributable to a sales mix change from ourinternational customers.

The slight increase in variable costs for thesix-month period ended June 30, 2007 as compared to the correspondingsix-month period ended June 30, 2006 higher material, hardware andconsumable costs, offset by improved margins on sales to certain customers.

35

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*Fixed field support andmanufacturing.**  *Fixed field support andmanufacturing costs include:

·       fieldoperations and support costs,

·       manufacturingcosts, and

·       supplychain costs.

The decrease in fixed costs for the three- andsix-month periods ended June 30, 2007 as compared to the three- and six-monthperiods ended June 30, 2006 was primarily due to the costs associated withour focus on improving certain programs during the three- and six-month periodsended June 30, 2006. As a result of these actions, fewer expenditures werecapitalized to the balance sheet and fixed support costs increased. Afterimproving the efficiencies in these programs, our fixed costs returned to morenormal levels.

*Programdepreciation.**  *Program depreciationprimarily consists of amortization and depreciation of costs incurred duringthe delivery process, where such costs are capitalized and then amortized ordepreciated over the useful lives of the assets to which the costs relate.

The slight increase inprogram depreciation for the three- and six-month periods ended June 30,2007 as compared to the three- and six-month periods ended June 30, 2006was primarily due to delivery of new programs, including Atlantic Canada,implemented during the first half of fiscal year 2007.

*Gross Profit*

| ** **                                          | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | **(in 000’s)**                    | ** ** |
| Gross Profit:                                       |       |                                        |       |                 |       |                  |       |                                      |       |                 |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                             |       | $                                           | 7,449      |                 | $          | 5,517                 |       |                                      | $          | 1,932                |       |                  |       | 35 | % |   | $ | 14,033 |   | $ | 10,708 |   |   | $ | 3,325 |   |   |   | 31 | % |   |
| Product and subscription                            |       | 2,838                                       |       | 2,713                |       |                  | 125        |                                      |       |                 | 5          | %                     |       | 6,285 |   | 5,067 |   |   | 1,218 |   |   |   | 24 | % |   |
| Total                                               |       | $                                           | 10,287     |                 | $          | 8,230                 |       |                                      | $          | 2,057                |       |                  |       | 25 | % |   | $ | 20,318 |   | $ | 15,775 |   |   | $ | 4,543 |   |   |   | 29 | % |   |
| Gross Profit (as %  of related revenue components): |       |                                        |       |                 |       |                  |       |                                      |       |                 |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                             |       | 33                                          | %          | 27                   | %          |                  |       |                                      |       |                 |       |                  |       | 32 | % | 25 | % |   |   |   |   |   |   |   |   |
| Product and subscription                            |       | 59                                          | %          | 62                   | %          |                  |       |                                      |       |                 |       |                  |       | 61 | % | 55 | % |   |   |   |   |   |   |   |   |
| Total                                               |       | 38                                          | %          | 33                   | %          |                  |       |                                      |       |                 |       |                  |       | 37 | % | 30 | % |   |   |   |   |   |   |   |   |

 

The changes in grossprofit as a percentage of revenue, for both the revenue components and overallgross profit, for the three- and six-month periods ended June 30, 2007 ascompared to the three- and six-month periods ended June 30, 2006, wasprimarily due to commensurate changes in costs of revenues, as described above.

*Operating Expenses*

*Sales and marketing*

| ** **                                   | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                   | ** ** | **(in 000’s)**                    | ** ** |
| Sales and marketing                          |       | $                                           | 4,365      |                 | $          | 4,685                 |       |                                      | $          | (320                 | )          |                  |       | (7 | )% |   | $ | 8,642 |   | $ | 9,224 |   |   | $ | (582 | ) |   |   | (6 | )% |   |
| Sales and  marketing (as % of total revenue) |       | 16                                          | %          | 19                   | %          |                  |       |                                      |       |                 |       |                  |       | 15 | % | 17 | % |   |   |   |   |   |   |   |   |
|                                              |            |                                             |            |                      |            |                       |            |                                           |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

36

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Sales and marketingexpenses consist primarily of:

·       compensation,benefits and related costs of sales and marketing employees, product managersand sales engineers,

·       recruitingexpenses,

·       traveland market research costs, and costs associated with marketing programs, suchas trade shows, public relations and new product launches,

·       stock-basedcompensation expense, and

·       chargesfor infrastructure and centralized costs.

The slight decreasein sales and marketing expense for the three-month period ended June 30,2007, as compared to the corresponding three-month period ended June 30,2006, resulted primarily from:

·       decreasedemployee compensation-related expenses of $0.2 million as part of therestructuring initiative that was accelerated in the second quarter of 2006,

The slight decreasein sales and marketing expense for the six-month period ended June 30,2007, as compared to the corresponding six-month period ended June 30,2006, resulted primarily from:

·       decreasedemployee compensation-related expenses of $0.5 million as part of therestructuring initiative that was accelerated in the second quarter of 2006,offset by

·       increasedprofessional fees and marketing costs of $0.3 million in connection with businessinitiatives relating to the REAL ID Act.

We anticipate that we willcontinue to invest in sales and marketing expenses at current levels.

*Research, development and engineering*

| ** **                                                     | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                                     | ** ** | **(in 000’s)**                    | ** ** |
| Research, development and  engineering                         |       | $                                           | 1,883      |                 | $          | 2,994                 |       |                                      | $          | (1,111               | )          |                  |       | (37 | )% |   | $ | 3,925 |   | $ | 6,230 |   |   | $ | (2,305 | ) |   |   | (37 | )% |   |
| Research,  development and engineering (as % of total revenue) |       | 7                                           | %          | 12                   | %          |                  |       |                                      |       |                 |       |                  |       | 7 | % | 12 | % |   |   |   |   |   |   |   |   |
|                                                                |            |                                             |            |                      |            |                       |            |                                           |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Research,development and engineering expenses consist primarily of :

·       compensation,benefits and related costs of software developers and quality assurancepersonnel

·       paymentsto outside contractors, 

·       thepurchase of materials and services for product development, primarily in thecard systems area,

·       stock-basedcompensation expense, and 

·       chargesfor infrastructure and centralized costs.

The decrease for the three-month period ended June 30,2007, as compared to the corresponding three-month period ended June 30,2006, resulted primarily from increased research, development and engineeringcosts of $1.1 million that we were able to capitalize to various programs,resulting in lower operating expenses.

37

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The decrease forthe six-month period ended June 30, 2007, as compared to the correspondingsix-month period ended June 30, 2006, resulted primarily from:

·       increasedresearch, development and engineering costs of $1.7 million that we were ableto capitalize to various programs, resulting in lower operating expenses, and

·       decreasedemployee compensation-related expenses of $0.5 million resulting from ourrestructuring initiative.

We anticipate that we willcontinue to invest in research, development and engineering expenses at currentlevels in the near term to support certain ongoing product initiatives, andexpect to moderate spending in the longer term.

*General and administrative*

| ** **                                          | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                          | ** ** | **(in 000’s)**                    | ** ** |
| General and administrative                          |       | $                                           | 3,809      |                 | $          | 4,172                 |       |                                      | $          | (363                 | )          |                  |       | (9 | )% |   | $ | 7,907 |   | $ | 9,382 |   |   | $ | (1,475 | ) |   |   | (16 | )% |   |
| General and  administrative (as % of total revenue) |       | 14                                          | %          | 17                   | %          |                  |       |                                      |       |                 |       |                  |       | 15 | % | 18 | % |   |   |   |   |   |   |   |   |
|                                                     |            |                                             |            |                      |            |                       |            |                                           |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

General andadministrative expenses consist primarily of:

·       compensation,benefits and related costs of executive, finance and administrative personnel, 

·       legal,human resources and other professional fees, 

·       stock-basedcompensation expense, and 

·       chargesfor infrastructure and centralized costs.

The decrease for the three-month period ended June 30,2007, as compared to the corresponding three-month period ended June 30,2006, resulted primarily from decreased audit, consulting and legal fees of$0.3 million due to improved efficiencies in our operations, including lessreliance on outside consultants.

The decrease for the six-month period ended June 30,2007, as compared to the corresponding six-month period ended June 30,2006, resulted primarily from decreased audit, consulting and legal fees of$1.1 million due to improved efficiencies in our operations, including lessreliance on outside consultants.

We anticipate that we willcontinue to incur general and administrative expenses at current levels in thenear term while continuing to examine means to reduce general andadministrative spending as a percentage of revenue in the longer term.

*Amortization of intangible assets*

| ** **                                                | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                                | ** ** | **(in 000’s)**                    | ** ** |
| Amortization of intangibles                               |       | $                                           | 509        |                 | $          | 550                   |       |                                      | $          | (41                  | )          |                  |       | (7 | )% |   | $ | 1,009 |   | $ | 1,123 |   |   | $ | (114 | ) |   |   | (10 | )% |   |
| Amortization of  intangibles (as % of total revenue) |       | 2                                           | %          | 2                    | %          |                  |       |                                      |       |                 |       |                  |       | 2 | % | 2 | % |   |   |   |   |   |   |   |   |
|                                                           |            |                                             |            |                      |            |                       |            |                                           |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

38

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We account for intangible assets resulting fromacquisitions in accordance with FASB Statement Nos. 141, *Business Combinations*and 142, *Goodwill and Other Intangible Assets*.These statements require the recording of intangible assets under purchaseaccounting rules, and require the amortization of such intangible assets overtheir expected useful life. As a result, in December 2001, we recorded$29.5 million of intangible assets related to the acquisition of certain assetsand certain liabilities from Polaroid and affiliates. These intangible assetswere set up to amortize over a 12-year period, representing the expecteduseful life. Changes in contract status and customer relationships may lengthenor shorten the expected useful life of such intangible assets, or cause animpairment charge related to the intangible asset, so some variability isexpected to exist related to intangibles depending on internal and externalfactors.

The slight decrease in amortizationof intangible assets for the three- and six-month periods ended June 30,2007, as compared to the corresponding three- and six-month periods ended June 30,2006 resulted primarily from extended amortization periods from contractextensions with several domestic customers.

*Intellectual property*

| ** **                                      | ** ** | **Three Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** | **Six Months  Ended  June 30,** | ** ** | **Dollar  Increase** | ** ** | **Percent  Increase** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|----------------------|------------|-----------------------|------------|-------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2007**                                    | ** ** | **2006**             | ** ** | **(Decrease)**        | ** ** | **(Decrease)**                            | ** ** | **2007**             | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** |
| ** **                                      | ** ** | **(in 000’s)**                    | ** ** |
| Intellectual property                           |       | $                                           | 476        |                 | $          | 481                   |       |                                      | $          | (5                   | )          |                  |       | (1 | )% |   | $ | 975 |   | $ | 912 |   |   | $ | 63 |   |   |   | 7 | % |   |
| Intellectual  property (as % of total  revenue) |       | 2                                           | %          | 2                    | %          |                  |       |                                      |       |                 |       |                  |       | 2 | % | 2 | % |   |   |   |   |   |   |   |   |
|                                                 |            |                                             |            |                      |            |                       |            |                                           |            |                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Intellectualproperty costs primarily consist of:

·       employee-relatedexpenses, such as salaries, benefits, recruiting costs, and incentive plans, 

·       costsassociated with documenting, applying for, and maintaining patents andtrademarks 

·       stock-basedcompensation expense, and 

·       chargesfor infrastructure and centralized costs.

The slight increase for the six-month period ended June 30,2007, as compared to the corresponding six-month period ended June 30,2006, resulted primarily from consulting fees paid to third-party agents andgovernment fees related to patent and other intellectual property work.

We anticipate that we willcontinue to invest in intellectual property expenses at current levels.

*Restructuring charges, net.*

| ** **                             | ** ** | **Three Months  Ended  June 30,** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                    | ** ** |
| ** **                             | ** ** | **(in 000’s)**                    | ** ** |
| Cost of revenue                        |       |                                        | $          | 159 |   |   |
| Sales and  marketing                   |       |                                        | 93         |   |   |
| Research,  development and engineering |       |                                        | 248        |   |   |
| General and administrative             |       |                                        | 47         |   |   |
| Total                                  |       |                                        | $          | 547 |   |   |

 

39

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*During the second quarter of 2006,we accelerated productivity improvement initiatives and significantly reducedfixed costs in order to facilitate our effort to achieve profitability. Thereduction in fixed costs included reduction of our workforce by nearly 20%since the beginning of 2006. The restructuring charge for the three-monthperiod ended June 30, 2006 totaled $547, primarily due to employeeseverance and related costs. These restructuring charges were allocated out ofthe departments as noted above.*

*Stock-basedcompensation.  **Stock-based compensation includes expense charges forall stock-based awards to employees and directors. Such awards include optiongrants, restricted stock awards, and shares expected to be purchased under anemployee stock purchase plan. We account for stock-based compensation inaccordance with SFAS No. 123(R),*Share-Based Payment (Revised2004),*whichrequires the measurement and recognition of compensation for all stock-basedawards made to employees and directors including stock options and employeestock purchases under a stock purchase plan based on estimated fair values.SFAS 123(R) supersedes previous accounting under Accounting PrinciplesBoard Opinion No. 25,*Accounting for Stock Issued to Employees,*for periods beginning in fiscal 2006.In March 2005, the SEC issued Staff Accounting Bulletin No. 107relating to application of SFAS 123(R). The Company has applied the provisionsof Staff Accounting Bulleting (“SAB”) 107 in our adoption of SFAS 123(R).*

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of January 1, 2006, the first day of our 2006fiscal year. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for periods prior to fiscal year2006 have not been restated to reflect this change. Stock-based compensationrecognized in the three- and six-month periods ended June 30, 2007 and2006 is based on the value of the portion of the stock-based award that willvest during the period, adjusted for expected forfeitures. Stock-basedcompensation recognized in the Company’s consolidated financial statements inthe three- and six-month periods ended June 30, 2007 and 2006 includescompensation cost for stock-based awards granted prior to, but not fully vestedas of, December 31, 2005 and stock-based awards granted subsequent to December 31,2005. The compensation cost for awards granted prior to January 1, 2006 isbased on the grant date fair value estimated in accordance with the pro formaprovisions of SFAS 123 while awards granted on or after January 1, 2006follow the provisions of SFAS 123(R) to determine the grant date fairvalue and compensation cost. Compensation cost for all stock-based awards isrecognized using the straight-line method.

Upon adoption of SFAS 123(R), the Companycontinued to use the Black-Scholes option pricing model as its method ofvaluation for stock-based awards. The Company’s determination of the fairvalue of stock-based awards on the date of grant using an option pricing modelis affected by our stock price as well as assumptions regarding a number ofhighly complex and subjective variables. These variables include, but are notlimited to the expected life of the award, our expected stock price volatilityover the term of the award and actual and projected exercise behaviors.Although the fair value of stock-based awards is determined in accordance withSFAS 123(R) and SAB 107, the Black-Scholes option pricing model requiresthe input of highly subjective assumptions, and other reasonable assumptionscould provide differing results.

40

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Theexpense was recorded in the respective statement of operations expensecategories for the employees to which it applies, as set forth in the tablebelow: 

| ** **                             | ** ** | **Three Months Ended  June 30,**          | ** ** | **Six Months Ended  June 30,**            | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **(in 000’s)**                                 | ** ** |
| Cost of revenue                        |       |                                                     | $          | 109                                                      |       |   |   | $ | 84 |   |   | $ | 215 |   | $ | 138 |   |
| Sales and  marketing                   |       |                                                     | 185        |                                                     |       |   | 134 |   |   | 392 |   | 256 |   |
| Research,  development and engineering |       |                                                     | 101        |                                                     |       |   | 76 |   |   | 173 |   | 190 |   |
| General and  administrative            |       |                                                     | 599        |                                                     |       |   | 478 |   |   | 1,207 |   | 974 |   |
| Intellectual  property                 |       |                                                     | 13         |                                                     |       |   | 10 |   |   | 25 |   | 18 |   |
| Total                                  |       |                                                     | $          | 1,007                                                    |       |   |   | $ | 782 |   |   | $ | 2,012 |   | $ | 1,576 |   |

 

The increase in stock-based compensation expense wasprimarily due to the increase in the Company’s stock price at grant date andthe effect of the timing of grants of stock-based awards.

We anticipate an additional $9.1 million instock-based compensation expense through fiscal 2011 for awards outstanding asof June 30, 2007. The future effect of the adoption of this statement onour financial position and results of operations will be determined bystock-based awards granted in future periods and the assumptions on which thevalue of those stock-based awards is based. Our tax accounting may also beaffected by actual exercise behavior and the relative market prices atexercise.

*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.4 and $0.8 million for the three- and six-month periodsended June 30, 2007, respectively, compared to $0.3 and $0.7 million forthe three- and six-month periods ended June 30, 2006. The net increaseprimarily resulted from higher interest earned on lower cash andinvestment balances.

*Provision for IncomeTaxes.*   The provision for income taxes reflectsexpected tax expense from profitability in certain foreign jurisdictions. Wehave recorded a full valuation allowance against domestic net deferred taxassets at June 30, 2007 due to the uncertainty of realization of theCompany’s net domestic operating losses. For the quarter ended March 31,2007, the Company recorded a $124 foreign deferred tax asset that it believesis more likely than not to be recognized in the future. We will continue toevaluate the realizability of our domestic and foreign net deferred tax assetsin future periods and may recognize income tax benefits in future earnings ifwe determine the realization of these assets is more likely than not.

**Liquidity andCapital Resources**

As of June 30, 2007, we had cash and cashequivalents, restricted cash, and short-term investments of $28.9 million,representing a decrease of approximately $4.2 million from $33.1 million at December 31,2006. The decrease primarily resulted from increased capital investments,including the deployment of fixed assets for the implementation of new programs.As of June 30, 2007, $9.6 million of cash and cash equivalents isrestricted as a result of the requirements of performance bonds that we areobligated to maintain in connection with some of our long-term contracts in ourpersonal identification systems business. Working capital at June 30, 2007was $29.7 million, compared to working capital of $29.9 million at December 31,2006.

41

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The$6.7 million of cash provided by operations for the six-months period ended June 30,2007 compares favorably to the $2.5 million of cash used in operations for thesix-months ended June 30, 2006. The components of operating cash flowswere:

| ** **                                           | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                      | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in 000’s)**                      | ** ** |
| Net loss                                             |       | $                                             | (1,517     | ) | $ | (11,041 | ) |
| Non-cash items                                       |       | 9,764                                         |       | 8,991 |   |
| Changes in  operating assets and liabilities         |       | (1,536                                        | )          | (467 | ) |
| Net cash provided  by (used in) operating activities |       | $                                             | 6,711      |   | $ | (2,517 | ) |

 

The major changesin the non-cash charges related to:

·       anincrease in depreciation and amortization from $7.7 million to$7.8 million primarily related to delivery of new programs in the laterhalf of 2006 or implemented during the quarter ended March 31, 2007,offset by the change in estimated useful lives of our program assets, and

·       an increase in stock-basedcompensation expense from $1.6 million to $2.0 million primarily related to theincrease in the Company’s stock price at grant date and the effect of thetiming of grants of stock-based awards.

The major changesin the operating assets and liabilities for the six-month period ended June 30, 2007primarily related to:

·       anincrease in trade accounts receivable, net of $2.0 million primarily reflectingincreased revenues during the second quarter of fiscal 2007 as compared to thefourth quarter of fiscal 2006,

·       adecrease in accrued payroll and related costs of $1.9 million reflectingpayment of accrued benefits related to the prior year, offset by

·       anincrease in deferred revenue of $2.7 million resulting from advanced billingsand cash collected on future revenues.

The major changesin operating assets and liabilities for the six-month period ended June 30, 2006primarily related to:

·       anincrease in restricted cash of $4.2 million, offset by

·       adecreases in trade and unbilled accounts receivable, net of $1.8 million andinventory of $1.1 million due to improved asset management.

The $12.8 million of cash used in investing activitiesfor the six-month period ended June 30, 2007 primarily related to $1.7million in net purchase of short-term investment activities and $11.1 millionfor the purchase of property and equipment related to new customer contracts,including capitalization of labor costs of $2.9 million.

The $3.7 million of cash used in investing activitiesfor the six-month period ended June 30, 2006 primarily related to $0.3million in net purchase of short-term investment activities and $3.4 millionfor the purchase of property and equipment related to new customer contracts,including capitalization of labor costs of $1.1 million.

The $0.6 million of cash provided by financingactivities for the six-month period ended June 30, 2007 resultedprimarily from the net issuance of stock of $0.9 million, offset by principalpayments on capital leases of $0.3 million.

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The $0.1 million of cash used in financing activitiesfor the six-month period ended June 30, 2006 resulted primarily from theprincipal payments on capital leases, partially offset by the proceeds from theissuance of stock.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $5.8 million as of June 30,2007, and are payable in monthly installments through November 2010. Ourobligations under non-cancelable capital leases, which totaled $1.0 million asof June 30, 2007, are payable in monthly installments through June 2011.

Many of our secure identity management contracts havesignificant capital requirements. The general industry model for supplyingdriver license issuance systems to state driver license issuers is for thesystem supplier to develop and install the issuance system using the supplier’scapital and to charge the customer on a per-card issued basis. As a result,during times of substantial competitive wins and/or substantial systemupgrades, the Company may experience significant working capital needs that mayexceed cash flow from operations. To date, the Company has relied upon cashreserves to fund such expenditures.

We have driver license contracts with various statesthat are not yet fully deployed and we have pending add-on and upgrade orders.In order to complete these contracts and pending orders, we estimate we willincur approximately $11 million of expenditures through 2008. Theestimates are derived from information known to us as of June 30, 2007,the time the estimates were prepared. Actual expenditures may vary from ourestimates. We anticipate that these expenditures will be recouped throughreceipts from the related long-term price-per-card agreements andfrom the value of the add-on and upgrade orders we have received.

Our planned operating expenses and capitalexpenditures may constitute a material use of our cash resources. In addition,we expect that we will continue to utilize cash in the upcoming few quarters aswe complete program implementations. We may utilize cash resources to fundacquisitions or investments in complementary businesses, technologies orproduct lines.

We believe that our current cash, cash equivalents,and short-term investment balances will satisfy our projected working capitaland capital expenditure requirements for at least the next 12 months.Thereafter, we anticipate continuing to use cash, cash equivalents, andshort-term investment balances to satisfy our projected working capital andcapital expenditure requirements. However, in the event that we were to wincontracts requiring significant capital investment, we may need to seekadditional financing.

In order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, orcredit facilities, although at this time we believe that our long-term workingcapital is sufficient to cover our foreseeable capital expenditures. If it werenecessary to obtain additional financings or credit facilities, we may not beable to do so, or if these funds are available, they may not be available onsatisfactory terms.

On April 13, 2007, wefiled a shelf registration with the SEC. The shelf registration is intended toprovide us flexibility to raise funds from time to time over a period of up tothree years, subject to market conditions and our capital needs. The shelfregistration became effective on May 25, 2007.

**Off-Balance SheetArrangements**

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenue or expenses, results of operations, liquidity, capitalexpenditures or capital resources that are material to our business.

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**Recent AccountingPronouncements**

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements,*which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair value. Thisstatement does not require any new fair value measurements, but providesguidance on how to measure fair value by providing a fair value hierarchy usedto classify the source of the information. SFAS No. 157 is effective forfirst fiscal year beginning after November 15, 2007. The Company iscurrently assessing the potential impact that adoption of this standard willhave on our financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Option for theFinancial Assets and Financial Liabilities,*which permits entitiesto choose to measure certain financial assets and liabilities at fair value.SFAS No. 159 is effective for first fiscal year beginning after November 15,2007. The Company has not determined whether it will adopt the fair valueoption method permitted by SFAS No. 159.

**Safe HarborStatement under the Private Securities Litigation Reform Act of 1995**

Because this Reporton Form 10-Q contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995, any of the riskfactors set forth in Item 1A or elsewhere in this Report on Form 10-Qor incorporated herein by reference could cause our actual results to differmaterially from those results projected or suggested in such forward-lookingstatements. Statements that are not historical facts are hereby identified as “forward-lookingstatements” for the purposes of the safe harbor provided by Section 21E ofthe Securities Exchange Act of 1934 and Section 27A of the Securities Actof 1933. Such forward-looking statements include but are not limited tostatements relating to:

·       trendsand expectations in revenue growth, including, but not limited to, statementsregarding the temporary nature of the decrease in ID systems bid activity andthe expected increase of such activity in the future, and statements regardinganticipated growth in U.S. driver license revenues due to broadening use of thedriver license as a secure credential;

·       ourfuture level of investment in our business, including investment in developmentof products and technology, acquisition of new customers and development of newmarket opportunities;

·       ourability to improve margins;

·       anticipatedexpenses, costs, margins and investment activities in the foreseeable future;

·       anticipatedrevenue to be generated from current contracts and as a result of new programs;

·       theinvestments required to complete certain driver license programs and ourability to recoup those expenses under the relevant contract;

·       ourprofitability in future periods;

·       businessopportunities that could require that we seek additional financing;

·       opportunitiesfor increased participation in the global market for ID systems;

·       thesize and growth of our markets, including the U.S. driver license market;

·       theexistence of international growth opportunities and our future investment insuch opportunities;

·       thesource of our future revenue;

·       ourexpected short-term and long-term liquidity positions;

·       ourability to fund our capital needs through cash flow from operations;

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·       ouruse of cash in upcoming quarters;

·       anticipatedlevels of backlog and bid activity in future periods;

·       anticipatedlevels of stock-based compensation expense in future periods and the futureeffect of our adoption of SFAS 123(R); and

·       thelikelihood or outcome of legal proceedings and claims and their effect on ourbusiness.

Such forward-lookingstatements also include other statements containing words such as “anticipate,”“estimate,” “expect,” “management believes,” “we believe,” “we intend,” “should”and similar words or phrases, which are intended to identify forward-lookingstatements. Actual results may vary materially due to, among other things, ourfailure to become profitable, the failure of the potential markets for ourdigital watermarking technology to develop as anticipated, the adoption ofalternative technologies within these markets, as well as changes in economic,business, competitive, technology and/or regulatory factors and trends, and theother factors described in this Form 10-Q or in our other documentsfiled with the SEC. All forward-looking statements are necessarily onlyestimates of future results and there can be no assurance that actual resultswill not differ materially from expectations, and, therefore, investors arecautioned not to place undue reliance on such statements. Investors shouldunderstand that it is not possible to predict or identify all risk factors andthat the risks discussed below should not be considered a complete statement ofall potential risks and uncertainties. We do not intend to update anyforward-looking statements as a result of future events or developments.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk.

The market risk disclosuresas set forth in Item 7A of our Annual Report on Form 10-K forthe year ended December 31, 2006 have not changed materially.

**Item 4.**                        Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

Internal management, withthe participation of the Chief Executive Officer and Chief Financial Officer,have evaluated the effectiveness of the disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) of theExchange Act) as of the end of the period covered by this report. Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that the disclosure controls and procedures, as of the end of theperiod covered by this report, were effective in ensuring that informationrequired to be disclosed in reports that are filed or submitted under theExchange Act is (i) recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rules andforms, and (ii) accumulated and communicated to internal management,including the principal executive officer and principal financial officer, asappropriate to allow timely decisions regarding required disclosure.

**Changes in InternalControls**

There were no significant changes to the internalcontrols over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) of the Exchange Act) that occurred during the secondquarter ended June 30, 2007 that would materially affect, or arereasonably likely to materially affect, the internal control over financialreporting.

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**PART II. OTHERINFORMATION.**

**Item 1.**                        LegalProceedings.

Beginning in September 2004, three purportedclass action lawsuits were filed in the U.S. District Court for the District ofOregon against the Company and certain of its current and former directors andofficers on behalf of purchasers of the Company’s securities during the period April 17,2002 to July 28, 2004. These lawsuits were later consolidated into oneaction for all purposes. The amended complaint, which sought unspecifieddamages, asserted claims under the federal securities laws relating to theCompany’s restatement of its financial statements for 2003 and the first twoquarters of 2004 and alleged that the Company issued false and misleadingfinancial statements and issued misleading public statements about the Company’soperations and prospects. On August 4, 2006, the court granted the Company’smotion to dismiss the lawsuit with prejudice and entered judgment in theCompany’s favor. Plaintiffs have filed a notice of appeal in the Ninth CircuitCourt of Appeals. The appeal was stayed pending the recent U.S. Supreme Court’sdetermination in another case of issues relating to the Private SecuritiesLitigation Reform Act, and briefing is scheduled to be completed by the end ofthe year. The Company anticipates oral argument and a decision in 2008. However,due to the inherent uncertainties of litigation, the Company cannot accuratelypredict the ultimate timing or outcome of the matter.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo.These lawsuits were consolidated into one action for all purposes on March 14,2005. This suit claims that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company. Thecomplaint is derivative in nature and does not seek relief from the Company.The Board of Directors appointed an independent committee to investigate theclaims asserted in this derivative lawsuit. On July 19, 2005, the courtgranted the Company’s motion to stay these consolidated actions in favor of ashareholder derivative action to be filed by plaintiffs in the Circuit Court ofthe State of Oregon for the County of Washington. On August 25, 2005, theCalifornia plaintiffs filed two new derivative lawsuits in the United StatesDistrict Court for the District of Oregon. On October 17, 2005, defendantsfiled a motion to dismiss these complaints for lack of subject matterjurisdiction and failure to state a claim. In May of 2006, the Boardcommittee, after completing its investigation, concluded that pursuit of theallegations would not be in the best interests of Digimarc or its shareholders.On August 24, 2006, the court granted defendants’ motion and dismissed thelawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22,2006. The briefs to the Ninth Circuit were completed in June, and the Companyanticipates oral argument and a decision in 2008. However, due to the inherentuncertainties of litigation, the Company cannot accurately predict the ultimatetiming or outcome of the matter.

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including Digimarc, certain ofits officers and directors, and certain underwriters of the Company’s initialpublic offering as defendants. The complaints have since been consolidated intoa single action, and a consolidated amended complaint was filed in April 2002.The amended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-marketsubsequent to the Company’s initial public offering. The Company and certain ofits officers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector 

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defendants entered intotolling agreements and, pursuant to a court order dated October 9, 2002,were dismissed from the litigation without prejudice. Furthermore, in July 2002,the Company and the other defendants in the consolidated cases filed motions todismiss the amended complaint for failure to state a claim. The motion todismiss claims under Section 11 was denied as to virtually all thedefendants in the consolidated actions, including the Company. The claimsagainst the Company under Section 10(b), however, were dismissed. In June 2003,a committee of the Company’s board of directors conditionally approved aproposed partial settlement with the plaintiffs in this matter. In June 2004,an agreement of settlement was submitted to the court for preliminary approval.The settlement would have provided, among other things, a release of theCompany and of the individual defendants for the alleged wrongful conduct inthe amended complaint in exchange for a guarantee from the Company’s insurersregarding recovery from the underwriter defendants and other consideration fromthe Company regarding its underwriters, including agreeing to assign away, notassert, or release certain potential claims the Company may have against itsunderwriters. The plaintiffs have continued to litigate against the underwriterdefendants. The district court directed that the litigation proceed within anumber of “focus cases” rather than in all of the 310 cases that have beenconsolidated. The Company’s case is not one of these focus cases. On October 13,2004, the district court certified the focus cases as class actions. Theunderwriter defendants appealed that ruling, and on December 5, 2006, theCourt of Appeals for the Second Circuit reversed the district court’s classcertification decision. On April 6, 2007, the Second Circuit deniedplaintiffs’ petition for rehearing. In light of the Second Circuit opinion, theCompany has informed the district court that this settlement cannot be approvedbecause the defined settlement class, like the litigation class, cannot becertified. Settlement and procedural discussions continue in the matter. TheCompany cannot predict whether the Company will be able to renegotiate asettlement that complies with the Second Circuit’s mandate. Due to the inherentuncertainties of litigation, the Company cannot accurately predict the ultimateoutcome of the matter.

The Company is subject,from time to time, to other legal proceedings and claims arising in theordinary course of business. Although the ultimate outcome of these othermatters cannot be determined, management believes that, as of June 30,2007, the final disposition of these proceedings will not have a materialadverse effect on the Company’s consolidated financial position, results ofoperations, or liquidity.

**Item 1A.**                RiskFactors

Our business, financialcondition, results of operation and cash flows may be affected by a number offactors, including the factors set forth below.

*We have a history of losses and we may not achieve orsustain profitability, particularly if we were to lose large contracts.*

Except for the year 2003,we have incurred significant net losses from inception. Our accumulated deficitas of June 30, 2007 was $101.1 million. In the second half of 2005 andcontinuing through 2006, we restructured our operations to improve productivityand reduce fixed costs. During the second quarter of 2006, we accelerated thoseactivities significantly, resulting in a reduction of our workforce by nearly20%. Overall, our workforce has been reduced by 30% since mid 2005. Theseactions resulted in an increase in earnings to a near break even level in thesecond half of 2006. However, in order to achieve sustained profitability, wewill need to generate higher revenue than we have in prior years whilecontrolling expenditures. Achieving sustained profitability will depend upon avariety of factors, including the impact of financial accounting mandatesrequiring us to expense stock options, as well as the extent to which we may berequired to increase the size of our workforce in order to execute our businessstrategy and capitalize on new opportunities. In addition, we evaluate ourstrategy and market opportunities on an ongoing basis and will adjust ourapproach to market conditions that prevail from time to time. Finally, variousadverse developments including the loss of large contracts or cost overruns onour existing 

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contractscould have a negative impact on our revenue or our margins. Accordingly,increases in our expenses may not be offset by revenue increases and as aresult we may not be able to achieve or sustain profitability.

*The loss of any large contract may result in loss ofrevenue and potential impairment of capital assets and/or intangible assets,including the acceleration of depreciation and/or amortization expense.*

Contracts betweengovernment agencies and Digimarc have varying duration, generally five or moreyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. We anticipate that several of oursignificant customers will award new contracts through such a competitivebidding process in 2007. If we were to lose a contract due to cancellation orin a competitive bidding situation, then, in addition to the loss of revenueand margin on a prospective basis, we could also incur impairment of capitaland/or intangible assets related to the customer, which could adversely affectour financial results.

*The market for our products is highly competitive, andas a result, alternative technologies or larger companies may undermine, limitor eliminate the market for our products’ technologies, which would decreaseour revenue and profits.*

The markets inwhich we compete for business are intensely competitive and rapidly evolving.We expect competition to continue from both existing competitors and new marketentrants. We face competition from other companies and from alternativetechnologies. The potential for an influx of federal funds into our core U.S.driver license market has drawn new competition and is likely to continue to doso. As we expand the applications for our technologies, we will experience morecompetition from products and services that are substitutes for ourapplications. Because our digital watermarking business is still in an earlystage of development, we also may face competition from unexpected sources.Alternative technologies that may directly or indirectly compete withparticular applications of our watermarking technologies include:

·       Encryption—securingdata during distribution using a secret code so it cannot be accessed except byauthorized users;

·       Containers—insertinga media object in an encrypted wrapper, which prevents the media object frombeing duplicated and is used for content distribution and transaction management;

·       DataGlyphs®—a slightly visiblemodification of the characteristics of an image or document that ismachine-readable;

·       ScrambledIndicia®—an opticalrefraction-based data-hiding technique that is inserted into an image and canbe read with a lens;

·       Traditionalanti-counterfeiting technologies—a number of solutions used currently by manygovernments (and that compete for budgetary outlays) designed to detercounterfeiting, including optically sensitive ink, magnetic threads and othermaterials used in the printing of currencies;

·       Radiofrequency tags—embedding a chip that emits a signal when in close proximitywith a receiver, which is being used in photo identification credentials,labels and tags;

·       Internettechnologies—numerous existing and potential Internet access and search methodsare competitive with the Digimarc MediaBridge and Digimarc Mobile systems andthe searching capabilities of Digimarc ImageBridge;

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·       Digitalfingerprints and signatures—a metric, or metrics, computed solely from a sourceimage or audio or video track, that can be used to uniquely identify an imageor track, or authenticate the image or track;

·       Smartcards—badges and cards including a semiconductor memory and/or processor usedfor authentication and related purposes; and

·       Barcodes—a data-carrying code, typically visible in nature (but invisible ifprinted in ultraviolet- or infrared-responsive inks).

In addition, as we more broadly apply our digitalwatermarking technologies to the Internet through new commercial solutionsapplications, we may begin to compete with a wide range of other types ofcompanies beyond those companies using digital watermarking technologies andalternative technologies. We cannot assure you that digital watermarkingtechnologies, and our products and services using these technologies, will gainwidespread market acceptance.

New developments areexpected to continue, and we do not assure you that discoveries by others,including current and potential competitors, will not render our services andproducts noncompetitive. Moreover, because of rapid technological changes, wemay be required to expend greater amounts of time and money than currentlyanticipated to develop new products and services, which in turn may requiregreater revenue streams from such products and services to cover developmentalcosts. Many of the companies that currently compete with us for some of ourbusiness, as well as other companies with whom we may compete in the future,are larger and national or international in scope and may have greatertechnical, financial, marketing, and political resources than we do. Theseresources could enable these companies to initiate severe price cuts or takeother measures in an effort to gain market share or otherwise impede our progress.We do not assure you that we will be able to compete successfully againstcurrent or future participants in our market or against alternativetechnologies, or that the competitive pressures we face will not decrease ourrevenue and profits in the future.

*Our products could have unknown defects or errors,which may give rise to claims against us, divert application of our resourcesfrom other purposes or increase our project implementation and support costs.*

Products and systems ascomplex as those we offer or develop may contain undetected defects or errors.Furthermore, we often provide complex implementation, integration,customization, consulting and other technical services in connection with theimplementation and ongoing maintenance of our products. Despite testing,defects or errors in our products and services may occur, which could result indelays in the development and implementation of products and systems, inabilityto meet customer requirements or expectations in a timely manner, loss of revenueor market share, increased implementation and support costs, failure to achievemarket acceptance, diversion of development resources, injury to ourreputation, increased insurance costs, increased service and warranty costs andwarranty or breach of contract claims. Although we attempt to reduce the riskof losses resulting from warranty or breach of contract claims through warrantydisclaimers and liability limitation clauses in our sales agreements when wecan, these contractual provisions are sometimes not included and may not beenforceable in every instance. If a court refuses to enforce theliability-limiting provisions of our contracts for any reason, or ifliabilities arose that were not contractually limited or adequately covered byinsurance, the expense associated with defending such actions or paying theresultant claims could be significant.

*If leading companies in our industry orstandard-setting bodies or institutions downplay, minimize, or reject the useof digital watermarking, its deployment may be slowed and we may be unable toachieve revenue growth—particularly in the media and entertainment sectors.*

Many of our businessendeavors, such as our licensing of intellectual property in support of audioand video copy-control applications, can be impeded or frustrated by larger,more influential companies or by 

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standard-settingbodies or institutions downplaying, minimizing or rejecting the value or use ofwatermarking technology or any of our other technologies. Such a negativeposition by these companies, bodies or institutions, if taken, may result inobstacles for us that we would be incapable of overcoming and may block orimpede the adoption of digital watermarking—particularly in the media andentertainment market. In addition, potential customers in the media andentertainment industry may delay or reject initiatives that relate todeployment of digital watermarking. Such a development would make theachievement of our business objectives in this market difficult or impossible.

*If we are unable to respond to regulatory or industrystandards effectively, or if we are unable to develop and integrate newtechnologies effectively, our growth and the development of our products andservices could be delayed or limited.*

Our future success will depend in part on our abilityto enhance and improve the responsiveness, functionality and features of ourproducts and services in accordance with regulatory or industry standards. Ourability to remain competitive will depend in part on our ability to influenceand respond to emerging industry and governmental standards, such as futureregulations under the REAL ID Act, in a timely and cost-effective manner. If weare unable to influence these or other standards or respond to such standardseffectively, our growth and the development of certain products and servicescould be delayed or limited.

Our market ischaracterized by new and evolving technologies. The success of our businesswill depend on our ability to develop and integrate new technologies effectivelyand address the increasingly sophisticated technological needs of our customersin a timely and cost-effective manner. Our ability to remain competitive willdepend in part on our ability to:

·       enhanceand improve the responsiveness, functionality and other features of theproducts and services we offer or plan to offer;

·       continueto develop our technical expertise; and

·       developand introduce new services, applications and technologies to meet changingcustomer needs and preferences and to integrate new technologies.

We do not assure you thatwe will be successful in responding to these technological and industrychallenges in a timely and cost-effective manner. If we are unable to developor integrate new technologies effectively or respond to these changing needs,our margins could decrease, and our release of new products and services andthe deployment of our watermarking technology could be adversely affected.

*We may need to retain additional employees or contractlabor in the future in order to take advantage of new business opportunitiesarising from increased demand, which could impede our ability to achieve orsustain profitability.*

In the second half of 2005and in 2006, we made significant reductions in our workforce as part of ourefforts to reach profitability. These reductions did not impede our ability tomeet demand because they were accompanied by improvements in our internalbusiness processes and coincided with a period of relatively low bid activitywith respect to development and deployment of new systems. We believe that thisdecrease in bid activity is temporary and that the U.S. driver license marketwill demonstrate increased demand in future periods. Our current reducedstaffing levels could affect our ability to respond to increased demand for ourservices. In addition, to meet any increased demand and take advantage of newbusiness opportunities in the future, we may need to increase our workforcethrough additional employees or contract labor, which would increase our costs.If we experience such an increase in costs, we may not succeed in achieving orsustaining profitability.

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*We depend on our senior management and key employeesfor our future success. If we are not able to retain, hire or integrate theseemployees, we may not be able to meet our commitments.*

Our success depends to a significant extent on theperformance and continued service of our senior management. Except for ourChief Executive Officer, our senior management does not have employmentagreements. The loss of the services of any of our senior management coulddelay projects or undermine customer relationships.

Due to the high level oftechnical expertise that our industry requires, our ability to successfullydevelop, market, sell, license and support our products, services, andintellectual property depends to a significant degree upon the continuedcontributions of our key personnel in engineering, sales, marketing,operations, legal and licensing, many of whom would be difficult to replace.Similarly, without the continued contributions of our key finance personnel, webelieve that our ability to meet our reporting obligations and operatesuccessfully as a public company may be limited. We believe our future successwill depend in large part upon our ability to retain our current key employeesand our ability to attract, integrate and retain such personnel in the future.It may not be practical for us to match the compensation certain of ouremployees could garner at other employment. In addition, we may encounterdifficulties in hiring and retaining employees because of concerns related toour financial performance. In addition, these circumstances may have a negativeeffect on the market price of our common stock, and employees and prospectiveemployees may factor in the uncertainties relating to our stability and thevalue of any equity-based incentives in their decisions regardingemployment opportunities and decide to leave our employ. In addition, ourbusiness is based in part on patented technology, which is unique and notgenerally known. New employees require substantial training, involvingsignificant resources and management attention. Competition for experiencedpersonnel in our business can be intense. If we do not succeed in attractingnew, qualified personnel or in integrating, retaining and motivating ourcurrent personnel, our growth and ability to deliver products and services thatour customers require may be hampered. Although our employees generally haveexecuted agreements containing non-competition clauses, there is no assurancethat a court would enforce all of the terms of these clauses or the clausesgenerally. If these clauses were not fully enforced, our employees could beable to freely join our competitors. Although we generally attempt to controlaccess to and distribution of our proprietary information by our employees,there are no assurances that the confidential nature of our proprietaryinformation will be maintained in the course of such future employment. Any ofthese events could have a material adverse effect on our financial and businessprospects.

*We expect our secure ID systems business to experiencevariability in gross margins.*

We are likely toexperience variability in gross margins on our government contracts due to numerousfactors, including, among other things, the following:

·       delaysin project implementation;

·       failureto achieve add-on sales to existing customers;

·       governmentalregulation of credentials and issuance policies;

·       privatesector usage trends for driver licenses and other credentials;

·       levelof commodity vs. proprietary components applicable to customer systemspecifications;

·       whethercontracts have been extended or renewed, and the amount of capital expenditureassociated with such extension or renewal;

·       pricecompetition in competitive bids, contract renewals and contract extensions;

·       variationsin costs of materials and manufacturing;

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·       varyinglevels of efficiency of our workforce in delivering, implementing, andservicing contracts;

·       seasonalityof issuance volumes;

·       salesmix related to card issuance revenues compared to product sales;

·       salesmix related to domestic sales compared to international sales;

·       salesmix related to adoption of new products compared to sales of current products;

·       strategicdecisions on new business;

·       depreciationand amortization of capitalized project costs related to new or upgradedprograms; and

·       variabilityin the extent to which we are able to allocate personnel expenses to capitalprojects and thereby amortize such costs over the life of the relevantcontract, rather than expensing such costs in the quarter in which they areincurred.

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. We arecontinually refining our predictive tools and increasing our understanding ofwhat drives these various factors. For reasons such as those listed above, weexpect that there will be fluctuations in our future operating results as aresult of the variability in margins from period to period in the secureID systems business.

*The majority of our revenue is subject to governmentprocurement processes that may involve unpredictable delays and otherunexpected changes which might limit our actual revenue in any given quarter.*

We derive substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new revenue aretied to procurement schedules, which could shift as the needs of the relatedgovernment procurement agencies change. Many of these governmental customersare facing continued budget pressures introducing added uncertainty. Inaddition, the Department of Homeland Security’s initiatives in passports andborder crossing cards, as well as delays in disbursement of funding for REAL IDAct projects, could create confusion within the U.S. driver license market thatmay delay purchase decisions by government customers. Any shift in thegovernment procurement process, which is outside our control and may not bepredictable, could result in delays in bookings forecasted for any particularfinancial period, could affect the predictability of our quarterly results, andmight limit our actual revenue in any given quarter, resulting in reduced andless predictable revenue and an adverse affect on profitability.

*Our future growth will depend to some extent on oursuccessful implementation of our intellectual property in solutions provided bythird parties, including partners and suppliers.*

Our business and strategyrely, in part, on deployment of our digital watermark reader technology bythird-party software developers and original equipment manufacturers. Forexample, one form of our digital watermark reader is commonly deployed in imageediting applications to permit users of these products to read watermarksembedded in imagery, and thereby discern the identities of image owners.Another form of our digital watermark reader is used in our anti-counterfeitingproduct offerings. If third parties who include our technologies in theirproducts cease to do so, or we fail to obtain other partners that willincorporate, embed, integrate or bundle our technologies, or these partners areunsuccessful in their efforts, our efforts to expand deployment of ourtechnologies would be adversely affected and, consequently, our ability toincrease revenues would be adversely affected and we may suffer other adverseeffects to our business. In addition, if our technologies do not performaccording to market expectations, our future sales would suffer as customersseek other providers.

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*Someof our revenue models relating to anticipated products and services are underdevelopment. If these revenue models and pricing structures do not gain marketacceptance, the corresponding anticipated products and services may fail toattract or retain customers and we may not be able to generate new or sustainexisting revenue.*

Some of our businessinvolves embedding digital watermarks in traditional and digital media,including identification documents, secure documents, audio, video and imagery,and licensing our intellectual property. Through 2001, our revenue stream wasbased primarily on a combination of development, consulting, subscription andlicense fees from copyright protection and counterfeit deterrence applications.Beginning in 2002 and for the foreseeable future, we have seen, and weanticipate, that the majority of our revenue will be from government andprivate-sector customers for providing security-related applications relatingto secure personal identification, copyright protection, and counterfeitdeterrence to these customers. We have not fully developed revenue models forcertain of our future digital watermarking applications and licensingendeavors. Because some of our products and services are not yetwell-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure for these products and services will gain marketacceptance or be sustainable over time or that the marketing for such productsand services will be effective.

*Thesecurity systems used in our product and service offerings may be circumventedor sabotaged by third parties, which could result in the disclosure ofsensitive government information or private personal information or cause otherbusiness interruptions that could damage our reputation and disrupt our business.*

Our business relies oncomputers and other information technologies, both internal and at customer andvendor locations. In addition, many of the systems we sell manage privatepersonal information and protect information involved in sensitive governmentfunctions. The protective measures that we use in these systems may not preventsecurity breaches, and failure to prevent security breaches may disrupt ourbusiness, damage our reputation, and expose us to litigation and liability. Aparty who is able to circumvent security measures used in these systems couldmisappropriate sensitive or proprietary information or materials or causeinterruptions or otherwise damage our products, services and reputation, andthe property of our customers. If unintended parties obtain sensitive data andinformation, or create bugs or viruses or otherwise sabotage the functionalityof our systems, we may receive negative publicity, incur liability to ourcustomers or lose the confidence of our customers, any of which may cause thetermination or modification of our contracts. Further, our insurance coveragemay be insufficient to cover losses and liabilities that may result from suchevents.

In addition, we may berequired to expend significant capital and other resources to protect ourselvesagainst the threat of security breaches or to alleviate problems caused bythese breaches. Such protection or remedial measures may not be available at areasonable price or at all, or may not be entirely effective if commenced.

*Theloss of international customers or the failure to find new internationalcustomers could adversely affect our profitability and slow our growth.*

Weexpect revenue from sales of products and services to governments and othercustomers outside the U.S. to represent a growing percentage of our totalrevenue in the future. International sales and services are subject to a numberof risks that can adversely affect our sales of products and services tocustomers outside of the United States, including the following:

·     changesin foreign government regulations and security requirements;

·     exportlicense requirements, tariffs and taxes;

·     tradebarriers;

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·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       longerpayment cycles than those for customers in the U.S.;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

In addition, our experience with large internationalissuance programs is more limited than our experience with domestic programs.We do not have an extensive operational infrastructure for our internationalbusiness. We generally act as a subcontractor or depend on local orinternational business partners and subcontractors for performance ofsubstantial portions of these programs. These factors may result in greaterrisk of performance problems or of reduced profitability with respect to our internationalprograms. In addition, if foreign customers, in particular foreign governmentauthorities, terminate or delay the implementation of our products andservices, we may have limited recourse against them to recover any potentiallosses.

We generally do notinvoice our foreign sales in U.S. dollars, and, consequently, we are exposed tocurrency exchange fluctuations. We currently do not engage in foreign currencyhedging transactions. We may in the future choose to limit our exposure by thepurchase of forward foreign exchange contracts, collared options, currency swapagreements or through similar hedging strategies. However, no currency hedgingstrategy can fully protect against exchange-related losses.

*A significant portion of our business depends oncontracts that are subject to a variety of terms and conditions, includingdamage payment obligations, as well as a variety of other provisions that maycause our quarterly results to fluctuate and our anticipated revenue topotentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and related products typically include termsrelating to time-based performance, development and delivery schedules,customer acceptance and testing, and other performance milestones. Becauseprocedures often require compliance over extended periods of time, they giverise to an increased risk that we may fail to meet timing or other deliveryrequirements and milestones pursuant to the terms of such contracts. If we failto meet such requirements or milestones, customers may assert against uscompensatory or liquidated damages, breach of contract, or other claims.Consequently, our failure to meet contractual milestones or other performancerequirements as promised could result in our having to incur increased costs,lower margins, or compensatory obligations, in addition to other losses, suchas harm to our reputation. Such unexpected increases in costs to meet ourcontractual obligations or any other requirements necessary to address claimsand damages with regard to our customer contracts could have a material adverseeffect on our business and financial results. We anticipate that futurecontracts will continue to have such provisions.

A significant portion of our business depends on alimited number of large, public-sector contracts, which are generally subjectto termination for convenience, as determined by the subject agency, or forlack of budgetary appropriation provided for the subject agency. Somegovernment contracts also may be one-time events, such as in the case of somepersonal identification systems in non-U.S. markets involving voterregistration programs. In such cases, we may generate substantial revenue thatmay not be subject to future renewal. Moreover, government contracts resultfrom purchasing decisions made by public sector agencies that may be subject topolitical influence, unusual procurement procedures, strict legal requirements,budget changes and cutbacks during economic downturns, variations inappropriations cycles, and protests of contract awards. Additionally, somegovernmental authorities require performance bonds that we are obligated tomaintain during the life of the contract. Often, the terms of these bonds 

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require that we maintainlarge restricted cash reserves as a guarantee, reducing our ability to usethese funds for our other business purposes. Even with the availability of suchcash reserve guarantees, we may not be able to obtain such performance bondunderwriting at a favorable rate or at all. In addition, these performancebonds may provide for security interests covering our receivables or otherassets, which could cause additional financing to be more difficult or moreexpensive to obtain.

Our failure to be able toprovide such performance bonds may preclude our ability to bid on newgovernment contracts or maintain our existing contracts for their full terms.The size, nature and purpose of, and the risks and uncertainties associatedwith, public sector contracts can potentially cause our quarterly results tofluctuate and anticipated revenue to decrease significantly.

*A significant portion of our business depends oncontracts with fixed price terms. In the event of cost overruns in connectionwith such contracts, our margins may be adversely affected.*

In addition to our normalprice-per-card issuance contracts, we occasionally enter into agreements tosell entire systems or portions of a system for an agreed upon price. Thesecontracts normally do not have clauses that allow for recovery of costoverruns. Under these contracts, we provide specific tasks for a specific priceand are typically paid on a milestone basis. We have experienced low margins orlosses on some of these contracts in the recent past. These contracts involvegreater financial risks because we bear the risk if actual project costs exceedthe amounts we are paid under the contracts.

*We may decline to pursue new, or renew existing,business opportunities in secure ID systems markets due to objectionable termsrequired by the contracting agencies, or we may agree to objectionable contractterms for competitive reasons.*

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure ID issuance systems. For example, it is customary for state agencies torequire that a vendor fund the capital-intensive initial deployment of a driverlicense issuance system (the costs of which the vendor normally recoups overthe life of the contract in per-card fees), while reserving the right toterminate the contract for convenience. Similarly, in connection withintellectual property rights, a contract may require that our pre-existingissuance system software be written in a different language and a state maythen argue that it falls within the class of works for which it owns thecopyright, enabling the state to turn the Digimarc-authored software over toone of our competitors, dedicate it to the public domain, or otherwise use thesoftware in a manner detrimental to our business. Objectionable contract termsmay lead us to decline to bid on identification issuance systems to newcustomers, or to decline to retain business with customers we have historicallyserved, which could reduce our market share and lower our revenues or profits.In addition, if we decline to retain business with customers we havehistorically served, it could result in the accelerated depreciation ofintangible assets. Alternatively, we may decide to accept at least some levelof objectionable terms rather than cede an important contract to a competitor,which could also lower our revenues or profits.

*A loss of a material supplier could have a materialadverse effect on our ability to perform effectively under some of ourcontracts.*

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. The loss of one or more ofthese suppliers could have a material adverse effect on our ability to performeffectively, if at all, under some of our contracts.

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*We are subject to risks encountered by companiesdeveloping and relying upon new technologies, products and services forsubstantial amounts of their growth or revenue.*

Our business andprospects must be considered in light of the risks and uncertainties to whichcompanies with new and rapidly evolving technologies, products and services,such as digital watermarking, are exposed. These risks include the following:

·       Wemay be unable to develop sources of new revenue or sustainable growth in revenuebecause our current and anticipated technologies, products and services may beinadequate or may be unable to attract or retain customers;

·       Theintense competition and rapid technological change in our industry couldadversely affect the market’s acceptance of our existing and new products andservices; and

·       Wemay be unable to develop and maintain new technologies upon which our existingand new products and services are dependent in order for our products andservices to be sustainable and competitive and in order for us to expand ourrevenue and business.

Some of our keytechnologies are in the development stage. Consequently, products incorporatingthese key technologies are undergoing technological change and are in the earlystage of introduction in the marketplace. Delays in the adoption of theseproducts or adverse competitive developments may result in delays in thedevelopment of new revenue sources or the growth in our revenue. In addition,we may be required to incur unanticipated capital expenditures in the eventproduct changes or improvements are required. Additionally, new industrystandards might redefine the products that we are able to sell, especially ifthese products are only in the prototype stage of development. If product changesor improvements are required, success in marketing these products and achievingprofitability from these products could be delayed or halted. We also may berequired to fund such changes or improvements out of operating income, whichcould adversely affect our profitability.

*We may not be able to protect adequately ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could adversely affect our business.*

Our success depends in part on licensing our proprietarytechnologies. To protect our growing intellectual property investments, we relyon a combination of patent, copyright, trademark and trade secret rights,confidentiality procedures and licensing arrangements. Unlicensed copying anduse of our intellectual property or illegal infringements of our intellectualproperty rights represent losses of revenue to us.

We face risks associated with our patent position,including the potential and sometimes actual need from time to time to engagein significant legal proceedings to enforce our patents, the possibility thatthe validity or enforceability of our patents may be denied, and thepossibility that third parties will be able to compete against us withoutinfringing our patents. Budgetary concerns may cause us not to file, orcontinue, litigation against known infringers of our patent rights, or maycause us not to file for, or pursue, patent protection for all of our inventivetechnologies in jurisdictions where they may have value. Some governmentalentities that might infringe our intellectual property rights may enjoysovereign immunity from such claims. Failure to reliably enforce our patentrights against infringers may make licensing more difficult. If we fail toprotect our intellectual property rights and proprietary technologiesadequately, if there are changes in applicable laws that are adverse to ourinterests, or if we become involved in litigation relating to our intellectualproperty rights and proprietary technologies or relating to the intellectualproperty rights of others, our business could be seriously harmed because thevalue ascribed to our intellectual property could diminish and result in alower stock price or we may incur significant costs in bringing legalproceedings against third parties who are infringing our patents.

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Effective protection of intellectual property rightsmay be unavailable or limited, both in the U.S. and in other countries. Patentprotection throughout the world is generally established on a country-by-countrybasis. We have applied for patent protection both in the U.S. and in variousother countries. However, we do not assure you that pending patents will beissued or that issued patents will be valid or enforceable. Failure to obtainsuch patents or failure to enforce those patents that are obtained may resultin a loss of revenue to us. We do not assure you that the protection of ourproprietary rights will be adequate or that our competitors will notindependently develop similar technologies, duplicate our services or designaround any of our patents or other intellectual property rights we hold.

We are the exclusive licensee under some third-partypatents, and may need the assistance of these parties if we choose to enforceany of these patent rights. The cooperation of these third parties cannot beassured even though we rely on some of these technologies for our products.

As more companies engage in business activitiesrelating to personal identification technologies and digital watermarking, anddevelop corresponding intellectual property rights, it is increasingly likelythat claims may arise which assert that some of our products or servicesinfringe upon other parties’ intellectual property rights. These claims couldsubject us to costly litigation, divert management resources and result in theinvalidation of our intellectual property rights. These claims may require usto pay significant damages, cease production of infringing products, terminateour use of infringing technologies or develop non-infringing technologies. Inthese circumstances, continued use of our technologies may require that weacquire licenses to the intellectual property that is the subject of thealleged infringement, and we might not be able to obtain these licenses oncommercially reasonable terms or at all. Our use of protected technologies mayresult in liability that threatens our continuing operation.

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. As deploymentof our technology increases, and more companies enter our markets, thelikelihood of a third party lawsuit resulting from such indemnificationincreases. If an infringement arose in a context governed by such a contract,we may have to refund to our customer amounts already paid to us or paysignificant damages, or we may be sued by the party allegedly infringed upon.Similarly, as we seek to broaden the number of companies licensed under ourpatent portfolio, some may seek contractual assurances that we will pursue—bylitigation if necessary—their competitors who use our patented technology butare not licensed to do so. Compliance with any such contract provisions mayrequire that we pursue litigation where our costs exceed our likely recovery.

As part of ourconfidentiality procedures, we generally enter into non-disclosure agreementswith our employees, directors, consultants and corporate partners, and attemptto control access to and distribution of our technologies, solutions,documentation and other proprietary information. Despite these procedures,third parties could copy or otherwise obtain and make unauthorized use of ourtechnologies, solutions or other proprietary information or independentlydevelop similar technologies, solutions or information. The steps that we havetaken to prevent misappropriation of our solutions, technologies or otherproprietary information may not prevent their misappropriation, particularlyoutside the U.S. where laws or law enforcement practices may not protect ourproprietary rights as fully as in the U.S..

*Products that we are developing for new secureidentification markets and components and subsystems markets may not beaccepted as quickly as we have projected or at all, which may negatively impactour revenues, margins, earnings and stock price.*

We have investedsignificant time and resources in product development activities for new secureidentification markets, including designing and developing numerousenhancements to our driver license systems and improving our cards’ ability towithstand intrusions or alterations without detection. If we do not experiencea timely, positive reaction from issuing authorities to our new offerings, ourprojected revenues, margins and earnings may be negatively impacted.

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*We are engaged in several lawsuits alleging violationsof securities law and cannot predict the outcome or ultimate cost of theseactions with certainty.*

We currently are engagedin litigation relating to the initial public offering of our securities, inaddition to the actions filed against us in connection with our previouslyannounced accounting errors. These matters are discussed in greater detail in Part II,Item 1 (Legal Proceedings) of this Quarterly Report on Form 10-Q andin Note 5 (Commitments and Contingencies) of the Notes to ConsolidatedFinancial Statements included in this Quarterly Report on Form 10-Q.We have incurred significant costs relating to these matters. Due to theinherent uncertainties of such litigation, the ultimate cost and outcome cannotbe predicted.

*If a judgment were to be entered against the Companyand our director and officer liability insurance was inadequate or unavailable,the obligation to pay the judgment may materially harm our business andfinancial condition.*

Our director and officerliability insurance policies provide protection against certain liabilitiesrelating to the securities class action and derivative lawsuits against us andcertain of our officers and directors up to prescribed policy limits. If thesepolicies do not adequately cover expenses and certain liabilities relating tothese lawsuits, our financial condition could be materially harmed. Inaddition, if this insurance coverage becomes unavailable to us or premiumsincrease significantly in the future, it could make it more difficult for us toretain and attract officers and directors and could expose us to potentiallyself-funding certain future liabilities ordinarily mitigated by director andofficer liability insurance.

*There is no assurance that our internal controls andprocedures will succeed in achieving their stated goals under all potentialfuture conditions, regardless of how remote.*

We have deployedsignificant resources to design, implement, and maintain effective internalcontrols and procedures, including disclosure controls and procedures. Whileour internal controls and procedures are designed to provide reasonableassurance of achieving their objectives, the design of any system of controlsis based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions, regardless of howremote. Any failure to maintain adequate controls or to adequately implement requirednew or improved controls could harm our operating results or cause us to failto meet our reporting obligations in a timely and accurate manner.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

We held our annual meeting of stockholders on May 2,2007. Two proposals were voted on by our stockholders.

**Proposal 1:  **Election of Three Class II Directors

PhilipJ. Monego, Sr., Peter W. Smith and Bernard Whitney were elected as Class IIdirectors for a term of 3 years. The voting for each director was as follows:

| ** **                  | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-----------------------------|------------|------------|------------|--------------|------------|
| Philip J.  Monego, Sr. |       | 16,944,342 |       | 972,304      |       |
| Peter W. Smith              |       | 17,284,027 |       | 632,619      |       |
| Bernard Whitney             |       | 17,284,727 |       | 631,919      |       |

 

The Company’s Class III and I directors did notstand for reelection at the annual meeting. The terms of the Company’s Class IIIdirectors, Bruce Davis, Brian J. Grossi and James T. Richardson will continueuntil the 2008 annual meeting of stockholders. The terms of the Company’s Class Idirectors, William J. 

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Miller, Jim Roth and LloydG. “Buzz” Waterhouse, will continue until the 2009 annual meeting ofstockholders.

**Proposal 2:  **Ratification of the Appointment of Grant ThorntonLLP as the Company’s Independent Certified Public Accountants

Grant Thornton wasratified as our independent certified public accountants for the fiscal yearending December 31, 2007 with 17,881,341 votes in favor, 26,712 votesagainst and 8,593 abstentions.

**Item 6.**                        Exhibits.

See attached exhibit index.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                            | DIGIMARC CORPORATION |
|----------------------------|----------------------|
| Date:  August 3, 2007 | By:                  | /s/  MICHAEL MCCONNELL |
|                       |                 | Michael McConnell |
|                       | * *             | *Chief  Financial Officer and Treasurer   (Duly Authorized Officer and   Principal Financial Officer)* |

 

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**EXHIBITINDEX**
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                   | ** ** | **Document** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| 3.1             |       | Second Amended and  Restated Certificate of Incorporation of the Registrant, as amended  (incorporated by reference to Exhibit 3.1 of Exhibits to the  Registrant’s Annual Report on Form 10-K, as filed with the  Securities and Exchange Commission on March 13, 2006) |
| 3.2             |       | Amended and  Restated Bylaws of the Registrant (incorporated by reference to  Exhibit 3.3 of Exhibits to Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on August 9, 2005)                                            |
| 31.1            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                 |
| 31.2            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                 |
| 32.1            |       | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                  |
| 32.2            |       | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                  |

 

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