---

---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

---

FORM 10-Q

|(Mark One)                                                    |                                                                                         
|------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|ý                                                             | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|For the quarterly period ended MARCH 31, 2003                
|OR                                                           
|o                                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the transition period
from                             to

Commission File Number 000-28317

---

DIGIMARC CORPORATION(Exact name of registrant as specified in its charter)

|Delaware(State or other jurisdiction of
incorporation or organization)               |  | 94-3342784(I.R.S. Employer Identification No.)
|------------------------------------------------------------------------------------ |  | ----------------------------------------------
|19801 SW 72nd Ave, Ste 250, Tualatin, Oregon(Address of principal executive offices) |  | 97062(Zip Code)                               
|(503) 885-9699(Registrant's telephone number, including area code)                  

---

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

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

As
of April 30, 2003, there were 17,712,735 shares of the registrant's common stock, par value $0.001 per share, outstanding.

---

---

---



Table of Contents

|PART I     |  |                                                                                                     |  |   
|---------- |  | --------------------------------------------------------------------------------------------------- |  | --
|Item 1.    |  | Financial Statements:                                                                               |  |   
|           |  | Condensed Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002.                   |  | 3 
|           |  | Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and 2002. |  | 4 
|           |  | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and 2002. |  | 5 
|           |  | Notes to Condensed Consolidated Financial Statements.                                               |  | 6 
|Item 2.    |  | Management's Discussion and Analysis of Financial Condition and Results of Operations.              |  | 10
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk.                                         |  | 27
|Item 4.    |  | Controls and Procedures.                                                                            |  | 27
|PART II    |  |                                                                                                     |  |   
|Item 1.    |  | Legal Proceedings.                                                                                  |  | 28
|Item 5.    |  | Other Information                                                                                   |  | 28
|Item 6.    |  | Exhibits and Reports on Form 8-K.                                                                   |  | 28
|SIGNATURES |  | 29                                                                                                 

2

---



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

DIGIMARC CORPORATION  CONDENSED CONSOLIDATED BALANCE SHEETS  (IN THOUSANDS)  (UNAUDITED)

|                                     |                             | March 31,
2003                       |                                            | December 31,
2002(1) |        
|------------------------------------ | --------------------------- | ------------------------------------ | ------------------------------------------ | -------------------- | -------
|ASSETS                               |                             |                                      |                                            |                      |        
|                                     | Current assets:             |                                      |                                            |                      |        
|                                     |                             | Cash and cash equivalents            |                                            | $                    | 28,883 
|                                     |                             | Restricted cash                      |                                            |                      | 16,241 
|                                     |                             | Short-term investments               |                                            |                      | 5,135  
|                                     |                             | Trade accounts receivable, net       |                                            |                      | 10,299 
|                                     |                             | Unbilled trade receivables           |                                            |                      | 4,895  
|                                     |                             | Inventory, net                       |                                            |                      | 5,689  
|                                     |                             | Other current assets                 |                                            |                      | 2,433  
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total current assets                       |                      |        
|                                     | Property and equipment, net |                                      |                                            | 30,271               |        
|                                     | Intangibles, net            |                                      |                                            | 25,977               |        
|                                     | Other assets, net           |                                      |                                            | 1,031                |        
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total assets                               |                      | $      
|                                     |                             |                                      |                                            |                      |        
|LIABILITIES AND STOCKHOLDERS' EQUITY |                             |                                      |                                            |                      |        
|                                     | Current liabilities:        |                                      |                                            |                      |        
|                                     |                             | Accounts payable                     |                                            | $                    | 5,757  
|                                     |                             | Accrued payroll and related costs    |                                            |                      | 1,792  
|                                     |                             | Deferred revenue                     |                                            |                      | 3,369  
|                                     |                             | Other current liabilities            |                                            |                      | 41     
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total current liabilities                  |                      |        
|                                     | Other long-term liabilities |                                      |                                            | 5                    |        
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total liabilities                          |                      |        
|                                     | Stockholders' equity:       |                                      |                                            |                      |        
|                                     |                             | Common stock                         |                                            |                      | 18     
|                                     |                             | Additional paid-in capital           |                                            |                      | 176,790
|                                     |                             | Deferred stock compensation          |                                            |                      | (888   
|                                     |                             | Accumulated other comprehensive loss |                                            |                      | (3     
|                                     |                             | Warrant                              |                                            |                      |       
|                                     |                             | Accumulated deficit                  |                                            |                      | (56,027
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total stockholders' equity                 |                      |        
|                                     |                             |                                      |                                            |                      |        
|                                     |                             |                                      | Total liabilities and stockholders' equity |                      | $      
|                                     |                             |                                      |                                            |                      |        

---

See
Notes to Condensed Consolidated Financial Statements

3

---



DIGIMARC CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS  (IN THOUSANDS, EXCEPT PER SHARE DATA)  (UNAUDITED)

|                                                |                                             | Three Months Ended
March 31, |                         
|----------------------------------------------- | ------------------------------------------- | ---------------------------- | ------------------------
|
|Revenue:                                        |                                             |                              |                         
|                                                | Product and subscription                    |                              | $                       
|                                                | Service                                     |                              |                         
|                                                |                                             |                              |                         
|                                                |                                             |                              | Total revenue           
|Cost of revenue:                                |                                             |                              |                         
|                                                | Product and subscription                    |                              |                         
|                                                | Service                                     |                              |                         
|                                                |                                             |                              |                         
|                                                |                                             |                              | Total cost of revenue   
|Gross profit                                    |                                             |                              | 9,758                   
|Operating expenses:                             |                                             |                              |                         
|                                                | Sales and marketing                         |                              |                         
|                                                | Research, development and engineering       |                              |                         
|                                                | General and administrative                  |                              |                         
|                                                |                                             |                              |                         
|                                                |                                             |                              | Total operating expenses
|                                                |                                             |                              |                         
|                                                |                                             |                              | Operating loss          
|Other income (expense):                         |                                             |                              |                         
|                                                | Interest income                             |                              |                         
|                                                | Interest expense                            |                              |                         
|                                                | Other                                       |                              |                         
|                                                |                                             |                              |                         
|                                                |                                             |                              | Total other income, net 
|                                                |                                             |                              |                         
|Income (loss) before provision for income taxes |                                             |                              | 79                      
|Provision for income taxes                      |                                             |                              | (50                     
|                                                |                                             |                              |                         
|                                                |                                             |                              | Net income (loss)       
|                                                |                                             |                              |                         
|Net income (loss) per sharebasic               |                                             | $                            | 0.00                    
|Net income (loss) per sharediluted             |                                             | $                            | 0.00                    
|                                                | Weighted average shares outstandingbasic   |                              |                         
|                                                | Weighted average shares outstandingdiluted |                              |                         

See
Notes to Condensed Consolidated Financial Statements

4

---



DIGIMARC CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  (IN THOUSANDS)  (UNAUDITED)

|                                                  |                                                                                          | Three Months Ended
March 31,                         |                                            
|------------------------------------------------- | ---------------------------------------------------------------------------------------- | ---------------------------------------------------- | -------------------------------------------
|
|Cash flows from operating activities:             |                                                                                          |                                                      |                                            
|                                                  | Net income (loss)                                                                        |                                                      | $                                          
|                                                  | Adjustments to reconcile net income (loss) to net cash provided by operating activities: |                                                      |                                            
|                                                  |                                                                                          | Depreciation and amortization                        |                                            
|                                                  |                                                                                          | Stock-based compensation expense                     |                                            
|                                                  |                                                                                          | Other non-cash charges                               |                                            
|                                                  |                                                                                          | Changes in operating assets and liabilities:         |                                            
|                                                  |                                                                                          |                                                      | Restricted cash                            
|                                                  |                                                                                          |                                                      | Trade and unbilled accounts receivable, net
|                                                  |                                                                                          |                                                      | Inventory, net                             
|                                                  |                                                                                          |                                                      | Other current assets                       
|                                                  |                                                                                          |                                                      | Other assets, net                          
|                                                  |                                                                                          |                                                      | Accounts payable                           
|                                                  |                                                                                          |                                                      | Accrued payroll and related costs          
|                                                  |                                                                                          |                                                      | Deferred revenue                           
|                                                  |                                                                                          |                                                      | Other current liabilities                  
|                                                  |                                                                                          |                                                      |                                            
|                                                  |                                                                                          |                                                      | Net cash provided by operating activities  
|Cash flows from investing activities:             |                                                                                          |                                                      |                                            
|                                                  | Purchase of property and equipment                                                       |                                                      |                                            
|                                                  | Capitalization of software development costs                                             |                                                      |                                            
|                                                  | Long-term investments                                                                    |                                                      |                                            
|                                                  | Sale or maturity of short-term investments                                               |                                                      |                                            
|                                                  | Purchase of short-term investments                                                       |                                                      |                                            
|                                                  |                                                                                          |                                                      |                                            
|                                                  |                                                                                          | Net cash provided by (used in) investing activities  |                                            
|Cash flows from financing activities:             |                                                                                          |                                                      |                                            
|                                                  | Net proceeds from issuance of common stock                                               |                                                      |                                            
|                                                  | Principal payments under capital lease obligations                                       |                                                      |                                            
|                                                  |                                                                                          |                                                      |                                            
|                                                  |                                                                                          | Net cash provided by financing activities            |                                            
|                                                  |                                                                                          |                                                      |                                            
|                                                  |                                                                                          | Net increase (decrease) in cash and cash equivalents |                                            
|                                                  |                                                                                          | Cash and cash equivalents at beginning of period     |                                            
|                                                  |                                                                                          |                                                      |                                            
|                                                  |                                                                                          | Cash and cash equivalents at end of period           |                                            
|                                                  |                                                                                          |                                                      |                                            
|Supplemental disclosure of cash flow information: |                                                                                          |                                                      |                                            
|                                                  | Cash paid for interest                                                                   |                                                      | $                                          

See
Notes to Condensed Consolidated Financial Statements

5

---



DIGIMARC CORPORATION  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (IN THOUSANDS)  (UNAUDITED)

1.     The Company, Basis of Presentation

Digimarc Corporation ("Digimarc", the "Company", "our", "us" or "we") is a leading provider of patented digital watermarking technologies that allow imperceptible
digital codes to be embedded in all forms of media content, including photographs, movies, music, financial instruments, personal identification documents, and product packages. The embedded codes
within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital processing devices. The Company also is a leading supplier of
secure personal identification systems. The Company supplies the issuance systems for the majority of driver licenses produced in the United States and provides all or part of the issuance systems for
national identifications, voter identifications, and driver licenses in more than twenty non-U.S. countries. The Company is developing and marketing enhanced security for personal
identification documents enabled by Digimarc's proprietary digital watermarking technology.

In
December 2001, the Company, through its wholly-owned subsidiary, Digimarc ID Systems, LLC and certain of that limited liability company's wholly-owned subsidiaries (collectively
"DIDS"), acquired certain assets of Polaroid Corporation, Polaroid ID Systems, Inc. and certain other affiliated entities of Polaroid Corporation. As part of the transaction, Digimarc also
assumed certain liabilities from the selling entities. The acquisition was accounted for using the purchase method of accounting.

The
condensed consolidated financial statements include the accounts of Digimarc and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been
eliminated. The condensed consolidated financial statements have been prepared from the Company's records without audit and, in management's opinion, include all adjustments (consisting of only normal
recurring adjustments) necessary to reflect a fair statement of the results for the periods presented. Certain information and footnote disclosures normally included in financial statements prepared
in accordance
with accounting principals generally accepted in the United States of America have been condensed or omitted under the Security and Exchange Commission's rules and regulations.

Certain
prior period amounts in the accompanying condensed consolidated financial statements and notes thereon have been reclassified to conform to current period presentation. These
reclassifications had no effect on the results of operations or financial position for any period presented.

These
condensed consolidated financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2002 included in the
Company's 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003.

2.     Income (Loss) Per Share Computation

Basic and diluted net income (loss) per share is computed using the weighted average number of shares of common stock outstanding for the period. The effect of
5,437 and 5,938 outstanding stock options and (in the first quarter of 2002) warrants for the three months ended March 31, 2003 and 2002, respectively, are excluded from the calculation of
diluted net loss per share for the periods presented because either the Company was in a loss position or their inclusion would be antidilutive.

6

---

3.     Pro Forma Income (Loss) Per Share

At December 31, 2002, the Company has various stock-based compensation plans, including stock option plans and an employee stock purchase plan. The Company
continues to apply the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25,Accounting for Stock Issued to
Employees,as allowed by Statement of Financial Accounting Standards ("SFAS") No. 123,Accounting for Stock-Based
Compensation. Under APB Opinion No. 25, no stock- based compensation expense is recognized for stock awards granted with an exercise price at or above fair market value
on the date of grant.

The
following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation.

|                                                                                                 |  | Three Months Ended
March 31, |       
|------------------------------------------------------------------------------------------------ |  | ---------------------------- | ------
|
|Net income (loss), as reported                                                                   |  | $                            | 29    
|Add: Stock-based compensation expense determined under the intrinsic value method                |  |                              | 444   
|Deduct: Total stock-based employee compensation expense determined under fair value based method |  |                              | 5,389 
|                                                                                                 |  |                              |       
|Pro forma net loss                                                                               |  | $                            | (4,916
|                                                                                                 |  |                              |       
|Net income (loss) per share:                                                                     |  |                              |       
|Basicas reported                                                                                |  | $                            | 0.00  
|Dilutedas reported                                                                              |  | $                            | 0.00  
|Basicpro forma                                                                                  |  | $                            | (0.28 
|Dilutedpro forma                                                                                |  | $                            | (0.28 

4.     Segment Information

The Company derives its revenue from a single operating segment, secure media solutions. There was no single customer in the three months ended March 31,
2003 or 2002 that accounted for more than 10% of total revenue.

5.     Stock-based Compensation Expense Allocation

Stock-based compensation expense is based on the difference between the fair market value of the Company's common stock and the exercise price of options to
purchase that stock on the date of grant, and is being recognized over the vesting period of the related options, usually four years. Stock-based compensation expense of $444 and $471 was recorded for
the three months ended March 31, 2003 and 2002, respectively, and is included in the respective statements of operations expense categories for the employees to which it applies. At
March 31, 2003, $888 of stock-based compensation remains deferred and we expect the entire balance to be amortized to expense in 2003.

6.     Commitments and Contingencies

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the
United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of the
Company's initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended
complaint alleges, among other things, that the underwriters of

7

---

the
Company's initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in
the Company's initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of the Company's stock in the after-market subsequent to the
Company's initial public offering. Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933, and
Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters' alleged compensation arrangements and
manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a Court Order dated October 9,
2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, Digimarc and the other issuers in the consolidated cases filed motions to dismiss the amended complaint
for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including Digimarc. The claims against
Digimarc under Section 10(b), however, were dismissed. Digimarc intends to defend these actions vigorously. Due to the inherent uncertainties of litigation and because the litigation is still
at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

In
October 2002, we filed a patent infringement case against Spectra Systems Corporation in the United States District Court for the District of Delaware alleging infringement of
Digimarc's patents 5,636,292, 5,745,604 and 6,385,330. In May 2003, Digimarc settled the patent infringement lawsuit it brought against Spectra Systems Corporation in the United States District Court
for the District of Delaware. Under the terms of the settlement, Spectra Systems Corporation agreed to not sell driver license products involving digital watermarking technology claimed in Digimarc
patents.

DIDS
in its normal course of business from time to time experiences delays in identification system implementation, timely acceptance for identification systems programs, concerns
regarding identification system program performance, and other contractual disputes. Management does not believe that there will be any material effect to the results of operations for costs related
to these contingencies.

The
Company's product license and services agreements include a limited indemnification provision for 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. The indemnification is generally
limited to the amount paid by the customer. To date, claims under such indemnification provisions have not been significant.

Digimarc
is subject to other legal proceedings and claims arising in the ordinary course of business. Although the ultimate outcome of these matters cannot be determined, management
believes that the final disposition of these proceedings will not have a material adverse effect on the consolidated financial position, results of operations, or liquidity of the Company.

7.     Comprehensive Income (Loss)

The Company has adopted SFAS No. 130,Reporting Comprehensive Income, which establishes standards of
reporting and display of comprehensive income (loss) and its components of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues,

8

---

expenses,
gains and losses that are not included in net income (loss) but rather are recorded directly in stockholders' equity. The following provides a summary of comprehensive loss:

|                                             |  | Three Months Ended
March 31, |   
|-------------------------------------------- |  | ---------------------------- | --
|
|Net income (loss)                            |  | $                            | 29
|Change in accumulated translation adjustment |  |                              | 40
|                                             |  |                              |   
|Comprehensive income (loss)                  |  | $                            | 69
|                                             |  |                              |   

8.     Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 143,Accounting for Asset Retirement
Obligations. This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. We implemented SFAS No. 143 on January 1, 2003. We do not expect this statement to have a material impact on our consolidated financial position or
results of operations.

In
June 2002, the FASB issued SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities. This statement
nullifies Emerging Issues Task Force ("EITF") Issue No. 94-3 ("EITF 94-3"),Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).SFAS No. 146 requires that a liability for a cost associated with an exit or
disposal activity is recognized when the liability is incurred. Under EITF 94-3, liabilities for exit costs were recognized at the date of an entity's commitment to an exit plan. The
provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. We implemented SFAS No. 146 on January 1, 2003 and do
not expect this statement to have a material impact on our consolidated financial position or results of operations.

In
November 2002, the EITF reached a consensus on Issue No. 00-21 ("EITF 00-21"),Revenue Arrangements with Multiple
Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating
activities. EITF 00-21 will be effective for interim periods beginning after June 15, 2003. We do not expect this issue to have a material impact on our consolidated financial
position or results of operations.

9

---



Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements
relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including those set forth under "Risks Related to Our Business" and "Risks Related to Our Markets," and those risks described in our Annual
Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003. This discussion and analysis should be read in conjunction with our interim unaudited
Condensed Consolidated Financial Statements and related notes included in this quarterly report on Form 10-Q.

Overview

We are a leading provider of patented digital watermarking technologies that allow imperceptible digital codes to be embedded in all forms of media content,
including photographs, movies, music, banknotes and other financial instruments, personal identification documents, and product packages. The embedded codes within various types of media content can
be detected and read by software or hardware detectors in personal computers and other digital processing devices.

We
also are a leading supplier of secure personal identification systems. We supply the issuance systems for the majority of driver licenses produced in the United States and provide all
or part of the issuance systems for national identifications, voter identifications, and driver licenses in more than twenty non-U.S. countries. We are developing and marketing enhanced
security for personal identification documents enabled by our proprietary digital watermarking technology.

The
majority of our revenues come from multi-year contracts with government agencies, including U.S. state departments of motor vehicles and central banks. We intend to
increase our revenue through increasing adoption of our products and services, marketing new digital watermarking applications, and licensing our intellectual property. We expect to target, among
other sources of revenue, government agencies, commercial printers, packaging companies, publishers, advertisers, proprietors of large image collections, and other producers of printed materials. Our
aim is to license our technologies to those content producers so that they may embed our digital watermarks in their printed media, such as identification documents, magazine advertisements and
articles, direct mail
coupons, catalogs, stationery and envelopes, product packaging, labels and tags, trading cards, credit cards, and business cards. Our current and anticipated products are intended to enable content
producers to control reproduction and alteration of their content, as well as to enable their printed materials to provide a link to relevant network services. Revenue from our new applications may
include one-time license fees, time-based or volume-based fees, subscription fees, royalties and revenue-sharing arrangements. We anticipate that the calculation of fees and
royalties will be based at least in part on the size of the installed base of personal computers, cameras, scanners, digital image capture and output devices, and software carrying our patented reader
technology, as well as the nature of the use of, and the nature and amount of licensed content carrying, our digital watermarks.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, intangible
assets, income taxes, restructuring, long-term service contracts, warranties, investments, and contingencies and litigation. We base our estimates on historical experience and on various
other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

10

---

Certain
of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term service contracts,
impairments and estimation of useful lives of long-lived assets, inventory valuation, and reserves for uncollectible accounts receivable. We believe the following critical accounting
policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:



11

---



Results of Operations

The following table presents our consolidated statement of operations data for the periods indicated as a percentage of total revenue.

Three Months Ended
March 31,2003

2002Revenue:Product and subscription

21
%
17
%Service

79

83Total revenue

100

100Cost of revenue:Product and subscription

12

6Service

43

52Total cost of revenue

55

58Gross profit

45

42Operating expenses:Sales and marketing

14

21Research, development and engineering

8

13General and administrative

23

32Total operating expenses

45

66Operating income (loss)

0

(24
)Other income (expense):Interest income

0

1Interest expense

0

0Other

0

0Total other income, net

0

1Income (loss) before provision for income taxes

0

(23
)Provision for income taxes

0

0Net income (loss)

0
%
(23
)%


Revenue

Total revenue was $21.7 million and $18.5 million for the three months ended March 31, 2003 and 2002, respectively. The $3.2 million
or 18% increase in total revenue resulted from increased international sales and services and increased issuance revenues from U.S. state driver license programs. Revenue from identified international
customers was $4.5 million and $2.5 million for the three months ended March 31, 2003 and 2002, respectively.

12

---

Product and subscription.Product and subscription revenue was $4.7 million and $3.1 million for the three
months ended March 31, 2003 and 2002, respectively. The $1.5 million or 49% increase was primarily related to increased international sales and domestic equipment sales. A portion of our
revenue each year is generated from the licensing of technology. In the competitive environment in which we operate, product generation, development and marketing processes relating to technology are
uncertain and complex, requiring accurate prediction of demand as well as successful management of various development risks inherent in technology development. In light of these dependencies, it is
possible that failure to successfully manage future changes in technology with respect to our technology could have a long-term impact on our revenue.

Service.Service revenue was $17.0 million and $15.3 million for the three months ended March 31, 2003
and 2002, respectively. The $1.7 million or 11% increase was primarily the result of increased issuance revenue.

Cost of Revenue

Product and subscription.Cost of product and subscription revenue primarily includes compensation for operations personnel,
costs of consumables sold to third parties, costs of machinery sold to third parties, Internet service provider connectivity charges and image search data fees to support the services offered to our
subscription customers. Cost of product and subscription revenue was $2.5 million and $1.1 million for the three months ended March 31, 2003 and 2002, respectively. The
$1.4 million or 125% increase was a result of increased international sales activity and domestic equipment sales activity.

Service.Cost of service revenue primarily includes compensation for software developers, quality assurance personnel,
product managers, field operations personnel, and business development personnel, outside contractors, costs of consumables used in delivering a service, depreciation charges for machinery used
specifically for service delivery, and travel costs directly attributable to service and development contracts. Cost of service revenue was $9.4 million and $9.5 million for the three
months ended March 31, 2003 and 2002, respectively. The $0.1 million or 1% decrease was primarily the result of our continued focus on cost control while maintaining service levels.
Field operations employees totaled 142 and 97 at March 31, 2003 and 2002, respectively.

Operating Expenses

Sales and marketing.Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and
marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research, and costs associated with marketing programs, such as trade shows, public relations and new
product launches. Sales and marketing expenses were $3.1 million and $3.9 million for the three months ended March 31, 2003 and 2002, respectively. The $0.8 million or 20%
decrease resulted from decreased salaries and other employee related costs of approximately $0.4 million, decreased use of outside consulting services of $0.3 million, and decreased
administrative costs of approximately $0.2 million related to sales and marketing activities, partially offset by approximately $0.1 million in sales and marketing costs due to the
decreased use of sales and marketing personnel to provide services for our revenue generating contracts that would have been included in cost of service revenue. Sales and marketing employees totaled
61 and 82 as of March 31, 2003 and 2002, respectively. We anticipate that we will continue to invest significantly in sales and marketing for the foreseeable future.

Research, development and engineering.Research, development and engineering expenses consist primarily of compensation,
benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $1.8 million and
$2.5 million for the three months ended March 31, 2003 and 2002, respectively. The

13

---

$0.7 million
or 28% decrease resulted from decreased costs related to outside consultants of approximately $1.0 million and decreased administrative costs of $0.2 million
associated with research, development and engineering activities, partially offset by increased salaries and other employee related costs of $0.1 million and by $0.4 million related to
decreased use of research, development and engineering personnel to provide services for our revenue generating contracts and to develop internal-use software. Research, development and
engineering personnel totaled 124 and 123 as of March 31, 2003 and 2002, respectively. We anticipate that we will continue to invest significantly in product research, development and
engineering for the foreseeable future.

General and administrative.General and administrative expenses consist primarily of compensation, benefits and related costs
of executive, finance and administrative personnel, facilities costs, legal and other professional fees, and depreciation and amortization expense. General and administrative expenses were
$4.9 million and $5.9 million for the three months ended March 31, 2003 and 2002, respectively. The $1.0 million or 17% decrease resulted from decreased costs of $0.7
related to outside consultants and decreased administrative costs of $0.3 million, which includes depreciation, amortization, and bad debt expense. General and administrative employees totaled
50 and 49 as of March 31, 2003 and 2002, respectively. We anticipate that we will continue to invest in general and administrative costs for the foreseeable future.

Stock-based compensation.Stock-based compensation expense includes costs relating to stock-based employee compensation
arrangements. Stock-based compensation expense is based on the difference between the fair market value of our common stock and the exercise price of options to purchase that stock on the date of
grant, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $0.4 million and $0.5 million was recorded for the
three months ended March 31, 2003 and 2002, respectively, and is included in the respective
statements of operations expense categories for the employees to which it applies. At March 31, 2003, $0.9 million of stock-based compensation remains deferred and we expect the entire
amount to be recognized as expense in 2003.

Total other income net.Total other income, net consists primarily of interest received and paid. Total other income, net was
$0.1 million and $0.3 million for the three months ended March 31, 2003 and 2002, respectively. The $0.2 million or 61% decrease resulted primarily from lower cash balances
and interest rates during the first quarter of 2003.

Provision for Income Taxes.We provided less than $0.1 million and no provision for income taxes for the three months
ended March 31, 2003 and 2002, respectively. The provision relates to taxes we believe we will pay in non-U.S. countries due to our profitable foreign operations.

Liquidity and Capital Resources

As of March 31, 2003, we had cash and cash equivalents, restricted cash, and short-term investments of $50.3 million, representing a
decrease of $2.9 million from $53.2 million at December 31, 2002. As of March 31, 2003, $16.2 million of cash and cash equivalents is restricted as a result of the
requirements of performance bonds that we are obligated to maintain in connection with some of our long-term contracts in our personal identification systems business. Working capital at
March 31, 2003 was $62.6 million, compared to working capital of $63.3 million at December 31, 2002.

The
$0.1 million of cash provided by operations for the three months ended March 31, 2003 was positively impacted by net income for the quarter, depreciation and
amortization of $2.3 million, a decrease in other current assets of $0.7 million, an increase in accrued payroll and related costs of $0.4 million, and stock-based compensation
expense of $0.4 million. Cash provided by operations for the three months ended March 31, 2003 was negatively impacted by a decrease in accounts payable of $2.3 million, an
increase in inventory of $0.6 million, an increase in restricted cash of $0.5 million, and

14

---

a
decrease in deferred revenue of $0.4 million. The $1.1 million of cash provided by operations in the three months ended March 31, 2002 was positively impacted by an increase in
accounts payable of $6.5 million, depreciation and amortization of $2.2 million, an increase of accrued payroll and related costs of $0.7 million, stock-based compensation expense
of $0.5 million, and an increase in deferred revenue of $0.4 million. Cash provided by operations for the three months ended March 31, 2002 was negatively impacted by a net loss
of $4.2 million, an increase in trade and unbilled accounts receivable, net of $4.5 million, and an increase in inventory of $0.5 million.

The
$1.7 million of cash used in investing activities for the three months ended March 31, 2003 was negatively impacted by the purchase of property and equipment of
$1.9 million and $1.8 million of capitalized software development costs, partially offset by the sale or maturity of $2.0 million in short-term investments. The
$15.3 million of cash provided by investing activities for the three months ended March 31, 2002 was positively impacted by the sale or maturity of $25.1 million of
short-term investments, partially offset by $4.2 million of purchases of short-term investments, the purchase of $3.3 million of property and equipment, and $2.0
of capitalized software development costs.

The
$0.1 million of cash provided by financing activities for the three months ended March 31, 2003 was positively impacted by the issuance of stock for $0.1 million
related to our stock incentive plans. The $0.4 million of cash provided by financing activities for the three months ended March 31, 2002 was positively impacted by the issuance of stock
for $0.6 million related to our stock incentive plans and was negatively impacted by $0.2 million of principal payments under capital leases.

Our
significant commitments consist of obligations under non-cancelable operating leases, which totaled $8.0 million as of March 31, 2003, and are payable in
monthly installments through October 2010.

Our
planned operating expenses and capital expenditures may constitute a material use of our cash resources. In addition, we may utilize cash resources to fund acquisitions or
investments in complementary businesses, technologies or product lines.

We
believe that our current cash, cash equivalents, and short-term investment balances will satisfy our projected working capital and capital expenditure requirements for at
least the next 12 months. Thereafter, we anticipate continuing to use cash, cash equivalents, and short-term investment balances to satisfy our projected working capital and capital
expenditure requirements. However, in order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities although we do not
believe at this time that our long-term working capital and capital expenditures will be of such a nature that we would be required to take steps presently to remedy any such potential
deficiency. If it were necessary to obtain additional financings or credit facilities, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 143,Accounting for Asset Retirement
Obligations. This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. We implemented SFAS No. 143 on January 1, 2003. We do not expect this statement to have a material impact on our consolidated financial position or
results of operations.

In
June 2002, the FASB issued SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities. This statement
nullifies Emerging Issues Task Force ("EITF") Issue No. 94-3 ("EITF 94-3"),Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).SFAS No. 146 requires that a liability for a cost associated with an exit or
disposal activity is recognized when the liability is incurred. Under EITF

15

---

94-3,
liabilities for exit costs were recognized at the date of an entity's commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities
that are initiated after December 31, 2002. We implemented SFAS No. 146 on January 1, 2003 and do not expect this statement to have a material impact on our consolidated financial
position or results of operations.

In
November 2002, the EITF reached a consensus on Issue No. 00-21 ("EITF 00-21"),Revenue Arrangements with Multiple
Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating
activities. EITF 00-21 will be effective for interim periods beginning after June 15, 2003. We do not expect this issue to have a material impact on our consolidated financial
position or results of operations.

Risks Related to Our Business

The markets for digital watermark applications are new and developing

Digital watermarking is a new and developing technology. Our success depends on the acceptance of this technology and the adoption of applications in areas such
as digital media commerce, counterfeiting and piracy deterrence, self-authentication of documents, and security and intelligence applications. The markets for products and services using
digital watermarks are evolving and are characterized by an increasing number of market entrants who have introduced or developed products and services using digital watermarking or alternative
technologies. As is typical in a new and evolving industry, demand and market acceptance of recently introduced products and services are subject to a high level of uncertainty. Our products and
services relating to digital watermarking are currently used by only a limited number of customers. It is difficult to predict the future growth rate, if any, and ultimate size of these markets or our
anticipated future markets. We cannot assure you that new markets for our products and services will develop or that our existing markets will grow.

Uncertainties associated with the integration of the Digimarc ID Systems business into our existing business could cause an interruption or loss in momentum in our existing
business and operating activities and the business and operating activities of the business acquired and, if material, might harm us

The
integration of the operations of Digimarc ID Systems, LLC and its affiliates (collectively referred to as "DIDS") into our business involves a number of risks, including:



16

---



The
process of integrating DIDS' operations could cause an interruption or loss in momentum in our business and operating activities and, if material, could harm our business. Moreover,
in the course of the integration and transition effort, we may discover facts or circumstances that were not known or apparent prior to the date we acquired the assets from Polaroid Corporation,
Polaroid ID Systems, Inc. and some other affiliated entities of Polaroid Corporation or during our due diligence review of these assets prior to the acquisition. These facts and circumstances
could result in delays or interruptions in the integration and transition and may have other negative effects which, if material, could adversely affect our business.

We may incur additional charges related to the integration of the Digimarc ID Systems business into Digimarc which might exceed our expectations and materially affect our
business, financial condition and results of operations

In connection with the acquisition of DIDS, we may incur charges or capital expenditures associated with integrating the acquired business with our existing one.
These charges may include:



While
we have completed more than a year's worth of transition activities, these activities and the risks associated with them will continue through the next few quarters.

While
many of the transition activities are complete or nearing completion, the aggregate amount of additional expenses, if any, is not yet determinable, but could be significant. In
addition, we cannot assure you that we will not incur additional charges in subsequent quarters to reflect costs and residual risks associated with the integration of DIDS' operations. Adverse
developments could include employee turnover, problems in integrating new financial and information systems, problems associated with the relocation to new office space, and remaining film and other
dependencies involving Polaroid. Any remaining costs that exceed our expectations could materially affect our business, financial condition, and results of operations.

We may not realize the synergistic benefits expected from the acquisition of DIDS

We cannot assure you that we will realize the synergistic benefits sought through the acquisition of DIDS. Although we view this acquisition as an opportunity to
significantly enhance the security and usefulness of driver licenses and other DIDS products, we cannot assure you that we will be successful in combining our current technological applications and
product offerings with those of DIDS or that the combined product offerings will be acceptable in the marketplace. Factors that could affect acceptance of these combined product offerings are changes
in government regulations and industry standards, and increased competition from DIDS' competitors who may develop superior or alternative technology that is more widely acceptable in the marketplace.
We cannot assure you that, if we fail to realize the synergistic benefits sought through the acquisition of DIDS, the resulting effect will not harm our business, operating results and financial
condition.

17

---

We have a history of losses and we cannot assure you that we will maintain profitability

We have incurred significant net losses since inception. Our accumulated deficit as of March 31, 2003 was approximately $56.0 million. In order to
maintain profitability, we will need to generate higher revenue than we have in prior years while controlling expenditures related to those higher revenues. Even though we achieved profitability
during the first quarter of 2003, we may not be able to sustain or increase our profitability. If our revenue grows more slowly than we anticipate, or if our operating expenses exceed our
expectations, our operating results will be harmed and we may not be profitable.

Because some of our revenue models relating to anticipated products and services are under development and the corresponding anticipated products and services may fail to
attract or retain customers, we cannot assure you that anticipated products and services will generate or sustain revenues

Our business involves embedding digital watermarks in traditional and digital media, including identification documents, secure documents, and images distributed
on the Internet, and licensing our intellectual property. Through 2001, our revenue stream was based primarily on a combination of development, consulting, subscription and license fees from copyright
protection and counterfeit deterrence applications. Beginning in 2002 and for the foreseeable future, we have seen, and we anticipate, that the majority of our revenues will be from government and
private sector customers for security-related applications relating to secure personal identification, copyright protection, and counterfeit deterrence to government and private sector customers. We
have not fully developed revenue models for our future applications and licensing endeavors. In addition, because some of our products and services are not yet fully established in the marketplace and
because such products and services will be sold in new and undeveloped markets, we cannot be certain that the pricing structure and marketing for them will be effective. We cannot assure you that our
anticipated products and services and licensable intellectual property will be able to compete effectively against other alternative technologies in our target markets or that we will be able to
compete effectively against current or future digital watermarking suppliers in terms of price, performance, applications or other features of their technologies. In addition, as we develop models for
generating revenue, they may not be sustainable over time, and as a result, our business, operating results and financial condition may seriously be harmed.

The loss of any large contract may seriously harm our business, operating results and financial condition

Contracts between government agencies and DIDS have varying duration, averaging four to five years in length, after which the government agency can
re-open the contract for competitive bidding. If we were to lose a contract, in addition to the loss of revenue and margin on a prospective basis, we could also incur accelerated
amortization expense or impairment of tangible or intangible assets related to the customer. The loss of one or more large contracts with governmental agencies may seriously harm our business,
operating results and financial condition.

We
historically derived a substantial portion of our revenue from a consortium of leading central banks with which we have a development and license agreement related to banknote
counterfeit deterrence. Since the acquisition of DIDS, revenue generated from the consortium has decreased as a percentage of our total revenue to below 10% for 2002. Nevertheless, the loss of this
consortium as a customer could harm our business, operating results and financial condition. The consortium has the right to terminate the agreement prior to the expiration of its term. Unless the
consortium exercises this right, we expect to earn revenue under the agreement through at least 2003, which concludes the current agreement with the consortium of banks. While we believe that the
agreement will be renewed for future periods, we cannot guarantee that this will happen.

18

---

Under
the terms of our agreement with the consortium, we are obliged to keep the identity of the participating banks, design of the system and timetable for deployment confidential. Any
change in our relationship with the consortium, including any actual or alleged breach of the contract by either party or the early termination of, or any other material change in, the agreement could
seriously harm our business, operating results and financial condition.

Our future growth will depend to some extent on our successful implementation of our intellectual property in solutions provided by third-party partners

Some of the products, services, and licensing of intellectual property that we intend to provide in the future will rely on the successful implementation of our
technology, including our reader technology, by third-party software developers and original equipment manufacturers. We anticipate maintaining and entering into agreements with third-party vendors to
create, promote and service products that incorporate, embed, integrate or bundle our technologies. If we fail to obtain partners that will incorporate, embed, integrate or bundle our technologies, or
these partners are unsuccessful in their efforts, our business, operating results and financial condition could be seriously harmed. In addition, if our technologies do not perform according to market
expectations, our business may be seriously harmed.

We have a limited operating history and are subject to the risks encountered by early-stage companies

We began our business in January 1995. Accordingly, we have a limited operating history, and our business and prospects must be considered in light of the
risks and uncertainties to which early-stage companies in new and rapidly evolving markets, such as digital watermarking, are exposed. These risks include the following:



We
cannot assure you that our business strategy will be successful or that we will successfully address these risks and the other risks described elsewhere in this report.

19

---



A significant portion of our business depends on large public sector contracts, which can be terminated at the convenience of the government authority, are subject to a variety
of requirements and influences and may only result in one-time revenue without potential for renewal

A significant portion of our business depends on a limited number of large public sector contracts. Government contracts are generally subject to termination for
convenience or lack of appropriation at the determination of the subject agency. Further, some government contracts may be one-time events, such as in the case of some personal
identification systems in foreign markets involving voter registration programs. In such cases, we may generate substantial revenues without renewal. Moreover, government contracts result from
purchasing decisions made by public sector agencies that may be subject to political influence, unusual procurement procedures, strict legal requirements, budget changes and cutbacks during economic
downturns, variations in appropriations cycles, and protests of contract awards. Additionally, some governmental authorities require performance or fidelity bonds that we are obligated to maintain
during the life of the contract. Often, the terms of these bonds require that we maintain large restricted cash reserves as a guarantee, reducing our ability to use these funds for our other business
purposes. The size, nature and purpose of, and the risks and uncertainties associated with, public sector contracts can impact the predictability of our quarterly results and may potentially have a
material negative effect on our financial position, results of operation or cash flows.

The majority of our revenues are subject to government procurement processes that are subject to unpredictable delays or unexpected changes

We derive substantial portions of our revenue from government contracts which are subject to periodic open competitive bids. The timing of such bids is solely
within the discretion of the governmental authority. Consequently, large components of new revenue are tied to procurement schedules, which could shift as the needs of the related government
procurement agencies change. Many U.S. state customers are facing budget cuts, and some international customers are facing debt crises, introducing added uncertainty. Any shift in the government
procurement process, which is outside of our control and may not be predictable, could result in delays in bookings forecasted for any particular financial period, could impact the predictability of
our quarterly results and may potentially have a material negative effect on our financial position, results of operation or cash flows.

Our future quarterly operating results may not meet analysts' expectations and may fluctuate significantly, which could adversely affect our stock price

Our quarterly operating results have fluctuated significantly in the past and may do so in the future. Our operating results are difficult to forecast because of
our limited operating history and the nature of our business. Accordingly, you should not rely on quarter-to-quarter comparisons of our historical results as an indication of
future performance or any trend in our performance. If our quarterly operating results do not meet the expectations of analysts or investors, the market price of our common stock will likely decline.

Our
quarterly results may fluctuate in the future as a result of several factors, many of which are outside our control, including:



20

---



In
addition, because the markets for certain of our products and services are new and rapidly evolving, it is difficult for us to predict certain aspects of our future financial results.
Our research and development, sales and marketing efforts and business expenditures are based in part on our expectations regarding developments involving counterfeiting and piracy, as well as other
security and intelligence needs, and on our estimates as to the use of digital watermarking as a solution to those problems. To the extent that these predictions prove inaccurate, our revenue and
operating results will fluctuate from our anticipated results.

We may not be able to adequately protect our intellectual property, and we may be subject to infringement claims

Our success depends in part on licensing our proprietary technologies. We rely on a combination of patent, copyright, trademark and trade secret rights,
confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. We face risks associated with our patent position, including the potential and sometimes actual
need to engage in significant legal proceedings
to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our
patents and the possibility that our products may infringe patent rights of third parties. Budgetary concerns may cause us not to file, or continue, litigation against known infringers of our patent
rights. Failure to reliably enforce our patent rights against infringers may make licensing more difficult. If we fail to protect our intellectual property rights and proprietary technologies
adequately, if there are changes in applicable laws that are adverse to our interests, or if we become involved in litigation relating to our intellectual property rights and proprietary technologies
or relating to the intellectual property rights of others, our business could be seriously harmed.

As
part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, directors, consultants and corporate partners, and attempt to
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 our technologies, solutions or other proprietary information or independently develop similar technologies, solutions or information. The steps that we have taken to prevent
misappropriation of our solutions, technologies or other proprietary information may not prevent their misappropriation, particularly in non-U.S. countries where laws or law enforcement
practices may not protect our proprietary rights as fully as in the United States.

Effective
protection of intellectual property rights may be unavailable or limited, both in the United States and in non-U.S. countries. Patent protection throughout the
world is generally established on a country-by-country basis. We have applied for patent protection both in the United

21

---

States
and in various countries outside the United States. However, we cannot assure you that pending patents will be issued or that issued patents will be valid or enforceable. We cannot assure you
that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar technologies, duplicate our services or design around any of our patents
or other intellectual property rights we hold.

Some
of our contracts include provisions assuring non-infringement of third party intellectual property rights. If an infringement arose in a context governed by such a
contract, our exposure could be large and our business could be materially harmed.

We
are the exclusive licensee under some third party patents, and may need the assistance of these parties if we choose to enforce any of these patent rights. The cooperation of these
third parties cannot be assured. Although we do not currently rely on these technologies for our core products, we may in the future.

We
have registered "DIGIMARC", "MARCSPIDER", "MARCCENTRE", "MEDIABRIDGE", "PICTUREMARC" and the "D" logo as trademarks in the United States and some other countries, and are pursuing
registration of the "DIGIMARC" trademark in additional countries. However, our tradenames or trademarks may be registered by third parties in other countries, impairing our ability to enter and
compete in these markets. In the United States, the trademark "Digimark" and the domain names "Digimark.com" and "Mediabridge.com" have been registered by unrelated companies. While we have put in
place formal arrangements for co-existence with one of these unrelated companies, and while we have co-existed successfully to date with the others, if we were forced to change
our name or were prevented from using our other brand names, we would lose a significant amount of our brand equity, and our business would suffer.

As
more companies engage in business activities relating to digital watermarking and develop intellectual property rights, it is increasingly likely that claims may arise which assert
that some of our products or services infringe upon other parties' intellectual property rights. These claims could subject us to costly litigation, divert management resources and result in the
invalidation of our intellectual property rights. These claims may require us to pay significant damages, cease production of infringing products, terminate our use of infringing technologies or
develop non-infringing technologies. In these circumstances, continued use of our technologies may require that we acquire licenses to the intellectual property that is the subject of the
alleged infringement, and we might not be able to obtain these licenses on commercially reasonable terms or at all. Our use of protected technologies may result in liability that threatens our
continuing operation. In addition, we offer indemnification against intellectual property infringement for some contracts to which we are a party. If a claim were made under such an indemnity
provision, we could incur significant expense.

The security systems that we use in our proprietary technologies and in our business may be circumvented by third parties, which could damage our reputation and disrupt our
business

Many of our products and services involve the embedding of digital code in media content that is imperceptible in normal use but that can be read by digital
devices. The success of these products and services depends on the security of our media commerce, anti-counterfeiting and piracy systems, self-authentication solutions, and
supporting infrastructure. Security breaches of these systems and solutions could damage our reputation and expose us to a risk of loss or litigation and possible liability. The security measures that
we use may not prevent security breaches, and failure to prevent these security breaches may disrupt our business. A party who is able to circumvent our security measures could misappropriate
proprietary information or cause interruptions or otherwise damage our products, services and reputation and the properties of our customers. If unintended parties obtain sensitive data and
information, or create bugs or viruses in an attempt to sabotage the functionality of our products

22

---

and
services, we may receive negative publicity, incur liability to our customers or lose the confidence of our customers, any of which may cause the termination or modification of our contracts.

We
may be required to expend significant capital and other resources to protect ourselves against the threat of security breaches or to alleviate problems caused by these breaches.
However, protection may not be available at a reasonable price or at all.

Our products could have unknown defects or errors, which may give rise to claims against us or divert application of our resources from other purposes

Products and systems as complex as those we offer or develop frequently contain undetected defects or errors. Despite testing, defects or errors may occur in
existing or new products, which could result in loss of revenue or market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance
costs and increased service and warranty costs, any of which could materially harm our business. Furthermore, we often provide implementation, customization, consulting and other technical services in
connection with the implementation and ongoing maintenance of our products. The performance of these products typically involves working with sophisticated software, computing and communications
systems. Our inability to meet customer expectations or project milestones in a timely manner could also result in a loss of, or delay in, revenue, loss of market share, failure to achieve market
acceptance, injury to our reputation and increased costs.

Because
many customers rely on our products for critical security applications, defects or errors in our products or services might discourage customers from purchasing future products
and services. These defects or errors could also result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty
disclaimers and liability limitation clauses in our sales agreements, these contractual provisions are sometimes not included and may not be enforceable in every instance. Furthermore, although we
maintain errors and omissions insurance, this insurance coverage may not adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason,
or if liabilities arose that were not contractually limited or adequately covered by insurance, our business could be materially harmed.

During
2002, DIDS engaged in activities in a number of jurisdictions to finish projects begun prior to our acquisition from Polaroid Corporation and its affiliates of the U.S. large
government programs identification systems and international digital identification systems businesses. DIDS also engaged in activities in several jurisdictions to correct legacy defects from
installations prior to our acquisition that were identified during or since the acquisition process as needing remedial action. We have made considerable progress with regard to these activities.
Nonetheless, there may be additional issues or defects that we have not yet identified that may require significant efforts and resources to correct and that would cause us to divert resources away
from other purposes.

We may encounter difficulties managing our planned growth and expansion that may harm our business

As of March 31, 2003 we had 377 employees and 53 contract workers. To effectively manage our operations, management must continue to improve our
operational and financial systems and train, improve and manage our employee base. Less than optimal rates of growth of our product lines and areas of business may require us to restructure our
business from time to time which, in turn, could significantly strain our managerial and financial resources. If we cannot manage our growth effectively, we may not be able to coordinate the
activities of our technical, legal, accounting and marketing staffs, and our business could be harmed.

23

---

If there is a sustained downturn in purchases or adoption of new technologies, our business may be harmed

Our growth plans assume, in part, that new technologies will gain widespread market acceptance and be purchased by a growing number of customers. If there is a
sustained downturn in purchases or adoption of new technologies, we may be unable to realize anticipated future revenue and our business could be materially harmed.

We may acquire other businesses or technologies and, if we do, we may be unable to integrate them with our own business, or we may impair our financial performance as a result
of doing so

From time to time we have discussions with third parties about potential acquisitions. If appropriate opportunities present themselves, we may attempt to acquire
other businesses or technologies. We may not be able to identify, negotiate or finance any future acquisition successfully. Other than the acquisition of DIDS, we have limited experience in
integrating an acquired business into our existing business. The process of integration may produce operating difficulties and expenditures and may require significant attention of our management that
otherwise would be available for the ongoing development of our business. In the end, we may be unsuccessful in integrating an acquired business or technology with our existing business. Moreover, if
we make acquisitions, we may issue shares of our stock that would dilute the equity holdings of our existing stockholders, incur debt, assume contingent liabilities or create additional expenses
related to amortizing intangible and other assets, any of which might negatively affect our financial results and cause our stock price to decline. Our due diligence of acquired companies may fail to
reveal material risks or liabilities. Any financing that we might need for future acquisitions may also place restrictions on our business. Furthermore, we may never achieve any of the benefits that
we might anticipate from a future acquisition.

We depend on key employees for our future success

Our success depends to a significant extent on the performance and continued service of our senior management. Almost all of our senior management do not have
employment agreements. Although our employees generally have executed agreements containing non-competition clauses, there is no assurance that a court would enforce all of the terms of
these clauses or the clauses generally. If these clauses were not fully enforced, our employees would be freely able to join our competitors. The loss of the services of any of our senior management
or any of our other key employees could harm our business.

If we are not able to retain, hire or integrate qualified personnel, our business may be harmed

Our ability to successfully develop, market, sell and license our products, services, and intellectual property depends to a significant degree upon the continued
contributions of our key personnel in engineering, sales, marketing and operations, many of whom would be difficult to replace. We believe our future success will also depend in large part upon our
ability to retain our current key employees or our ability to attract, integrate and retain other highly skilled managerial, engineering, sales, marketing, and operations personnel in the future. Our
business is based in part on patented technology, which is unique and not generally known. New employees require substantial training, involving significant resources and management attention.
Competition for experienced personnel in our market segments can be intense. If we do not succeed in attracting new, qualified personnel or in integrating, retaining and motivating our current
personnel, our business could be harmed.

24

---

Our promotion of the Digimarc brand must be successful in order for us to attract users and other strategic partners

We believe that establishing and maintaining our brand is important to our success and that the importance of brand recognition will increase due to the growing
number of technologies that compete with our watermarking technologies and the increasing number of competitors offering technologies similar to ours. If our brand-building strategy is unsuccessful,
the effort and expenses spent may never be recovered, we may be unable to increase our future revenue and our business could be seriously harmed.

Anti-takeover provisions in our charter documents could prevent or delay transactions from occurring that could be profitable for our stockholders

The anti-takeover provisions of Delaware law and our certificate of incorporation and bylaws may make a change of control of us more difficult, even
if a change of control would be beneficial to our stockholders. These provisions may allow our board of directors to prevent changes in management and control of us. Under Delaware law, our board may
adopt additional anti-takeover measures in the future.

We
have the following anti-takeover provisions in our charter documents:



These
provisions could have the effect of discouraging a third party from making a tender offer or otherwise attempting to gain control of us. In addition, these provisions could limit
the price that investors might be willing to pay in the future for shares of our common stock.

Risks Related to Our Markets

If we are unable to respond to regulatory or industry standards effectively, our business could be harmed

Our future success will depend in part on our ability to enhance and improve the responsiveness, functionality and features of our products and services in
accordance with regulatory or industry standards. Our ability to remain competitive will depend in part on our ability to influence and respond to emerging industry and statutory standards, including
any standards that may be adopted for the protection of audio, video, and image content, and for other uses of metadata with such content, in a timely and cost-effective manner. If we are
unable to influence or respond to these standards effectively, our business could be harmed.

If we are unable to integrate new technologies effectively, our business could be harmed

Our target markets are characterized by new and evolving technologies. The success of our business will depend on our ability to address the increasingly
sophisticated technological needs of our

25

---

customers
in a timely and cost-effective manner. Our ability to remain competitive will depend in part on our ability to:



We
cannot assure you that we will be successful in responding to these technological and industry challenges in a timely and cost-effective manner. If we are unable to
integrate new technologies effectively or respond to these changing needs, our business could be harmed.

If leading companies in our industry or standard setting bodies or institutions downplay, minimize, or reject the use of watermarking, our business could be harmed

Many of our business endeavors, from our work for the consortium of banks to our licensing of intellectual property in support of audio and video applications,
can be impeded or frustrated by larger, more influential companies or by standard setting bodies or institutions downplaying, minimizing or rejecting the value or use of watermarking technology or any
of our other technologies. Such a negative position by these companies, bodies or institutions, if taken, may result in obstacles for us that we would be incapable of overcoming and may make achieving
our business objectives difficult or impossible, harming our business as a result.

Our markets for digital watermarking applications are highly competitive

The markets for digital watermarking applications are intensely competitive and rapidly evolving. We expect competition to continue from both existing competitors
and new market entrants. We face competition from other companies using digital watermarking technologies and from alternative technologies. As we expand the applications for our digital watermarking
technologies, we will experience more competition from products and services that are substitutes for our digital watermarking applications. Because our business models are new and emerging, we may
face competition from unexpected sources. Alternative technologies that may directly or indirectly compete with particular applications of our watermarking technologies include:



26

---



In
addition, as we more broadly apply our technologies to the Internet through new commercial solutions applications, we may begin to compete with a wide range of other types of
companies beyond those companies using digital watermarking technologies and alternative technologies. Moreover, many of the companies that currently compete with us, as well as other companies with
whom we may compete in the future, are national or international in scope and may have greater technical, financial, marketing, and political resources than we do. These resources could enable these
companies to initiate severe price cuts or take other measures in an effort to gain market share or otherwise impede our progress in target markets. We cannot assure you that digital watermarking
technologies, and our products and services using these technologies, will gain widespread market acceptance.

New
developments are expected to continue, and we cannot assure you that discoveries by others, including current and potential competitors, will not render our services and products
noncompetitive. Moreover, because of rapid technological changes, we may be required to expend greater amounts of time and money than currently anticipated to develop new products and services, which
in turn may necessitate us to require greater revenue streams on such products and services to cover developmental costs. We cannot assure you that we will be able to compete successfully against
current or future participants in our markets or against alternative technologies, nor can we assure you that the competitive pressures we face will not harm our business, operating results and
financial condition.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The Company's market risk disclosures set forth in Item 7A of its Annual Report on Form 10-K for the year ended December 31, 2002 have
not changed materially. In addition, if market interest rates were to increase immediately and uniformly by 10% from levels as of December 31, 2002, the decline of the fair market value of our
fixed income portfolio and loans outstanding would not be material.

Item 4. Controls and Procedures.

Within the 90-days prior to the filing of this report, we carried out an evaluation, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. There have been no
significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to our most recent evaluation of our internal controls. It should be noted
that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions, regardless of how remote.

27

---

PART II. OTHER INFORMATION.

Item 1. Legal Proceedings.

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the
United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's
initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint
alleges, among other things, that the underwriters of our initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed
commissions or stock stabilization practices) in our initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of our stock in the
after-market subsequent to our initial public offering. Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of
1933, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters' alleged compensation
arrangements and manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a Court Order dated
October 9, 2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, Digimarc and the other issuers in the consolidated cases filed motions to dismiss the
amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including Digimarc. The
claims against Digimarc under Section 10(b), however, were dismissed. We intend to defend these actions vigorously. Due to the inherent uncertainties of litigation and because the litigation is
still at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

In
October 2002, we filed a patent infringement case against Spectra Systems Corporation in the United States District Court for the District of Delaware alleging infringement of
Digimarc's patents 5,636,292, 5,745,604 and 6,385,330. In May 2003, Digimarc settled the patent infringement lawsuit it brought against Spectra Systems Corporation in the United States District Court
for the District of Delaware. Under the terms of the settlement, Spectra Systems Corporation agreed to not sell driver license products involving digital watermarking technology claimed in Digimarc
patents.

Item 5. Other Information.

In March 2003, our board of directors adopted a resolution, in accordance with the terms of our Second Amended and Restated Certificate of Incorporation,
as amended, and our Amended and Restated
Bylaws, which amended Section 3.1 of our Amended and Restated Bylaws to increase the size of our board of directors from eight to nine members. Thereafter, our board of directors elected
James T. Richardson to fill the newly created vacancy on our board of directors and, in addition, appointed Mr. Richardson to the audit committee of our board of directors.

In
April 2003, our board of directors approved a revised Audit Committee Charter and Audit Committee Responsibilities Checklist. This Form 10-Q includes as an
exhibit hereto the revised Audit Committee Charter and Audit Committee Responsibilities Checklist.

Finally,
this Form 10-Q includes as an exhibit hereto an Employment Agreement, dated as of July 16, 2001, between Digimarc and Bruce Davis, our Chief Executive
Officer, which was inadvertently not previously filed.

Item 6: Exhibits and Reports on Form 8-K.







28

---





SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.

|                   |  | DIGIMARC CORPORATION
|------------------ |  | --------------------
|Date: May 15, 2003 |  | By:                 

29

---



CERTIFICATION

I, Bruce Davis, certify that:

Date:
May 15, 2003

| |  |     |                                                  
| |  | --- | -------------------------------------------------
| |  | By: | /s/BRUCE DAVISBruce Davis Chief Executive
Officer

30

---



CERTIFICATION

I, E.K. Ranjit, certify that:

Date:
May 15, 2003

| |  |     |                                                  
| |  | --- | -------------------------------------------------
| |  | By: | /s/E.K. RANJITE.K. Ranjit Chief Financial
Officer

31

---

EXHIBIT INDEX

|Exhibit
Number |  | Document                                                                                                                                                                                                                                                                              
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1            |  | Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Securities and Exchange Commission on November 14,
2000)                            
|3.2            |  | Certificate of Amendment of Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Securities and Exchange
Commission on November 14, 2000)
|3.3            |  | Amended and Restated Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 of Exhibits to Registrant's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 31, 2003)                                                   
|10.1           |  | Employment Agreement, dated as of July 16, 2001, between the Registrant and Bruce Davis                                                                                                                                                                                               
|99.1           |  | Audit Committee Charter and Audit Committee Responsibilities Checklist                                                                                                                                                                                                                

---

QuickLinks