**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

 

**Washington, 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 SEPTEMBER 30,  2004**                                                                                                                                                                 |
|                                                                                                                                                                                                                        |
| **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**

 

**DIGIMARCCORPORATION**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                | ** ** | **94-3342784**                   |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction ofincorporation or organization)    | ** ** | (I.R.S. Employer Identification  No.) |
| ** **                                                       | ** ** | ** **                            |
| **9405 SW Gemini Drive, Beaverton, Oregon**                      |       | **97008**                             |
| (Address of principal executive offices)                         |       | (Zip Code)                            |
| ** **                                                       |       |                                  |
| **(503) 469-4800**                                               |
|  (Registrant’s  telephone number, including area code) |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes  o   No   ý

 

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

 

As of March 31, 2005, there were 20,723,429 shares of the registrant’scommon stock, par value $0.001 per share, outstanding.

 

 

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**Table of Contents**

 
| **PART I  FINANCIAL INFORMATION** | ** **                                                                                                                                            |
|----------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                | Financial Statements:                                                                                                                                 |   |
|                                   | Condensed Consolidated  Balance Sheets as of September 30, 2004 and December 31, 2003  (restated).                                          |   |
|                                   | Condensed  Consolidated Statements of Operations for the three and nine months ended September 30,  2004 and September 30, 2003 (restated). |   |
|                                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and September 30, 2003 (restated).           |   |
|                                   | Notes  to Condensed Consolidated Financial Statements.                                                                                                |   |
| Item  2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations.                                                          |   |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk.                                                                                          |   |
| Item 4.                                | Controls and  Procedures.                                                                                                                             |   |
| **PART II  OTHER INFORMATION**    | ** **                                                                                                                                            |
| Item 1.                                | Legal  Proceedings.                                                                                                                                   |   |
| Item 2.                                | Changes in  Securities, Use of Proceeds and Issuer Purchasers                                                                                         |   |
| Item 6.                                | Exhibits.                                                                                                                                             |   |
| **SIGNATURES**                         |                                                                                                                                                  |

 

----

 

**PART I.FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**DIGIMARC CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003 (1)** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | ** **                   | ** ** | **(Restated)**                  | ** ** |
| **ASSETS**                                       |       |                         |       |                            |       |
| Current  assets:                                 |       |                         |       |                            |       |
| Cash and  cash equivalents                       |       | $                            | 31,726     |                            | $          | 33,626 |   |
| Restricted  cash                                 |       | —                       |       | 1,976                           |       |
| Short-term  investments                          |       | 23,984                       |       | 43,031                          |       |
| Trade  accounts receivable, net                  |       | 11,277                       |       | 9,168                           |       |
| Unbilled  trade receivables                      |       | 4,554                        |       | 4,321                           |       |
| Inventory,  net                                  |       | 5,802                        |       | 6,253                           |       |
| Other  current assets                            |       | 1,446                        |       | 2,052                           |       |
| Total  current assets                            |       | 78,789                       |       | 100,427                         |       |
| Restricted  cash                                 |       | 235                          |       | —                          |       |
| Property and  equipment, net                     |       | 59,399                       |       | 35,813                          |       |
| Intangibles,  net                                |       | 21,814                       |       | 23,698                          |       |
| Other  assets, net                               |       | 1,172                        |       | 1,215                           |       |
| Total assets                                     |       | $                            | 161,409    |                            | $          | 161,153 |   |
|                                             |       |                         |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   |       |                         |       |                            |       |
| Current  liabilities:                            |       |                         |       |                            |       |
| Accounts  payable                                |       | $                            | 6,683      |                            | $          | 6,584 |   |
| Accrued  payroll and related costs               |       | 2,233                        |       | 1,069                           |       |
| Deferred  revenue                                |       | 3,574                        |       | 3,160                           |       |
| Other  current liabilities                       |       | 1,457                        |       | 304                             |       |
| Total  current liabilities                       |       | 13,947                       |       | 11,117                          |       |
| Other  long-term liabilities                     |       | 1,049                        |       | 1,286                           |       |
| Total  liabilities                               |       | 14,996                       |       | 12,403                          |       |
| Stockholders’  equity:                      |       |                         |       |                            |       |
| Common stock                                     |       | 21                           |       | 20                              |       |
| Additional  paid-in capital                      |       | 206,789                      |       | 203,634                         |       |
| Accumulated  other comprehensive income          |       | 8                            |       | 96                              |       |
| Warrant                                          |       | —                       |       | 881                             |       |
| Accumulated  deficit                             |       | (60,405                      | )          | (55,881                         | )          |
| Total  stockholders’ equity                 |       | 146,413                      |       | 148,750                         |       |
| Total  liabilities and stockholders’ equity |       | $                            | 161,409    |                            | $          | 161,153 |   |

 

----

(1)          Derived from the Company’s December 31, 2003 restated auditedconsolidated financial statements

 

See Notes to Condensed Consolidated Financial Statements.

 

1

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**DIGIMARC CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

**(UNAUDITED)**

 
| ** **                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | ** **                                 | ** ** | **(Restated)**                            | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Revenue:                                         |       |                                       |       |                                      |       |   |   |   |   |
| Service                                          |       | $                                          | 20,001     |                                      | $          | 19,471 |   | $ | 55,524 |   | $ | 55,351 |   |
| Product and  subscription                        |       | 3,519                                      |       | 2,829                                     |       | 15,128 |   | 11,199 |   |
| Total  revenue                                   |       | 23,520                                     |       | 22,300                                    |       | 70,652 |   | 66,550 |   |
| Cost of  revenue:                                |       |                                       |       |                                      |       |   |   |   |   |
| Service                                          |       | 11,942                                     |       | 10,482                                    |       | 33,199 |   | 29,928 |   |
| Product and  subscription                        |       | 1,788                                      |       | 1,462                                     |       | 10,139 |   | 6,383 |   |
| Total cost  of revenue                           |       | 13,730                                     |       | 11,944                                    |       | 43,338 |   | 36,311 |   |
| Gross profit                                     |       | 9,790                                      |       | 10,356                                    |       | 27,314 |   | 30,239 |   |
| Operating  expenses:                             |       |                                       |       |                                      |       |   |   |   |   |
| Sales and  marketing                             |       | 3,090                                      |       | 2,748                                     |       | 8,493 |   | 9,095 |   |
| Research,  development and engineering           |       | 1,931                                      |       | 1,427                                     |       | 5,203 |   | 5,962 |   |
| General and  administrative                      |       | 7,436                                      |       | 5,404                                     |       | 18,480 |   | 14,567 |   |
| Total  operating expenses                        |       | 12,457                                     |       | 9,579                                     |       | 32,176 |   | 29,624 |   |
| Operating  income (loss)                         |       | (2,667                                     | )          | 777                                       |       | (4,862 | ) | 615 |   |
| Other income  (expense):                         |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                  |       | 232                                        |       | 162                                       |       | 659 |   | 470 |   |
| Interest  expense                                |       | (30                                        | )          | (2                                        | )          | (81 | ) | (6 | ) |
| Other                                            |       | (8                                         | )          | (14                                       | )          | (12 | ) | (48 | ) |
| Total other  income, net                         |       | 194                                        |       | 146                                       |       | 566 |   | 416 |   |
| Income  (loss) before provision for income taxes |       | (2,473                                     | )          | 923                                       |       | (4,296 | ) | 1,031 |   |
| Benefit (provision)  for income taxes            |       | 6                                          |       | (81                                       | )          | (228 | ) | (243 | ) |
| Net income  (loss)                               |       | $                                          | (2,467     | )                                         | $          | 842 |   | $ | (4,524 | ) | $ | 788 |   |
| Net income  (loss) per share–basic          |       | $                                          | (0.12      | )                                         | $          | 0.04 |   | $ | (0.22 | ) | $ | 0.04 |   |
| Net income  (loss) per share–diluted        |       | $                                          | (0.12      | )                                         | $          | 0.04 |   | $ | (0.22 | ) | $ | 0.04 |   |
| Weighted  average shares outstanding - basic     |       | 20,371                                     |       | 18,752                                    |       | 20,287 |   | 18,072 |   |
| Weighted  average shares outstanding - diluted   |       | 20,371                                     |       | 19,727                                    |       | 20,287 |   | 18,840 |   |

 

See Notes to Condensed Consolidated Financial Statements.

 

2

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**DIGIMARC CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                                | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| ** **                                                                                | ** ** | **(Restated)**               | ** ** | **(Restated)** | ** ** |
| Cash flows  from operating activities:                                                    |       |                         |       |   |   |
| Net income  (loss)                                                                        |       | $                            | (4,524     | ) | $ | 788 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                         |       |   |   |
| Depreciation  and amortization                                                            |       | 9,701                        |       | 7,888 |   |
| Stock-based  compensation expense                                                         |       | —                       |       | 1,178 |   |
| Impairment  of investments                                                                |       | 300                          |       | — |   |
| Issuance of  common stock for litigation settlement                                       |       | 348                          |       | — |   |
| Other  non-cash charges                                                                   |       | 574                          |       | 122 |   |
| Changes in  operating assets and liabilities:                                             |       |                         |       |   |   |
| Restricted  cash                                                                          |       | 1,741                        |       | 10,693 |   |
| Trade and  unbilled accounts receivable, net                                              |       | (2,342                       | )          | 2,026 |   |
| Inventory,  net                                                                           |       | 451                          |       | 69 |   |
| Other  current assets                                                                     |       | 606                          |       | 382 |   |
| Other  assets, net                                                                        |       | (257                         | )          | (137 | ) |
| Accounts  payable                                                                         |       | 99                           |       | (3,908 | ) |
| Accrued  payroll and related costs                                                        |       | 1,164                        |       | 751 |   |
| Deferred  revenue                                                                         |       | 414                          |       | (648 | ) |
| Other  liabilities                                                                        |       | 974                          |       | 52 |   |
| Net cash  provided by operating activities                                                |       | 9,249                        |       | 19,256 |   |
| Cash flows  from investing activities:                                                    |       |                         |       |   |   |
| Purchase of  property and equipment                                                       |       | (22,309                      | )          | (6,463 | ) |
| Capitalization  of labor costs                                                            |       | (9,679                       | )          | (4,495 | ) |
| Sale or  maturity of short-term investments                                               |       | 173,389                      |       | 8,790 |   |
| Purchase of  short-term investments                                                       |       | (154,342                     | )          | (14,029 | ) |
| Net cash  used in investing activities                                                    |       | (12,941                      | )          | (16,197 | ) |
| Cash flows  from financing activities:                                                    |       |                         |       |   |   |
| Net proceeds  from issuance of common stock                                               |       | 1,927                        |       | 27,210 |   |
| Principal  payments under capital lease obligations                                       |       | (135                         | )          | (7 | ) |
| Net cash  provided by financing activities                                                |       | 1,792                        |       | 27,203 |   |
| Net increase  (decrease) in cash and cash equivalents                                     |       | (1,900                       | )          | 30,262 |   |
| Cash and  cash equivalents at beginning of period                                         |       | 33,626                       |       | 17,682 |   |
| Cash and  cash equivalents at end of period                                               |       | $                            | 31,726     |   | $ | 47,944 |   |
|                                                                                      |       |                         |       |   |   |
| Supplemental  disclosure of cash flow information:                                        |       |                         |       |   |   |
| Cash paid  for interest                                                                   |       | $                            | 81         |   | $ | 6 |   |
| Cash paid  for taxes                                                                      |       |                         |       |   |   |   |
| Summary of  non-cash investing and financing activities:                                  |       |                         |       |   |   |   |
| Equipment  acquired or exchanged under capital lease obligations                          |       | $                            | 77         |   | — |   |

 

See Notes to Condensed Consolidated Financial Statements.

 

3

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**DIGIMARC CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

**(UNAUDITED)**

 

**1. TheCompany, Basis of Presentation**

 

#### *Descriptionof Business*

 

DigimarcCorporation (“Digimarc,” the “Company,” “we,” “us,” or “our”) is one of theleading suppliers of secure personal identification systems, providing morethan 60 million personal identification documents and driver licenses peryear. The Company supplies the issuance systems for the majority of driverlicenses produced in the United States (“U.S.”) and provides all or part of theissuance systems for national identifications, voter identifications, anddriver licenses in more than 20 international programs.

 

TheCompany also is a leading provider of patented digital watermarkingtechnologies and solutions that allow imperceptible digital codes to beembedded in media content, including personal identification documents,financial instruments, photographs, movies, music and product packages. Theembedded codes within various types of media content can be detected and readby software or hardware detectors in personal computers and other digitalprocessing devices.

 

InDecember 2001, the Company, through its wholly-owned subsidiary, DigimarcID Systems, LLC, and certain of that subsidiary’s wholly-ownedsubsidiaries (also referred to herein as “DIDS”), acquired the assets andassumed certain liabilities of the U.S. large government programsidentification systems and international digital identification systemsbusinesses of Polaroid Corporation and certain other affiliated entities ofPolaroid Corporation (“LGP”).  Theacquisition was accounted for using the purchase method of accounting.

 

#### *InterimFinancial Statements*

#### * *

Thecondensed consolidated financial statements include the accounts of Digimarcand its wholly-owned subsidiaries. All significant intercompany transactionsand balances have been eliminated. The condensed consolidated financialstatements have been prepared from the Company’s records without audit and, inmanagement’s opinion, include all adjustments (consisting of only normal recurringadjustments) necessary to fairly reflect the financial condition and theresults for the periods presented. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with U.S.generally accepted accounting principles have been condensed or omitted underthe Securities and Exchange Commission’s rules and regulations.

 

These condensed consolidated financial statementsshould be read in conjunction with the audited condensed consolidated financialstatements included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2004, which was filed with the Securities andExchange Commission (the “SEC”) contemporaneously herewith and includesrestated financial results for the fiscal year ended December 31, 2003,including as of and for each of the quarters in the fiscal year ended December31, 2003, and the quarterly periods ended March 31, 2004 and June 30,2004 (see Note 2 “Restatement”).  Theresults of operations for the interim periods presented in these condensedconsolidated financial statements are not necessarily indicative of the resultsfor the full year.

 

*Use of Estimates*

 

The preparation of consolidated financialstatements in accordance with U.S. generally accepted accounting principlesrequires Digimarc to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. Certain of the Company’s accounting policiesrequire higher degrees of judgment than others in their application. Theseinclude revenue recognition on long-term service contracts, impairments andestimation of useful lives of long-lived assets, inventory valuation, reservesfor uncollectible accounts receivable, and contingencies and litigation.Digimarc bases its estimates on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions.

 

 

#### *Reclassifications*

 

Certainprior period amounts in the accompanying condensed consolidated financialstatements and notes thereto have been reclassified to conform to currentperiod presentation. These reclassifications had no effect on the results ofoperations or financial position for any period presented.  These reclassifications include the reclassificationof market auction preferred investments from cash equivalents to short-terminvestments.

 

4

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**2.Restatement**

 

*Summary*.  The Company has restated its consolidatedfinancial statements as of and for the fiscal year ended December 31,2003, including as of and for each of the quarterly periods in the year ended December 31,2003, and the quarterly periods ended March 31, 2004 and June 30,2004 primarily as a result of certain errors in the capitalization of costsrelated to internal use software and project accounting cost tracking and costdeferrals at DIDS.

 

*Background*.** **On September 13,2004 the Company announced that it was reviewing certain accounting practices and previouslyreported financial statements as a result of possible errors discovered by itsmanagement in the accounting for software development costs and projectcapitalization and other project cost capitalization accounting practices atthe Company’s DIDS business unit.  On November 8,2004, the Company announced that it was delaying the filing of its Form 10-Qfor the quarter ended September 30, 2004 due to the ongoing evaluation ofcertain accounting issues relating to transactions entered into in priorperiods.  During the course of itsreview, the Company determined that errors in the accounting for softwaredevelopment costs, project accounting, revenue recognition, and tax accrualsamong other areas with respect to certain prior periods had been made andrequired adjustment.  The Company hasrestated its consolidated financial statements to correct these accountingerrors.

 

The Company identified these errors as a result of areview of its accounting and the review of its internal control over financialreporting in preparation for compliance with Section 404 of theSarbanes-Oxley Act of 2002 and its implementing regulations.  This reviewinvolves a detailed analysis and documentation of the processes that impact thepreparation of the Company’s financial statements, an assessment of the risksthat could adversely affect the accurate and timely preparation of thosefinancial statements and the identification of the controls that are in placeto mitigate the risks of untimely or inaccurate preparation of those financialstatements.

 

*Effect of Adjustments*.  The key impacts of the restatement adjustments for the three and nine months ended September 30, 2003 are to:

 

•                  decreasenet income from $0.07 per share to net income of $0.04 per share and no changein revenues for the three months ended September 30, 2003; and 

 

•                  decreasenet income from $0.08 per share to net income of $0.04 per share and no changein revenues for the nine months ended September 30, 2003.

 

*Description of Adjustments.*

 

*Capitalized software development costs*.  The Company produces software that is used internally, and as such has costs that qualify under the American Institute of Certified Public Accountants’ Statement of Position (“SOP”) 98-1, *Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.*  The Company’s policy requires expensing of activities related to the preliminary stage of a software project (such as the conceptual formulation of alternatives), allows capitalization of activities related to the application development stage of a software project (such as coding, installation, and testing), and requires expensing of activities related to the post-implementation stage (such as training, maintenance, and support) consistent with the guidance in SOP 98-1.  Under this policy, the Company capitalizes costs in the application development stage of a software project.  In connection with the restatement, the Company determined that certain costs had been erroneously capitalized because either a portion of such costs did not qualify for capitalization (e.g., costs related to the preliminary or post-implementation stages) or the project itself did not qualify as internal-use software (e.g., costs related to a non-software project).

 

5

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*Project accounting cost trackingand cost deferrals*.  The Company erroneously tracked costs forvarious projects as a result of certain difficulties the Company had in implementinga new accounting system in late 2003 and early 2004.  As a result, certain costs that should havebeen recognized as expenses in the period incurred were erroneously recorded asinventory or as fixed assets.

 

*Tax accrual timing*.  The Company identified certain international tax expenses that had not been properly accrued in the period incurred.

 

The following tables set forth the restatement adjustments to our financial statements for the periods indicated.  The amounts in the tables are expressed in thousands.  The reasons for the adjustments are described further below.

 

***As of and for the three months ended September 30,2003:***

 
| ** **                  | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Tax  accrual** | ** ** | **As  Restated** | ** ** |
|-----------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
|                        |       |                         |       |                         |       |                    |       |             |       |             |       |
| Revenue                     |       | $                            | 22,300     |                         | —     |                    | —     |             | —     |             | $          | 22,300 |   |
| Cost of  revenue            |       | 11,706                       |       | $                            | 185        |                    | $          | 53               |       | —           |       | 11,944 |   |
| Gross profit                |       | 10,594                       |       | (185                         | )          | (53                     | )          | —           |       | 10,356           |       |
| Operating  expense          |       | 9,405                        |       | 146                          |       | 28                      |       | —           |       | 9,579            |       |
| Operating  income (loss)    |       | 1,189                        |       | (331)                        |       | (81                     | )          | —           |       | 777              |       |
| Other income                |       | 146                          |       |                         |       |                    |       |             |       | 146              |       |
| Provision  for income taxes |       | (51                          | )          | —                       |       | —                  |       | $                | (30        | )                | (81        | ) |
| Net income  (loss)          |       | $                            | 1,284      |                         | $          | (331                    | )          | $                | (81        | )                | $          | (30 | ) | $ | 842 |   |

 

***As of and for the nine months ended September 30,2003:***

 
| ** **                  | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Tax  accrual** | ** ** | **As  Restated** | ** ** |
|-----------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
|                        |       |                         |       |                         |       |                    |       |             |       |             |       |
| Revenue                     |       | $                            | 66,550     |                         | —     |                    | —     |             | —     |             | $          | 66,550 |   |
| Cost of  revenue            |       | 35,945                       |       | $                            | 298        |                    | $          | 68               |       | —           |       | 36,311 |   |
| Gross profit                |       | 30,605                       |       | (298                         | )          | (68                     | )          | —           |       | 30,239           |       |
| Operating  expense          |       | 29,268                       |       | 410                          |       | 28                      |       | (82              | )          | 29,624           |       |
| Operating  income (loss)    |       | 1,337                        |       | (708                         | )          | (96                     | )          | 82               |       | 615              |       |
| Other income                |       | 416                          |       | —                       |       | —                  |       | —           |       | 416              |       |
| Provision  for income taxes |       | (153                         | )          | —                       |       | —                  |       | $                | (90        | )                | (243       | ) |
| Net income  (loss)          |       | $                            | 1,600      |                         | $          | (708                    | )          | $                | (96        | )                | $          | (8 | ) | $ | 788 |   |

 

**Cash flow changes:**

 
| ** **                                | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Tax  accrual** | ** ** | **As  Restated** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
| Net Income                                |       | $                            | 1,600      |                         | $          | (708                    | )          | $                | (96        | )                | $          | (8 | ) | $ | 788 |   |
| Depreciation  and amortization            |       | 7,719                        |       | 169                          |       | —                  |       | —           |       | 7,888            |       |
| Inventory                                 |       | 13                           |       | —                       |       | 56                      |       | —           |       | 69               |       |
| Other  current assets                     |       | 464                          |       | —                       |       | —                  |       | (82              | )          | 382              |       |
| Other  assets, net                        |       | 16                           |       | (153                         | )          | —                  |       | —           |       | (137             | )          |
| Other  liabilites                         |       | (38                          | )          | —                       |       | —                  |       | 90               |       | 52               |       |
| Net cash  provided by operating activites |       | 19,988                       |       | (692                         | )          | (40                     | )          | —           |       | 19,256           |       |
| Purchase of  property and equipment       |       | (6,487                       | )          | —                       |       | 24                      |       | —           |       | (6,463           | )          |
| Capitalization  of labor costs            |       | (5,203                       | )          | 692                          |       | 16                      |       | —           |       | (4,495           | )          |
| Net cash  used in investing activites     |       | (16,929                      | )          | 692                          |       | 40                      |       | —           |       | (16,197          | )          |
|                                           |            |                              |            |                              |            |                         |            |                  |            |                  |            |  |  |  |  |  |

 

6

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***At September 30, 2003:***

 
| ** **                                       | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Tax  Accrual** | ** ** | **Total****period  adjustments** | ** ** | **Prior****restatement  items (1)** | ** ** | **As  Restated** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|------------------|------------|----------------------------------|------------|-------------------------------------|------------|------------------|------------|
| ** **                                       | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** **              | ** ** | ** **       | ** ** | ** **                       | ** ** | ** **                          | ** ** | ** **       | ** ** |
| **Assets:**                                      |       |                         |       |                         |       |                    |       |             |       |                             |       |                                |       |             |       |
| Trade  accounts receivable, net                  |       | $                            | 8,412      |                         | —     |                    | —     |             | —     |                             | —     |                                | —     |             | $          | 8,412 |   |
| Inventory,  net                                  |       | 5,078                        |       | —                       |       | $                       | (56        | )                | —     |                             | $          | (56                                 | )          | —           |       | 5,022 |   |
| Other current  assets                            |       | 2,643                        |       | —                       |       | —                  |       | —           |       | —                           |       | $                                   | 82         |             | 2,725      |   |
| Total  current assets                            |       | 98,810                       |       | —                       |       | (56                     | )          | —           |       | (56                              | )          | 82                                  |       | 98,836           |       |
| Property and  equipment, net                     |       | 34,513                       |       | $                            | (331       | )                       | (25        | )                | —     |                             | (356       | )                                   | (392       | )                | 33,765     |   |
| Other  assets, net                               |       | 1,004                        |       | —                       |       | —                  |       | —           |       | —                           |       | —                              |       | 1,004            |       |
| Total assets                                     |       | $                            | 158,727    |                         | $          | (331                    | )          | $                | (81        | )                                | —     |                                | $          | (412             | )          | $ | (310 | ) | $ | 158,005 |   |
| **Liabilities  and Stockholders’ Equity:**  |       |                         |       |                         |       |                    |       |             |       |                             |       |                                |       |             |       |
| Accounts  payable                                |       | $                            | 4,100      |                         | —     |                    | —     |             | —     |                             | —     |                                | —     |             | $          | 4,100 |   |
| Accrued  payroll and related costs               |       | 2,138                        |       | —                       |       | —                  |       | —           |       | —                           |       | —                              |       | 2,138            |       |
| Other  current liabilities                       |       |                         | 31         |                         | —     |                    | —     |             | $          | 30                               |       | $                                   | 30         |             | $          | 60 |   | 121 |   |
| Total  current liabilities                       |       | 9,353                        |       |                         | —     |                    |       | —           |       |                             | 30         |                                |       | 30               |       |   | 60 |   | 9,443 |   |
| Total  liabilities                               |       | 9,353                        |       |                         | —     |                    |       | —           |       |                             | 30         |                                |       | 30               |       |   | 60 |   | 9,443 |   |
| Total  stockholders’ equity                 |       | 149,374                      |       | $                            | (331       | )                       | $          | (81              | )          | $                                | (30        | )                                   |       | (442             | )          |   | (370 | ) | 148,562 |   |
| Total  liabilities and stockholders’ equity |       | $                            | 158,727    |                         | $          | (331                    | )          | $                | (81        | )                                | —     |                                | $          | (412             | )          | $ | (310 | ) | $ | 158,005 |   |

 

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(1)          These changes represent restatement items fromthe first and second quarters of 2003. These changes relate to capitalized software development costs, projectaccounting costs, and income tax accrual timing.  See our Annual Report on Form 10-K forthe year ended December 31, 2004 filed contemporaneously with this Form 10-Qfor additional information about these changes.

 

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

 

Netincome (loss) per share (or earnings per share (“EPS”)) is calculated in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 128, *Earnings per Share*, which provides thatbasic and diluted net income per share for all periods presented are to becomputed using the weighted average number of common shares outstanding duringeach period, with diluted net income (loss) per share including the effect ofpotentially dilutive common shares.

 
| ** **                               | ** ** | **Three Months Ended September 30,  2004** | ** ** | **Three Months Ended September 30,  2003  (Restated)** | ** ** |
|------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                               | ** ** | **Income  (000’s)  (Numerator)**           | ** ** | **Shares  (000’s)  (Denominator)**                     | ** ** | **Per  Share  Amount** | ** ** | **Income  (000’s)  (Numerator)** | ** ** | **Shares  (000’s)  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
| **Basic  EPS**                           |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| ** **                               |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| Income  available to common stockholders |       | $                                               | (2,467     | )                                                           | 20,371     |   | $ | (0.12 | ) | $ | 842 |   | 18,752 |   | $ | 0.04 |   |
|                                     |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| **Effect  of Dilutive Securities**       |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| Common stock  equivalents                |       |                                            |       | —                                                      |       |   |   |   |   | 975 |   |   |   |
|                                     |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| **Diluted  EPS**                         |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| ** **                               |       |                                            |       |                                                        |       |   |   |   |   |   |   |   |   |
| Income  available to common stockholders |       | $                                               | (2,467     | )                                                           | 20,371     |   | $ | (0.12 | ) | $ | 842 |   | 19,727 |   | $ | 0.04 |   |
|                                          |            |                                                 |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                               | ** ** | **Nine Months Ended September 30,  2004** | ** ** | **Nine Months Ended September 30,  2003  (Restated)** | ** ** |
|------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                               | ** ** | **Income****(000’s)  (Numerator)**        | ** ** | **Shares****(000’s)  (Denominator)**                  | ** ** | **Per****Share  Amount** | ** ** | **Income****(000’s)  (Numerator)** | ** ** | **Shares****(000’s)  (Denominator)** | ** ** | **Per****Share  Amount** | ** ** |
| **Basic  EPS**                           |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| ** **                               |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| Income  available to common stockholders |       | $                                              | (4,524     | )                                                          | 20,287     |   | $ | (0.22 | ) | $ | 788 |   | 18,072 |   | $ | 0.04 |   |
|                                     |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| **Effect  of Dilutive Securities**       |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| Common stock  equivalents                |       |                                           |       | —                                                     |       |   |   |   |   | 768 |   |   |   |
|                                     |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| **Diluted  EPS**                         |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| ** **                               |       |                                           |       |                                                       |       |   |   |   |   |   |   |   |   |
| Income  available to common stockholders |       | $                                              | (4,524     | )                                                          | 20,287     |   | $ | (0.22 | ) | $ | 788 |   | 18,840 |   | $ | 0.04 |   |

 

7

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Commonstock equivalents related to stock options and warrants of 6,556 and 5,866 wereexcluded from diluted net loss per share calculations for the three and ninemonth periods ended September 30, 2004, respectively, as their exerciseprice was higher than the average market price of the underlying common stockfor the period and therefore their impact would be antidilutive.  In addition, common stock equivalents relatedto stock options of 227 and 320 for the three and nine month periods ended September 30,2004, respectively, were excluded from diluted net loss per share as theCompany was in a loss position and their inclusion would be antidilutive.  The effect of 2,109 and 4,420 outstandingstock options for the three and nine months ended September 30, 2003,respectively, were excluded from the calculation of diluted net income pershare because their exercise price was higher than the average market price ofthe underlying common stock for the period and therefore their inclusion wouldbe antidilutive.

 

**4. StockBased Compensation**

 

TheCompany has various stock-based compensation plans, including stock incentiveplans and an employee stock purchase plan. The Company continues to apply therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees,*and related interpretations including FinancialAccounting Standards Board (“FASB”) Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation, an Interpretation of APB Opinion No. 25*, asallowed by FASB Statement No. 123, *Accountingfor Stock-Based Compensation*. FASB Statement No. 123 and FASBStatement No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure, an amendment of FASBStatement No. 123*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans. Under APB Opinion No. 25, stock-basedcompensation expense is recognized for stock awards granted with an exerciseprice below fair market value on the date of grant.

 

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share (or earnings per share) if the Company had applied the fairvalue recognition provisions of SFAS No. 123 to stock-based employeecompensation for the three months and nine months ended September 30, 2004and 2003, respectively (in thousands, except per-share amounts):

 
| ** **                                                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2004**                                   | ** ** | **2003  (Restated)**                      | ** ** | **2004** | ** ** | **2003  (Restated)** | ** ** |
| ** **                                                                                                        | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss), as reported                                                                                   |       | $                                          | (2,467     | )                                         | $          | 842 |   | $ | (4,524 | ) | $ | 788 |   |
| Add:  Stock-based compensation expense determined under the intrinsic value method                                |       | —                                     |       | 316                                       |       | — |   | 1,178 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards |       | (3,246                                     | )          | (4,697                                    | )          | (9,205 | ) | (14,957 | ) |
| Pro forma  net loss                                                                                               |       | $                                          | (5,713     | )                                         | $          | (3,539 | ) | $ | (13,729 | ) | $ | (12,991 | ) |
| *Earnings  per share:*                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Basic - as  reported                                                                                              |       | $                                          | (0.12      | )                                         | $          | 0.04 |   | $ | (0.22 | ) | $ | 0.04 |   |
| Diluted - as  reported                                                                                            |       | $                                          | (0.12      | )                                         | $          | 0.04 |   | $ | (0.22 | ) | $ | 0.04 |   |
| Basic - pro  forma                                                                                                |       | $                                          | (0.28      | )                                         | $          | (0.19 | ) | $ | (0.68 | ) | $ | (0.72 | ) |
| Diluted -  pro forma                                                                                         |       | $                                          | (0.28      | )                                         | $          | (0.19 | ) | $ | (0.68 | ) | $ | (0.72 | ) |

 

Stockbased compensation expense is based on the difference between the fair marketvalue of the Company’s common stock and the exercise price of options topurchase that stock on the measurement

 

8

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date, and is beingrecognized over the vesting period of the related options, usually fouryears.  The Company did not incur anystock-based compensation expense for the three and nine months ended September 30,2004, respectively.  The Company recordedstock-based compensation expense of $316 and $1,178 for the three and ninemonths ended September 30, 2003, respectively.  Stock-based compensation expense is includedin the respective statements of operations expense categories for the employeesto which it applies.

 

**5. SegmentInformation**

 

TheCompany derives its revenue from a single reporting segment, secure mediasolutions. There was no single customer in the three or nine month periodsended September 30, 2004 or 2003 that accounted for more than 10% of totalrevenue.

 

Followingis a breakout of revenue and gross profits for both of the company’s operatingunits:

 
| ** **                             | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                  | ** ** | **2003  (Restated)** | ** ** |
| **DIDS**                               |       |                                      |       |   |   |
| Revenue                                |       | $                                         | 20,755     |   | $ | 19,828 |   |
| Revenue as a  percent of Total Revenue |       | 88                                        | %          | 89 | % |
| Gross Profit  percentage               |       | 38                                        | %          | 45 | % |
|                                   |       |                                      |       |   |   |
| **Digital  Watermarking**              |       |                                      |       |   |   |
| Revenue                                |       | $                                         | 2,765      |   | 2,472 |   |
| Revenue as a  percent of Total Revenue |       | 12                                        | %          | 11 | % |
| Gross Profit  percentage               |       | 70                                        | %          | 62 | % |
|                                   |       |                                      |       |   |   |
| **Total  Company**                     |       |                                      |       |   |   |
| Revenue                                |       | $                                         | 23,520     |   | $ | 22,300 |   |
| Revenue as a  percent of Total Revenue |       | 100                                       | %          | 100 | % |
| Gross Profit  percentage               |       | 42                                        | %          | 46 | % |
| ** **                             |       | **Nine Months Ended  September 30,** |       |
| ** **                             |       | ** **                                |       | ** ** |   |
| ** **                             |       | **2004**                                  |       | **2003  (Restated)** |   |
| **DIDS**                               | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Revenue                                |       | 62,182                                    |       | 59,289 |   |
| Revenue as a  percent of Total Revenue |       | 88                                        | %          | 89 | % |
| Gross Profit  percentage               |       | 35                                        | %          | 44 | % |
|                                   |       |                                      |       |   |   |
| **Digital  Watermarking**              |       |                                      |       |   |   |
| Revenue                                |       | 8,470                                     |       | 7,261 |   |
| Revenue as a  percent of Total Revenue |       | 12                                        | %          | 11 | % |
| Gross Profit  percentage               |       | 69                                        | %          | 60 | % |
|                                   |       |                                      |       |   |   |
| **Total  Company**                     |       |                                      |       |   |   |
| Revenue                                |       | 70,652                                    |       | 66,550 |   |
| Revenue as a  percent of Total Revenue |       | 100                                       | %          | 100 | % |
| Gross Profit  percentage               |       | 39                                        | %          | 45 | % |

 

9

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**6.********Commitments andContingencies**

 

Beginning in September 2004, threepurported class action lawsuits were commenced against the Company and certainof the Company’s current and former directors and officers by or on behalf ofpersons claiming to have purchased or otherwise acquired the Company’ssecurities during the period from April 17, 2002 to July 28,2004.  These lawsuits were filed in theUnited States District Court for the District of Oregon and were consolidatedinto one action for all purposes on December 16, 2004.  The complaints assert claims under thefederal securities laws, specifically Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, relating to the Company’s announcement that ithad discovered errors in its accounting for software development costs andproject capitalization and other project cost capitalization accountingpractices at the Company’s DIDS business unit, and that the Company likelywould be required to restate its previously reported financial statements forfull fiscal year 2003 and the first two quarters of 2004.  Specifically, these actions allege that theCompany issued false and misleading financial statements in order to inflatethe value of Digimarc stock, which resulted in insider sales of personalholdings at inflated values, and that the Company maintained insufficientaccounting controls, which created an environment where improper accountingcould be used to manipulate financial results. The complaints seek unspecified damages. The Company believes that it has substantial legal and factual defensesto the claims, which it intends to pursue vigorously.  Due to the inherent uncertainties oflitigation and because the lawsuits are still at a preliminary stage, theultimate outcome of the matter cannot be predicted.  No accrual has been recorded because theamounts are not probable or reasonably estimatable in accordance with SFASNo.5, *Accounting for Contingencies.*

 

On orabout October 19, 2004, two purported shareholder derivative lawsuits werefiled against certain of the Company’s officers and directors, naming theCompany as a nominal defendant, in the Superior Court of the State ofCalifornia for the County of San Luis Obispo. The suits claim that certain of these officers and directors breachedtheir fiduciary duties to the Company’s shareholders and to the Company.  The complaints are derivative in nature anddo not seek relief from the Company.  On November 8,2004, a letter was mailed to the chairman of the Company’s Board of Directorsby a law firm purporting to represent a shareholder of the Company, demandingthat the board commence a civil action against each of the directors andofficers on behalf of the Company to recover for damages alleged to have beenincurred as a result of alleged breaches of fiduciary duties.  The Company has appointed a committee toinvestigate the claims asserted in the demand letter and in the derivativelawsuits.

 

The Company has received a notice from the staff ofthe SEC stating that it is conducting an informal inquiry relating to theCompany’s previous announcement that it was restating its prior financialresults.  The inquiry focuses on theerrors made in the capitalization of certain software and other projectcosts.  The staff has requested that theCompany voluntarily produce documents and information related to the SEC’sinquiry.  The Company is cooperating withthe staff’s request.  It is not possibleto predict whether this inquiry will have any impact on the Company or itsfinancial results.

 

On August 24,2004, the Company settled the lawsuit filed in October 2003 by a formerpresident of the Company, who was also chief executive officer and a formermember of the Company’s board of directors. As previously disclosed, the former president had asserted in hiscomplaint that he had the right to 56,000 shares of the Company’s common stock,or the value thereof, because the Company had failed to timely exercise itsright of repurchase with regard to such shares following termination of hisemployment with the Company in 1997.  Inconnection with the settlement, the Company issued 40,000 shares of its commonstock to this individual and recorded the value of the shares as an expense ingeneral and administrative.  The terms ofthe settlement are confidential.

 

Beginning in May 2001, a number ofsubstantially identical class action complaints alleging violations of thefederal securities laws were filed in the United States District Court for theSouthern District of New York naming approximately 300 companies, including theCompany, certain of its officers and directors, and certain underwriters of theCompany’s initial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensationarrangements (such as undisclosed commissions or stock stabilization practices)in the Company’s initial public offering registration statement and by engagingin manipulative practices to artificially inflate the price of the Company’sstock in the after-market subsequent to the Company’s initial public offering.The Company and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the

 

10

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Securities Act of 1933, and Section 10(b) and Rule 10b 5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),however, were dismissed. In June 2003, a committee of the Company’s Boardof Directors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval.  The settlement would provide, among otherthings, a release of the Company and of the individual defendants for theconduct alleged in the amended complaint to be wrongful. The Company wouldagree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. The parties are directed to report back to the court regarding themodifications.  If the parties are ableto agree upon the required modifications, and such modifications are acceptableto the court, notice will be given to all class members of the settlement, a “fairness”hearing will be held and if the court determines that the settlement is fair tothe class members, the settlement will be approved.  There can be no assurance that this proposedsettlement would be approved and implemented in its current form, or at all.  Due to the inherent uncertainties oflitigation, the ultimate outcome of the matter cannot be predicted.

 

DIDS in its normal course of business from time totime experiences delays in identification system implementation, timelyacceptance for identification systems programs, concerns regardingidentification system program performance, and other contractual disputes.Management does not believe that there will be any material effect to theresults of operations for costs related to these contingencies.  In addition, from time to time, customershave given notice of their intention to assert claims for liquidateddamages.  Management believes that theseassertions are part of the resolution process involving commercialdisagreements over the delivery terms of these contracts.  Such disputes are not uncommon and tend to beresolved over time.  To date, we have notpaid liquidated damages in connection with a dispute with a domestic customer.  While there is always risk that liquidateddamages could be assessed in the future, management does not believe that it isprobable that material amounts will be paid, nor can we predict what the amountof any such damages would be if they were to be imposed.  

 

The Company’s product license and servicesagreements include a limited indemnification provision for claims from thirdparties relating to the Company’s intellectual property. Such indemnificationprovisions are accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*. Theindemnification is generally limited to the amount paid by the customer. Todate, claims under such indemnification provisions have not been significant.

 

Digimarc is subject from time to time to other legalproceedings and claims arising in the ordinary course of business. Although theultimate outcome of these matters cannot be determined, management believesthat the final disposition of these proceedings will not have a materialadverse effect on the consolidated financial position, results of operations,or liquidity of the Company.  No accrual has been recorded because the amounts are not probable or reasonablyestimable in accordance with SFAS No. 5, *Accounting for Contingencies*.

 

**7. ComprehensiveIncome (Loss)**

 

TheCompany has adopted SFAS No. 130, *ReportingComprehensive Income*, which establishes standards of reporting anddisplaying comprehensive income (loss) and its components of net income (loss)and other comprehensive income (loss). Other comprehensive income (loss) refersto revenues, expenses, gains and losses that are not included in net income(loss) but rather are recorded directly in stockholders’ equity. Comprehensiveincome (loss) is defined as changes in stockholders’ equity exclusive oftransactions with owners. To date, only foreign currency translation adjustmentsare required to be reported in comprehensive income (loss). The following tableprovides a summary of comprehensive income (loss) for the three and nine monthperiods ended September 30, 2004 and 2003, respectively (in thousands):

 

11

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| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2004**                                   | ** ** | **2003  (Restated)**                      | ** ** | **2004  (Restated)** | ** ** | **2003  (Restated)** | ** ** |
| Net income (loss)                        |       | $                                          | (2,467)    |                                      | $          | 842 |   | $ | (4,524 | ) | $ | 788 | ** ** |
| Foreign  currency translation adjustment |       | (23                                        | )          | 15                                        |       | (88 | ) | 122 |   |
| Comprehensive  income (loss)             |       | $                                          | (2,490     | )                                         | $          | 857 |   | $ | (4,612 | ) | $ | 910 |   |

 

**8. RecentAccounting Pronouncements**

 

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an amendment of ARB No. 43,Chapter 4* (“FAS 151”). FAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges. The Company is currently evaluating the provisions of FAS 151 and doesnot expect that the adoption will have a material impact on its consolidatedfinancial position or results of operations.

 

On December 16, 2004, the FASB issued StatementNo. 123(R) *Share-Based Payment*,which is a revision of Statement No. 123 and supersedes APB Opinion No. 25. Statement No. 123(R) requires all share-based payments to employees,including grants of employee stock options, to be valued at fair value on thedate of grant, and to be expensed over the applicable vesting period.  Proforma disclosure of the income statement effects of share-based payments is nolonger an alternative.  Statement No. 123(R) is effective for allstock-based awards granted on or after July 2005.  In addition,companies must also recognize compensation expense related to any awards thatare not fully vested as of the effective date.  Compensation expense forthe unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123.  The Company is currentlyassessing the impact of adopting Statement 123(R) to its consolidated resultsof operations.

 

**9. RevenueRecognition**

 

Revenuefrom the Company’s long-term identification and driver license issuance systemsis generated from the production of cards. The Company recognizes revenue onthese contracts based on the actual monthly production of cards, if available,or, in limited situations, on the estimated production of cards. When actualproduction information becomes available, typically within one month, theCompany bills the customer accordingly and any differences from the estimatesare recognized in the month the billing occurs. Differences to date have notbeen significant.  Revenue earned whichhas not been invoiced is classified as unbilled trade receivables in thecondensed consolidated balance sheets. Revenue related to an enhancement of orupgrade to an existing system is deferred and recognized over the remaininglife of the contract.

 

Revenuefor sales of consumables and equipment not related to a long-termidentification or driver license production contract is recognized when theproducts have been shipped, ownership has been transferred, evidence of an arrangementexists, the sales price is fixed and determinable, and collectibility isreasonably assured.

 

Revenuefrom professional services arrangements is generally determined based on timeand material or a cost plus a profit margin measure. Revenue for professionalservices is recognized as the services are performed.  Progress towards completion is measured usingcosts incurred compared to the budgeted amounts contained in the contract. Ourestimates of revenue and costs on customer contracts change periodically in thenormal course of business, occasionally due to modifications of our contractualarrangements or cost overruns. Losses on contracts, if any, are provided for inthe period in which the loss becomes determinable. Billing for servicesrendered generally occurs within one month following when the services areprovided. Revenue earned which has not been invoiced is classified as unbilledtrade receivables in the condensed consolidated balance sheets.

 

Royaltyrevenue is recognized when the royalty amounts owed to the Company have beenearned, are determinable, and collection is probable. Subscriptions are paid inadvance and revenue is recognized ratably over the term of the subscription.

 

Deferredrevenue consists of payments received in advance for professional services,subscriptions, and hardware for which revenue has not been earned.

 

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TheCompany also generates revenue from the licensing of digital watermarkingproducts and services for use in authenticating documents, detecting fraudulentdocuments and deterring unauthorized duplication or alteration of high-valuedocuments, for use in communicating copyright, asset management andbusiness-to-business image commerce solutions, and for use in connecting analogmedia to a digital environment. Software revenue is recognized in accordancewith the American Institute of Certified Public Accountant (“AICPA”) SOP No. 97-2,*Software Revenue Recognition*, asamended by AICPA SOP No. 98-9, *Modificationof SOP 97-2*, *With Respect to CertainTransactions*.  Revenue forlicenses of the Company’s software products is recognized upon the Companymeeting the following criteria: persuasive evidence of an arrangement exists;delivery has occurred; the vendor’s fee is fixed or determinable; and collectibilityis probable.

 

AICPASOP No. 98-9 requires that revenue be recognized using the “residualmethod” in circumstances when vendor specific objective evidence exists onlyfor undelivered elements. Under the residual method, revenue is recognized asfollows: (1) the total fair value of undelivered elements, as indicated byvendor specific objective evidence, is deferred and subsequently recognized inaccordance with the relevant sections of AICPA SOP No. 97-2, and (2) thedifference between the total arrangement fee and the amount deferred for theundelivered elements is recognized as revenue related to the deliveredelements.

 

Certain customer arrangements encompass multiple deliverables, such as hardware sales, consumables sales,maintenance fees, and software development fees. The Company accounts for thesearrangements in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables*.If the deliverables meet the criteria in EITF Issue No. 00-21, thedeliverables are divided into separate units of accounting and revenue isallocated to the deliverables based on their relative fair values. The criteriaspecified in EITF Issue No. 00-21 are as follows: (i) the delivereditem has value to the customer on a stand-alone basis, (ii) there isobjective and reliable evidence of the fair value of the undelivered item, and (iii) ifthe arrangement includes a general right of return relative to the delivereditem, delivery or performance of the undelivered item is considered probableand substantially in the control of the vendor. For our purposes, fair value isgenerally defined as the price at which a customer could purchase each of theelements independently from other vendors or as the price at which the Companyhas sold the element separately to another customer. Applicable revenuerecognition criteria is considered separately for each separate unit ofaccounting. Management applies judgment to ensure appropriate application ofEITF Issue No. 00-21, including value allocation among multiple deliverables,determination of whether undelivered elements are essential to thefunctionality of delivered elements and timing of revenue recognition, amongothers.

 

**10.Inventories**

 

Inventoriesconsist primarily of the components used to manufacture identification cards,such as inks, laminates, and adhesives and hardware for sale.  Inventories are valued on a first-in,first-out basis at the lower of cost or market value (net realizable value).

 
| ** **                            | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Equipment and deferred contract costs |       | 717                     |       | 849                    |       |
| Consumable materials                  |       | 5,853                   |       | 5,474                  |       |
| Inventory reserve                     |       | (768                    | )          | (70                    | )          |
| Inventory, net                        |       | 5,802                   |       | 6,253                  |       |

 

**Thereserve for slow moving and obsolete items was $768 and $70 at September 30,2004 and December 31, 2003, respectively. While we do not currently expectto be able to sell or otherwise use the reserved inventory we have on handbased upon our forecast and backlog, it is possible that a customer orcustomers will decide in the future to purchase a portion of the reservedinventory. It is not possible currently to predict if or when this will happen,or how much we may sell. Such sales have not had a significant impact on grossprofit margin, nor does the Company expect such sales to have a significantimpact in future periods.**

 

**11.Software Development Costs**

 

UnderSFAS No. 86, *Accounting for the Cost ofComputer Software to Be Sold, Leased, or Otherwise Marketed*,software development costs are to be capitalized beginning when a product’stechnological feasibility has been established and ending when a product ismade available for general release to customers. To date, the establishment oftechnological feasibility of the Company’s products has occurred shortly beforegeneral release and, therefore, software development costs qualifying forcapitalization have

 

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beenimmaterial. Accordingly, the Company has not capitalized any such softwaredevelopment costs and has charged all such costs to research and developmentexpense.

 

Internaluse software development costs are accounted for in accordance with AICPA SOP No. 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*. Costs incurred inthe preliminary project stage are expensed as incurred and costs incurred inthe application development stage, which meet the capitalization criteria, arecapitalized and amortized on a straight-line basis over the estimated usefullife of the asset, generally three to five years.

 

**12.Related Party Transactions**

 

Duringthe nine month periods ended September 30, 2004 and 2003 the Companyrecognized revenue of $537 and $118, respectively, from a holder of commonstock.  At September 30, 2004, netaccounts receivable from this customer was $24, which has subsequently beencollected.  At September 30, 2003,no receivables were outstanding from this customer.  The Company believes these transactions arearm’s length transactions and reflect the market value of such arrangements.

 

TheCompany entered into two loans in 2002 with a former executive officer of theCompany prior to such officer’s departure from the Company.  Both loans were entered into in connectionwith the former officer’s relocation to the Company’s facilities inMassachusetts.  The first loan wasentered into on July 1, 2002, and has a principal amount of $100 and aninterest rate of 6.75% per year.  Suchloan is not due and payable to the Company until June 30, 2006; provided,however, that the entire amount of the loan accelerates if the former officer’semployment was terminated “for cause.” The second loan was also entered into on July 1, 2002, and has aprincipal amount of $260 and an interest rate of 4.99% per year. The secondloan provides that it will be forgiven in full on a pro-rata basis over a termof four years; provided, however, that if the former officer voluntarily leftthe Company’s employment for any reason, or if the former officer wasterminated “for cause,” then the outstanding balance of the loan acceleratesand the former officer shall be responsible for paying the outstandingprincipal balance, plus any interest that is accrued and unpaid, in full within90 days of the date of his departure. The former executive officer’s employment with the Company wasterminated in July 2004.  TheCompany has reserved an amount equal to the remaining amount of the loans.

 

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**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations.**

 

*Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations contains forward-looking statements relating to futureevents or the future financial performance of Digimarc, which involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements. Please see the discussionregarding forward-looking statements included in this Form 10 Q under thecaption “Safe Harbor Statement under the Private Securities Litigation ReformAct of 1995.”*

 

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readers arealso urged to carefully review and consider the various disclosures made by uswhich attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made under the caption “RiskFactors” and the audited and restated consolidated financial statements andrelated notes included in our Annual Report filed on Form 10-K forthe year ended December 31, 2004 filed contemporaneously herewith, andother reports and filings made with the Securities and Exchange Commission.*

 

**Overview**

 

Weare one of the leading suppliers of secure personal identification systems,providing more than 60 million personal identification documents anddriver licenses per year. We supply the issuance systems for the majority ofdriver licenses produced in the United States (“U.S.”) and provide all or partof the issuance systems for national identifications, voter identifications,and driver licenses in more than 20 international programs. We estimate thatour next-closest competitor with regard to U.S. driver license issuance systemsheld contracts with approximately 13 driver license issuing authorities as of September 30,2004.  We are developing and marketingenhanced security solutions for personal identification documents enabled byour proprietary digital watermarking technology.

 

Wealso are a leading provider of patented digital watermarking technologies andsolutions that allow imperceptible digital codes to be embedded in mediacontent, including personal identification documents, financial instruments,photographs, movies, music, and product packages. The embedded codes withinvarious types of media content can be detected and read by software or hardwaredetectors in personal computers and other digital processing devices. Weprovide solutions based on this technology directly and through our licensees.We believe we have the broadest intellectual property patent portfolio andcommercial deployment of watermarking-based applications amongst entities ofwhich we are aware.

 

The majority of our revenue comes from multi-year contracts withgovernment agencies, including U.S. state departments of motor vehicles andfederal agencies, and central banks from around the world. We intend toincrease our revenue through increasing adoption of our products and services,marketing new digital watermarking applications, marketing our products in newsecure identification markets and components and subsystems markets, andlicensing our intellectual property. We expect to target, among other sourcesof revenue, government agencies, commercial printers, packaging companies,publishers, advertisers, proprietors of large image collections, and otherproducers of printed materials. Our aim is to license our technologies to thosecontent producers so that they may embed our digital watermarks in theirprinted media, such as identification documents, magazine advertisements andarticles, direct mail coupons, catalogs, stationery and envelopes, productpackaging, labels and tags, trading cards, credit cards, and business cards.Our current and anticipated products are intended to enable content producersto control reproduction and alteration of their content, as well as to enabletheir printed materials to provide a link to relevant network services. Revenuefrom our new applications may include one-time license fees, time-based orvolume-based fees, subscription fees, royalties and revenue-sharingarrangements. We anticipate that the calculation of revenue and royalties forthese new applications will be based at least in part on the

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size of the installed baseof personal computers, cameras, scanners, digital image capture and outputdevices, and software carrying our patented reader technology, as well as thenature of the use and amount of licensed content carrying our digitalwatermarks.

 

**Restatementof Prior Financial Results**

 

On September 13, 2004, we announced thatwe were reviewing certain accounting practices and previously reportedfinancial statements as a result of possible errors discovered by ourmanagement in the accounting for software development costs and projectcapitalization and other project cost capitalization accounting practices atour DIDS business unit.  On November 8,2004, we announced that we were delaying the filing of our Form 10 Q forthe third quarter ended September 30, 2004 due to our ongoing evaluationof certain accounting issues relating to transactions entered into in priorperiods.  During the course of ourreview, we determined that errors in the accounting for software developmentcosts, project accounting, revenue recognition, and tax accruals among otherareas with respect to certain prior periods had been made and requiredadjustment.  We identified these errorsas a result of our review of our accounting and our review of our internalcontrol over financial reporting in preparation for compliance with Section 404of the Sarbanes-Oxley Act of 2002 and its implementing regulations.  This review involves a detailed analysis anddocumentation of the processes that impact the preparation of our financialstatements, an assessment of the risks that could adversely affect the accurateand timely preparation of those financial statements and the identification ofthe controls that are in place to mitigate the risks of untimely or inaccuratepreparation of those financial statements.

 

As a result, we have restated our audited consolidated financialstatements as of and for the fiscal year ended December 31, 2003,including as of and for each of the quarterly periods in the year ended December 31,2003, and the quarterly periods ended March 31, 2004 and June 30,2004.  Concurrently with this Form 10-Q,we are filing our Form 10-K for the year ended December 31, 2004, bothof which reflect the restatement.  Theeffects of the restatement are reflected in our condensed consolidatedfinancial statements, including the footnotes thereto, accompanying this Form 10-Q,as well as Management’s Discussion and Analysis of Financial Condition andResults of Operations in this Form 10-Q. Please see Note 2 to the consolidated financial statements on theCompany included herewith as well as our 2004 Form 10-K for additionalinformation on the adjustments made in the restatement.

 

In connection with the restatement, weidentified and reported to our audit committee material weaknesses in ourinternal control over financial reporting. Please see “Item 4. Controls and Procedures” below for a description ofthese matters and certain measures that we have implemented during 2004 todate, as well as additional steps we plan to take to strengthen our controls.

 

We have not separately amended our Annual Report on Form 10-Kor Quarterly Reports on Form 10-Q for periods affected by the restatement,and the financial statements and any independent registered public accountingfirm’s report and related financial information for the affected periodscontained in such reports should no longer be relied upon.  Any disclosures in any such amendments to ourForm 10-K or Form 10-Q for periods affected by the restatement wouldin large part repeat the disclosures contained in this report.  All financial and other information includedin this Form 10-Q reflects the restatement of our consolidated financialstatements for such prior periods.  For adescription of the reasons for the restatement and the adjustments resultingfrom the restatement for the three and nine months ended September 30,2004, see Note 2 to the consolidated financial statements included in this Form 10-Q.  For information about the restatement ofother periods, see Notes 2 and 13 to the consolidated financial statementsincluded in our Form 10-K for the year ended December 31, 2004 andItem 7, “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations – Restatement of Financial Statements” in such Form 10-K.

 

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**CriticalAccounting Policies and Estimates**

 

Thepreparation of our condensed consolidated financial statements in accordancewith U.S. generally accepted accounting principles requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenue and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to bad debts, inventories, intangible assets, income taxes,restructuring, long-term service contracts, warranties, investments, and contingenciesand litigation. We base our estimates on historical experience and on variousother assumptions we believe to be reasonable under the circumstances. Actualresults may differ from these estimates under different assumptions orconditions.

 

Certainof our accounting policies require higher degrees of judgment than others intheir application. These include revenue recognition on long-term servicecontracts, impairments and estimation of useful lives of long-lived assets,inventory valuation, reserves for uncollectible accounts receivable andcontingencies and litigation. We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our condensed consolidated financial statements:

 

•                  **Revenue recognition onlong-term service contracts: **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.These amounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting results, our practice isto compare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Revisions to our estimates have been less than 0.5% of total revenue inevery period reported in 2002, 2003 and 2004 (since the LGP transaction).  Any estimated amounts are included in unbilledreceivables on the balance sheet until the actual production information isavailable and the billing occurs. Any estimation process involves inherentrisk. We reduce the inherent risk relating to production estimation through ourapproval and monitoring processes related to accounting estimates.

 

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

 

•                  **Impairments and estimationof useful lives of long-lived assets:**We periodically assess long-lived assets for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable in accordance with the provisions of SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets.*This statement requires that long-lived assetsand certain identifiable intangibles be reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to future net undiscounted cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Fairvalue is determined based on discounted cash flows or appraised

 

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values,depending on the nature of the asset. If our estimates of projected future cashflows were too high by 10%, we believe there would be no material impact on thereported value of long-lived assets on our condensed consolidated balancesheets. Also, we periodically review the useful lives of long-lived assetswhenever events or changes in circumstances indicate that the useful life mayhave changed. If the estimated useful lives of such assets do change, we adjustthe depreciation or amortization period to a shorter or longer period, based onthe circumstances identified.

 

•                  **Inventory valuation:**Inventory consists primarily of consumablesupplies that are used in the production of driver licenses and products heldfor resale to customers. We value inventory at the lower of cost or marketvalue (which lower amount is the net realizable value). We reduce the value ofour inventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required.

 

•                  **Reserves for uncollectibleaccounts receivable:**Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. We determine theallowance based on historical write-off experience and current information. Wereview, and adjust when appropriate, our allowance for doubtful accounts on atleast a quarterly basis. If the financial condition of our customers were todeteriorate, resulting in an impairment of their ability to make payments,additional allowances may be required. If our estimate of uncollectibleaccounts were too low by 10%, there would be no material impact on the reportedvalue of accounts receivable on our condensed consolidated balance sheets.

 

•                  **Contingencies and Litigation:**  We periodically evaluate all pending orthreatened contingencies or commitments, if any, that are reasonably likely tohave a material adverse effect on our operations or financial position.  We assess the probability of an adverseoutcome and determine if it is remote, reasonably possible or probable asdefined in accordance with the provisions of SFAS No. 5, Accounting forContingencies.  If information availableprior to the issuance of our financial statements indicates that it is probablethat an asset has been impaired or a liability has been incurred at the date ofour financial statements, and the amount of the loss, or the range of probableloss can be reasonably estimated, then such loss is accrued and charged tooperations. If no accrual is made for a loss contingency because one or both ofthe conditions pursuant to SFAS No. 5 are not met, but the probability ofan adverse outcome is at least reasonably possible, we will disclose the natureof the contingency and provide an estimate of the possible loss or range ofloss, or state that such an estimate cannot be made.

 

**Results ofOperations**

 

Duringthe three and nine month periods ended September 30, 2004, we invested incapital equipment and software development for several new programs, includingprograms based in Florida, Mexico, and Alabama which caused our working capitalto decrease for the periods. Two of these three programs began to contribute revenuein the second half of 2004 and all of these programs are expected to be fullydeployed in 2005. Operating results were negatively impacted by lower margins(resulting from sales mix, depreciation as a higher percentage of revenue,competitive pricing, inventory reserves, and lower yields on new products) aswell as charges for Sarbanes-Oxley compliance, increased spending on ourrestatement, litigation settlement charges, and impairment charges.

 

Thefollowing table presents our condensed consolidated statements of operationsdata for the periods indicated as a percentage of total revenue.

 

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| ** **                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                   | ** ** | **2003  (Restated)**                      | ** ** | **2004  (Restated)** | ** ** | **2003  (Restated)** | ** ** |
| Revenue**:**                                     | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                                          |       | 85                                         | %          | 87                                        | %          | 79 | % | 83 | % |
| Product and  subscription                        |       | 15                                         |       | 13                                        |       | 21 |   | 17 |   |
| Total  revenue                                   |       | 100                                        |       | 100                                       |       | 100 |   | 100 |   |
| Cost of  revenue:                                |       |                                       |       |                                      |       |   |   |   |   |
| Service                                          |       | 51                                         |       | 47                                        |       | 47 |   | 45 |   |
| Product and  subscription                        |       | 7                                          |       | 7                                         |       | 14 |   | 10 |   |
| Total cost  of revenue                           |       | 58                                         |       | 54                                        |       | 61 |   | 55 |   |
| Gross profit                                     |       | 42                                         |       | 46                                        |       | 39 |   | 45 |   |
| Operating  expenses:                             |       |                                       |       |                                      |       |   |   |   |   |
| Sales and  marketing                             |       | 13                                         |       | 12                                        |       | 12 |   | 14 |   |
| Research,  development and engineering           |       | 8                                          |       | 6                                         |       | 8 |   | 9 |   |
| General and  administrative                      |       | 32                                         |       | 25                                        |       | 26 |   | 22 |   |
| Total  operating expenses                        |       | 53                                         |       | 43                                        |       | 46 |   | 45 |   |
| Operating  income (loss)                         |       | (11                                        | )          | 3                                         |       | (7 | ) | 0 |   |
| Other income  (expense):                         |       |                                       |       |                                      |       |   |   |   |   |
| Interest  income                                 |       | 1                                          |       | 1                                         |       | 1 |   | 1 |   |
| Interest  expense                                |       | 0                                          |       | 0                                         |       | 0 |   | 0 |   |
| Other                                            |       | 0                                          |       | 0                                         |       | 0 |   | 0 |   |
| Total other  income, net                         |       | 1                                          |       | 1                                         |       | 1 |   | 1 |   |
| Income  (loss) before provision for income taxes |       | (10                                        | )          | 4                                         |       | (6 | ) | 1 |   |
| Provision  for income taxes                      |       | 0                                          |       | 0                                         |       | 0 |   | 0 |   |
| Net income  (loss)                               |       | (10%                                       | )          | 4                                         | %          | (6% | ) | 1 | % |

 

*Revenue*

 

Totalrevenue was $23.5 million and $70.7 million for the three and nine monthperiods ended September 30, 2004, respectively, compared to total revenueof $22.3 million and $66.6 million for the three and nine month periods ended September 30,2003, respectively. The changes in total revenue between the comparable threeand nine month periods of 2004 and 2003 resulted primarily from an increase inour product and subscription revenue for the period.

 

Based on projected driver license production volumesand other commitments we have for the periods under contract with ourrespective customers, including driver license issuing authority customers, weanticipate our current contracts as of September 30, 2004 to generate morethan $270 million in revenue during the life of such contracts, currentlyexpected to be up to eight years.  Weconsider as backlog production volumes reasonably expected to be achieved undercurrently existing contractual terms, government orders that are firm but notyet funded, and government contracts awarded but not yet signed.  However, there can be no assurance that ourbacklog will result in actual revenue in any particular period, because ourbacklog includes contracts that extend for several years, during which timethey could be cancelled or suspended.  Anticipatedrevenues from long-term contracts may cover periods as long as eight years, andin many instances such contracts may be terminated by the customer throughoutthe period.  We may never realize revenueon contracts included in our backlog or the timing of such recognition maychange because the contract could be reduced, modified, or terminated early orthe project schedule could be changed.

 

Innon-U.S. markets, where we provide driver license, national identification, andvoter identification systems, services, and components in partnership withlocal card producers, security printers, system integrators, and others, we mayserve as prime contractor or sub-contractor, depending on the circumstances. Asa sub-contractor, we are responsible for delivering hardware, software, orconsumables to the prime contractor and, as a prime contractor, we areresponsible for integrating the components of the system to the customer’sspecifications. Revenue from international customers was $4.6 million and$15.7 million for the three and nine month periods ended September 30,2004, respectively, compared to $2.9

 

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million and $11.2 millionfor the three and nine month periods ended September 30, 2003,respectively. International sales during the nine month period ended September 30,2004 represented approximately 22% of our total revenue. International salesfor us have typically taken the form of an outright sale of equipment and/orconsumables to non-U.S. government agencies or their prime contractors. Thesesales often can be large, carry relatively low margins and may cause noticeablespikes in quarterly revenue and variations in gross profit trends. We enterinto such contracts from time to time to maintain market presence and customerand partner relationships, as such programs often transition to more profitabledigital technologies over time. Due to the nature of the internationalcustomers, the timing of these sales is somewhat less predictable than in thecontext of service revenues provided to us by domestic customers and,consequently, international sales can occur unevenly during the course of ayear. We believe that international growth opportunities exist for us and weexpect to continue to invest in personnel and resources to support our potentialrevenue growth outside of the United States.

 

*Service.*   Service revenue consists primarily of card productionon a price-per-card basis, software development services, and hardware andsoftware maintenance. The majority of service revenue arrangements aretypically structured as price-per-card product agreements, time and materialsconsulting agreements, or fixed price consulting agreements. Service revenue isan umbrella category consisting of both service revenue and contract-basedservice revenue. The distinction between these two subcategories is thatservice revenue is generated from long-term identification and driver licenseproduction contracts, while contract-based service revenue is generated fromother long-term, time-and-materials service contracts.

 

Servicerevenue was $20.0 million and $55.5 million for the three and nine monthperiods ended September 30, 2004, respectively, compared to $19.5 millionand $55.4 million for the three and nine month periods ended September 30,2003, respectively. The $0.5 million or 3% increase for the three month periodresulted from increased issuance revenue from program transitions (the additionof programs based in Mexico, Florida, and Latvia partially offset by the lossof programs based in Oklahoma, Alaska and Maryland).  The $0.1 million increase or relatively flatrevenue for the nine month period ended September 30, 2004 was primarilythe result of increased services provided under our long-term contract with theinternational consortium of central banks.

 

*Product and subscription.*  Product and subscription revenueconsists primarily of the sale of equipment and consumables related toidentification card production systems, software license sales, andsubscriptions related to various software products.

 

Productand subscription revenue was $3.5 million and $15.1 million for the three andnine month periods ended September 30, 2004, respectively, compared to $2.8million and $11.2 million for the three and nine month periods ended September 30,2003, respectively. The $0.7 million or 24% increase for the three month periodand $3.9 million or 35% increase for the nine month period ended September 30,2004, respectively, as compared to the corresponding three and nine month periodsof 2003, were due primarily to the delivery of a large, internationalfilm-based system to a customer, the sale of equipment to a domestic customer,and the license and related revenues for intellectual property rights tointernational customers.

 

*Cost ofRevenue*

 

*Service.*  Cost of service revenue primarily includes compensation forsoftware developers, quality assurance personnel, product managers, fieldoperations personnel, and business development personnel, outside contractors,costs of consumables used in delivering a service, depreciation charges formachinery, equipment, capitalized software, and deployment costs usedspecifically for service delivery, and travel costs directly attributable toservice and development contracts.

 

Costof service revenue was $11.9 million and $33.2 million for the three and ninemonth periods ended September 30, 2004, respectively, compared to $10.5million and $29.9 million for the three and nine month periods ended September 30,2003, respectively. The $1.4 million or 14% increase for the three month periodand $3.3 million or 11% increase for the nine month period ended September 30,2004,

 

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respectively,as compared to the corresponding three and nine month periods of 2003 wereprimarily the result of inventory charges taken during the second quarter of2004 and unexpectedly high yield losses during the start-up production of a newproduct.  We also experienced generallyhigher costs to deliver support and maintenance for existing programs.  Field operations employees totaled 142 and147 at September 30, 2004 and 2003, respectively.

 

*Product and subscription.*   Cost of product andsubscription revenue primarily includes compensation for operations personnel,costs of consumables sold to third parties, costs of machinery sold to thirdparties, Internet service provider connectivity charges and image search datafees to support the services offered to our subscription customers.

 

Costof product and subscription revenue was $1.8 million and $10.1 million for thethree and nine month periods ended September 30, 2004, respectively,compared to $1.5 million and $6.4 million for the three and nine month periodsended September 30, 2003, respectively. The $0.3 million or 22% increasefor the three month period and $3.8 million or 59% increase for the nine monthperiod ended September 30, 2004, respectively, as compared to thecorresponding three and nine month periods of 2003 were the result of increasedmaterial costs in connection with the delivery of the large international film-basedsystem to one customer during the three and nine month periods ended September 30,2004 noted above. This large delivery had particularly low margins. We alsosold quantities of older or expiring film at low or no margins during thesecond quarter which drove up costs and reduced margins for the three and ninemonth periods ended September 30, 2004.

 

*Gross Profit*

 

Overall gross profit as a percentage of revenue forthe three and nine month periods ended September 30, 2004 was 42% and 39%,respectively, compared to the 46% and 45% for the three and nine month periodsended September 30, 2003.  The decrease in gross profit as apercentage of revenue was primarily related to the following factors:

 

•                  inventory and program asset chargesrelated to excess, obsolete, and slow-moving inventory;

 

•                  an unfavorable revenue mix during thefirst half of the year, including low margin revenues from follow-on film salesinto a foreign voter identification project and some domestic equipment sales;

 

•                  cost overruns in a driver licenseissuance system in the first half of the year; and

 

•                  higher depreciation charges originatingfrom the capitalized costs related to hardware, software, and deliveryactivities in the deployment of new contracts and upgrades to existingcontracts.

 

In particular, the high level of new programs, whileindicative of our continuing marketing successes and anticipated to be aprecursor to significant growth in revenues, exerted operational pressures onour identification systems business during the quarter as the organizationincurred higher expenses as part of the upfront implementation costs associatedwith making these new programs operational.  We believe that theseoperational pressures on our identification systems business will likelycontinue for the next few quarters, resulting in continued margin pressures aswe continue to incur significant expenses without corresponding revenueincreases, until the new programs are fully implemented and producing revenuesin timing and amount that offset such increased expenses in connection withthem.

 

*OperatingExpenses*

 

*Sales and marketing.*   Sales and marketingexpenses consist primarily of compensation, benefits and related costs of salesand marketing employees, product managers and sales engineers, as well asrecruiting, travel, market research, and costs associated with marketingprograms, such as trade shows, public relations and new product launches. Salesand marketing expenses were $3.1 million and $8.5 million for the three andnine month periods ended September 30, 2004, respectively, compared to$2.7 million and $9.1 million for the three and nine month periods ended September 30,2003, respectively.  Although sales andmarketing expenses increased slightly during the three month period ended September 30,2004 as compared to the corresponding three month period of 2003, the overalldecrease for the nine month period ended September 30, 2004 as compared tothe corresponding nine month period of 2003 generally resulted 

 

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from managing costseffectively within the group, in particular by tightening controls onspending.  The $0.4 million or 12%increase for the three month period ended September 30, 2004 as comparedto the corresponding three month period of 2003 resulted primarily from recentadditions of resources in our watermarking business and $0.3 million ofimpairment charges related to a technology investment. The $0.6 million or 7%****decrease for the nine month period ended September 30,2004 as compared to the corresponding nine month period of 2003 resultedprimarily from managing costs as mentioned above.  Starting in 2003, we reduced many of theoverhead and variable costs within sales and marketing by consciously makingstrategic spending decisions.  Theseefforts have resulted in targeted spending for critical areas, yielding loweroverall spending within the function. Sales and marketing employees totaled 58 and 52 as of September 30,2004 and 2003, respectively. Although overall sales and marketing expenses arerelatively flat for the quarter, we have recently added resources to themarketing area of our watermarking business and have added experienced salesresources to help expand opportunities in identified markets in ouridentification systems business. We also anticipate that we will continue toinvest at or slightly above the current run rate in sales and marketing for theforeseeable future. 

 

*Research, development and engineering.*   Research, development andengineering expenses consist primarily of compensation, benefits and relatedcosts of software developers and quality assurance personnel and payments tooutside contractors. Research, development and engineering expenses were $1.9million and $5.2 million for the three and nine month periods ended September 30,2004, respectively, compared to $1.4 million and $6.0 million for the three andnine month periods ended September 30, 2003, respectively. The $0.5million or 35% increase for the three month period ended September 30,2004 as compared to the same three month period of 2003 generally came from newproduct initiatives within our ID systems business, such as card developmentand products we are developing for a channels sales strategy.  The $0.8 million or 13% decrease for the ninemonth period ended September 30, 2004 as compared to the same period of2003 generally came from managing costs effectively, as mentioned above, whichincludes limiting travel costs and controlling discretionary spending.  We anticipate that we will continue to investat the current run rate or more in product research, development andengineering for the foreseeable future. Research, development and engineering personnel totaled 115 as of September 30,2004 and 2003.

 

*General and administrative.*   General and administrativeexpenses consist primarily of compensation, benefits and related costs ofexecutive, finance and administrative personnel, facilities costs, legal, humanresources and other professional fees, and depreciation and amortizationexpense not directly associated with programs. General and administrativeexpenses were $7.4 million and $18.5 million for the three and nine monthperiods ended September 30, 2004, respectively, compared to $5.4 millionand $14.6 million for the three and nine month periods ended September 30,2003, respectively.

 

The$2.0 million or 38% increase forthe three month period ended September 30, 2004 as compared to thecorresponding three month period of 2003 resulted primarily from:

 
| • |   | a total charge of $0.4  million to settle litigation against the Company by a former president and  chief executive officer of the Company in the form of common stock and cash; |   |   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   |                                                                                                                                                                             |   |   |
| • |   | increased consulting and  professional fees of $0.3 million associated with our ongoing accounting and  restatement review;                                                      |   |   |
|   |   |                                                                                                                                                                             |   |   |
| • |   | incremental costs related  to third party services in support of our efforts to comply with the  Sarbanes-Oxley Act of 2002; and                                                 |   |   |
|   |   |                                                                                                                                                                             |   |   |
| • |   | incremental charges  related to the provision for uncollectible accounts receivable and  uncollectible notes receivable of $0.4 million.                                         |   |   |
|   |   |                                                                                                                                                                             |   |   |

The increase in generaland administrative expenses was partially offset by a decrease in amortizationcharges related to intangible assets compared to the prior year.

 

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The$3.9 million or 27% increase for the nine month period ended September 30,2004 as compared to the corresponding nine month period of 2003 resultedprimarily from the same factors as mentioned above.

 

Generaland administrative employees totaled 63 and 53 as of September 30, 2004and 2003, respectively. We incurred an increase in general and administrative expenses in thethree and nine month periods ended September 30, 2004 as a result of ourimplementation of provisions of the Sarbanes-Oxley Act of 2002, particularlythose related to Section 404 concerning management’s assessment ofinternal controls.  Our general andadministrative expenses also increased because of the legal and otherprofessional fees related to the accounting review and restatement of ourpreviously reported financial statements. We expect general and administrative expenses will remain at increasedlevels in future periods primarily due to the legal and other professional feesrelated to the foregoing matters, as well as the recently filed shareholderderivative lawsuits, and the increased accounting, audit and legal fees relatedto our compliance with Section 404. We also expect such expenses to increase in future quarters because weanticipate that we will continue to invest in our finance and informationtechnologies organizations and the operational infrastructure at ouridentification systems business.

 

*Amortizationof intangible assets*.  We account for intangible assets resultingfrom acquisitions in accordance with FASB Statement Nos. 141, *Business Combinations* and 142, *Goodwill andOther Intangible Assets*. These statements require the recording of intangible assets underpurchase accounting rules, and require the amortization of such intangibleassets over their expected useful life. As a result, in December 2001 we recorded $29.5 million ofintangible assets related to the acquisition of certain assets and certainliabilities from Polaroid and affiliates. These intangible assets were set up to amortize over a 12-year period,representing the expected useful life. Changes in contract status and customer relationships may lengthen orshorten the expected useful life of such intangible assets, or cause animpairment charge related to the intangible asset, so some variability isexpected to exist related to intangibles depending on internal and externalfactors.  Amortization of intangibleassets is included in general and administrative expenses in the statements ofoperations.

 

*Stock based compensation.*   Stock-based compensationexpense includes costs relating to stock-based employee compensationarrangements. Stock-based compensation expense is based on the differencebetween the fair market value of our common stock and the exercise price ofoptions to purchase that stock on the date of grant, and is being recognizedover the vesting periods of the related options, usually four years.Stock-based compensation expense of $0.3 million and $1.2 million was recordedfor the three and nine month periods ended September 30, 2003,respectively, with no expense recorded during the comparable periods in 2004.Stock-based compensation is included in the respective statements of operationsexpense categories for the employees to which it applies. These expenses wererecorded to the following categories:

 
| ** **                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                       |       |                                      |       |   |   |   |   |
| Sales and  marketing                   |       | $                                          | —     |                                      | $          | 74,000 |   | $ | — |   | $ | 273,000 |   |
| Research,  development and engineering |       | —                                     |       | 13,000                                    |       | — |   | 235,000 |   |
| General and  administrative            |       | —                                     |       | 229,000                                   |       | — |   | 670,000 |   |
|                                   |       | $                                          | —     |                                      | $          | 316,000 |   | $ | — |   | $ | 1,178,000 |   |

 

*Total other income, net.*   Total other income, netconsists primarily of interest received and paid. Total other income, net was$0.2 million and $0.6 million for the three and nine month periods ended September 30,2004, respectively, as compared to $0.1 million and $0.4 million for the threeand nine month periods ended September 30, 2003, respectively. The $0.1million increase for the three month period and $0.2 million increase for thenine month period ended September 30, 2004, respectively, as compared tothe corresponding three and nine month periods of 2003 resulted primarily fromhigher average cash balances that originated from the private placementoffering in the third quarter of 2003, higher  interest earning balances

 

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and higher interest ratesduring 2004.

 

*Provision for Income Taxes.* The provision for income taxesprimarily reflects expected tax expense from profitability in foreignjurisdictions and to a lesser extent state income taxes.  We have available net operating losscarryforwards and, as such, have included no provision for U.S. federal andstate income tax reporting purposes.

 

**Liquidityand Capital Resources**

 

Asof September 30, 2004, we had cash and cash equivalents, restricted cash,and short-term investments of $55.9 million, representing a decrease ofapproximately $22.7 million from $78.6 million at December 31, 2003. Thedecrease primarily resulted from investments in significant new programimplementations, in particular in Florida, Mexico, and Alabama. As of September 30,2004, $0.2 million of cash and cash equivalents is restricted as a result ofthe requirements of performance bonds that we are obligated to maintain inconnection with some of our long-term contracts in our personal identificationsystems business. However, due to the losses incurred to date and the projectedlosses for the year, we were required to increase our restricted cash duringthe fourth quarter to $8.3 million and to classify it as long-term.  Working capital at September 30, 2004was $64.8 million, compared to working capital of $89.3 million at December 31,2003. The decrease in working capital resulted primarily from investments madein the new Florida, Mexico, and Alabama programs that we anticipate will contributeto revenue growth in the second half of the year and early 2005.

 

The$9.2 million of cash provided by operations for the nine months ended September 30,2004 resulted from a net loss of $4.5 million, offset by non cash items relatedto depreciation and amortization of $9.7 million, a decrease in restricted cashof $1.7 million, along with an increase in other liabilities of $1.0million and accrued payroll and related costs of $1.2 million. Cash provided byoperations was negatively impacted by an increase in trade and unbilledaccounts receivable, net of $2.3 million. The $19.3 million of cash provided byoperations for the nine months ended September 30, 2003 was positivelyimpacted by $0.8 million of net income for the period, a decrease in restrictedcash of $10.7 million, depreciation and amortization of $7.9 million, adecrease of trade unbilled accounts receivable, net of $2.0 million, andstock-based compensation expense of $1.2 million.  Cash provided by operations for the ninemonths ended September 30, 2003 was negatively impacted by a decrease inaccounts payable of $3.9 million.

 

The$12.9 million of cash used in investing activities for the nine month periodended September 30, 2004 primarily related to $32.0 million for thepurchase of property and equipment, including capitalization of labor costs,partially offset by $19.0 million in net sale or maturity of short-terminvestments. We also acquired approximately $0.1 million of fixed assets during2004 through capital lease arrangements. The $16.2 million of cash used ininvesting activities for the nine months ended September 30, 2003 wasrelated primarily to the purchase of property and equipment of $11.0 million,including capitalization of labor costs, and $5.2 million net purchases ofshort-term investments.

 

The$1.8 million of cash provided by financing activities for the nine month periodended September 30, 2004 resulted primarily from the issuance of commonstock. On January 7, 2004, five holders of warrants to purchase shares ofcommon stock exercised their warrants for an aggregate of 74,506 shares ofcommon stock, which resulted in approximately $1.0 million of grossproceeds to us. The remaining proceeds resulted from the issuance of stockrelated to our stock incentive plans. The $27.2 million of cash provided byfinancing activities for the nine months ended September 30, 2003primarily related to the issuance of stock and warrants to purchase commonstock in our private placement transaction completed on August 25, 2003,which yielded approximately $23.7 million to the Company.  The remaining $3.5 million related to theissuance of common stock through our stock incentive plans.

 

Oursignificant commitments consist of obligations under non-cancelable operatingleases, which totaled $11.1 million as of September 30, 2004, and arepayable in monthly installments through August 2011. Our obligations undernon-cancelable capital leases, which totaled $1.6 million as of September 30,2004, are payable in monthly installments through 2007.

 

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Ourplanned operating expenses and capital expenditures may constitute a materialuse of our cash resources. In addition, we expect that we will continue toutilize cash in the upcoming few quarters as we complete our programimplementations in Florida, Alabama and Ohio and build inventory levels forthese programs and the Mexico program as such programs reach fullproduction.  We may utilize cash resourcesto fund acquisitions or investments in complementary businesses, technologiesor product lines.

 

Webelieve that our current cash, cash equivalents, and short-term investmentbalances will satisfy our projected working capital and capital expenditurerequirements for at least the next 12 months, although we expect thatinvestments in new programs during the fiscal year ending December 31,2004 will exceed cash from operations through the end of the year. Thereafter,we anticipate continuing to use cash, cash equivalents, and short-terminvestment balances to satisfy our projected working capital and capitalexpenditure requirements.  However, inthe event that we were to win contracts requiring significant capitalinvestment, we may need to seek additional financing.

 

Inorder to take advantage of opportunities, we may find it necessary to obtainadditional equity financing, debt financing, or credit facilities although wedo not believe at this time that our long-term working capital and capitalexpenditures will be of such a nature that we would be required to take stepspresently to remedy any such potential deficiency. If it were necessary toobtain 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 satisfactoryterms.

 

**Off-BalanceSheet Arrangements**

 

Wedo not have any off-balance sheet arrangements that have or are reasonablylikely to have a current or future effect on our financial condition, changesin financial condition, revenue or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

 

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**RecentAccounting Pronouncements**

 

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs, an amendment of ARB No. 43,Chapter 4* (“FAS 151”). FAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges. We are currently evaluating the provisions of FAS 151 and do notexpect that the adoption will have a material impact on our consolidatedfinancial position or results of operations.

 

On December 16, 2004, the FASB issued StatementNo. 123(R) *Share-Based Payment*,which is a revision of Statement No. 123 and supersedes APB Opinion No. 25. Statement No. 123(R) requires all share-based payments to employees,including grants of employee stock options, to be valued at fair value on thedate of grant, and to be expensed over the applicable vesting period.  Proforma disclosure of the income statement effects of share-based payments is nolonger an alternative.  Statement No. 123(R) is effective for allstock-based awards granted on or after July 2005.  In addition,companies must also recognize compensation expense related to any awards thatare not fully vested as of the effective date.  Compensation expense forthe unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123.  The Company is currentlyassessing the impact of adopting Statement 123(R) to its consolidated resultsof operations.

 

**Risk Factors**

 

Ourbusiness, financial condition, results of operation and cash flows may beimpacted by a number of factors, including the factors set forth below.  The order in which these risk factors arepresented does not necessarily reflect their relative significance.

 

***Risks Related to Our Business***

 

*We are subject to risksencountered by companies developing and relying upon new technologies, productsand services for substantial amounts of their growth or revenue*

 

Digital watermarking isa new and developing technology, and our business and prospects must beconsidered in light of the risks and uncertainties to which companies with newand rapidly evolving technologies, products and services, such as digitalwatermarking, are exposed. These risks include the following:

 

•               We may be unable todevelop sources of new revenue or sustainable growth in revenue because ourcurrent and anticipated technologies, products and services may be inadequateor may be unable to attract or retain customers;

 

•               The intense competitionand rapid technological change in our industry could adversely affect themarket’s acceptance of our existing and new products and services; and

 

•               We may be unable todevelop and maintain new technologies upon which our existing and new productsand services are dependent in order for our products and services to besustainable and competitive and in order for us to expand our revenue andbusiness.

 

Some of our keytechnologies are still in the development stage. Consequently, productsincorporating these key technologies are undergoing technological change andare in the early stage of introduction in the marketplace. Delays in theadoption of these products or adverse competitive developments may result indelays in the development of new revenue sources or the growth in our revenue.In addition, we may be required to incur unanticipated capital expenditures inthe event product changes or improvements are required. Additionally, newindustry standards might redefine the products that we are able to sell,especially if these products are only in the prototype stage of development. Ifproduct changes or improvements are required, success in marketing theseproducts and achieving profitability from these products could be delayed orhalted. We also may be required to fund such changes or improvements out ofoperating income, which could reduce or eliminate our profitability.

 

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

 

We derive substantial portions of our revenue fromgovernment contracts which are subject to periodic open, competitive bids. Thetiming of such bids is solely within the discretion of the governmentalauthority. Consequently, large components of new revenue are tied toprocurement schedules, which could shift as the needs of the related governmentprocurement agencies change. Many of these governmental customers are facingcontinued budget pressures introducing added uncertainty. Any shift in thegovernment procurement process, which is outside our control and may not bepredictable, could result in delays in bookings forecasted for any particularfinancial period, could impact the predictability of our quarterly results, andmight limit our actual revenue in any given quarter, resulting in reduced andless predictable revenue and lower profitability.

 

*Because some of our revenue models relating toanticipated products and services are under development, the correspondinganticipated products and services may fail to attract or retain customers, ourrevenue models and pricing structures may not gain market acceptance, and wemay not be able to generate new or sustain existing revenue*

 

Some of our business involves embedding digitalwatermarks in traditional and digital media, including identificationdocuments, secure documents, audio, video and imagery, and licensing ourintellectual property. Through 2001, our revenue stream was based primarily ona combination of development, consulting, subscription and license fees fromcopyright protection and counterfeit deterrence applications. Beginning in 2002and for the foreseeable future, we have seen, and we anticipate, that themajority of our revenue will be from government and private-sector customersfor providing security-related applications relating to secure personalidentification, copyright protection, and counterfeit deterrence to suchcustomers. We have not fully developed revenue models for certain of our futuredigital watermarking applications and licensing endeavors. In addition, becausesome of our products and services are not yet well-established in themarketplace, and because some such products and services will not directlydisplace existing solutions, we cannot be certain that the pricing structureand marketing for them will be effective. We cannot assure you that ouranticipated digital watermarking products and services and licensableintellectual property will be able to compete effectively against otheralternative technologies or that we will be able to compete effectively againstcurrent 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 digital watermarking revenue, these modelsmay not gain market acceptance or may not be sustainable over time, and, as aresult, we may not be able to generate new or sustain existing revenue fromdigital watermarking.

 

*The loss of any large contract may result in loss ofrevenue and potential acceleration of amortization expense or impairment ofintangible assets*

 

Contracts between government agencies and DIDS havevarying duration, averaging three to five years in length.  Some contracts we enter into containcancellation clauses.  In addition, aftera contract period expires, generally the government agency can re-open thecontract for competitive bidding. If we were to lose a contract due tocancellation or in a competitive bidding situation, then, in addition to theloss of revenue and margin on a prospective basis, we could also incuraccelerated amortization expense or impairment of intangible assets related tothe customer.

 

*We have a history of losses, and we cannot assure youthat we will*attain sustained*profitability, particularly if we were to lose largecontracts*

 

We incurred significant net losses from inceptionthrough the fiscal year ended December 31, 2002, and during 2004. Ouraccumulated deficit as of September 30, 2004 was $60.4 million. Inorder to attain sustainedprofitability, we will need to generate higher revenue than we have in prioryears while controlling expenditures. Even though we have achievedprofitability in the past, we were not profitable in 2004 and do not expect toreturn to profitability until after the first half of 2005, if not later.  A return to profitability will depend upon avariety of factors, including the impact of 

 

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newregulatory mandates requiring us to expense stock options, the amount of costswe incur in connection with our compliance with Sarbanes-Oxley, and the extentof any ongoing expenses that we incur in connection with our restatement andrelated matters, such as our continuing remediation efforts with respect tofinancial controls as well as expenses related to litigation and otherproceedings that have arisen as a result of the restatement.  In addition, we evaluate our strategy andmarket opportunities on an ongoing basis and will adjust our approach to marketconditions that prevail from time to time. Accordingly, in the short term we may focus more on growing our revenueand taking advantage of market opportunities than an immediate return toprofitability.  Finally, various adversedevelopments including the loss of large contracts or cost overruns on ourexisting contracts could have a negative impact on our revenue or ourmargins.  Accordingly, increases in ourexpenses may not be offset by revenue increases and as a result we may not beable to regain and/or sustain profitability.

 

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

 

Our business and our strategy rely,in part, on deployment of our watermark reader technology by third parties. Forexample, one form of our watermark reader is commonly deployed in image editingapplications (offered by vendors including Adobe, Corel and Ulead) to permitusers of these products to read watermarks embedded in imagery, and therebydiscern the identities of image owners. Another form of our watermark reader isused in our anti-counterfeiting product offerings. If third parties who includesuch technology in their products, and other parties who we expect to includesuch technology in their products, decline to do so, then we would lose aportion of our currently anticipated revenue and we may suffer other adverseaffects to our business model.  Althoughsuch anticipated revenue amounts are not currently significant, they may be inthe future.

 

Some of the products, services, and licensing ofintellectual property that we intend to provide in the future will rely on thesuccessful implementation of our technology, including our reader technology,by third-party software developers and original equipment manufacturers. Weanticipate entering into agreements with third-party vendors to create, promoteand service products that incorporate, embed, integrate or bundle ourtechnologies. If we fail to obtain partners that will incorporate, embed,integrate or bundle our technologies, or these partners are unsuccessful intheir efforts, our efforts to bring our technologies to market would beadversely affected and, consequently, we would not generate revenue as anticipated.In addition, if our technologies do not perform according to marketexpectations, our future sales would suffer as customers seek other providersand, consequently, our anticipated future revenues would decrease.

 

We are materially dependent on a limited number ofthird parties to produce systems or assemblies necessary for us to produce someof our products. While we strive to have alternative suppliers provide us withmany of our products, a loss of one or more of such suppliers could have amaterial adverse effect on our ability to perform effectively, if at all, forsome of our long-term contracts.

 

*A significant portion of our business depends oncontracts that are subject to a variety of terms and conditions, includingdamage payment obligations and fixed price terms, as well as a variety of otherinfluences that may cause our quarterly results to fluctuate and ouranticipated revenue to potentially decrease significantly*

 

Our contracts for driver license and otheridentification issuance systems and their related products typically includeterms relating to supplier dependencies, time-based performance, developmentand delivery schedules and milestones, and other contract terms that may createsituations where a customer may assert that we are late in meeting our deliveryobligations and that we owe them late penalties, charges or other damages.  Such provisions are common in large scalegovernment contractsat the state and federal levels.  These contracts include installation,customer acceptance and testing, and other delivery and relatedprocedures.  Because procedures oftenrequire compliance over extended periods of time, they give rise to anincreased risk that we may fail to meet timing or other delivery requirementsand milestones pursuant to the terms of such contracts.   If we failed to meet such requirements ormilestones, customers may assert against us compensatory or liquidated damages,breach of contract, or other claims. Consequently, our failure to meet contractual milestones or otherperformance requirements as promised could result in our 

 

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having to incur increased costs, lower margins, orcompensatory obligations, inaddition to other losses, such as harm to our reputation.  Such unexpected increases in costs to meetour contractual obligations or any other requirements necessary to addressclaims and damages with regard to our customer contracts could have a material adverse effect on our businessand financial results.  We anticipatethat future contracts will continue to have such provisions unless and untilindustry practices change.

 

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts.  Fixed price contracts typically consist ofagreements to sell entire systems or portions of a system for an agreed uponprice.  These contracts normally do nothave clauses that allow for recovery of cost overruns.  Under fixed price contracts, we providespecific tasks for a specific price and are typically paid on a milestonebasis. We have experienced low margins or losses on such contracts in therecent past. Such contracts involve greater financial risks because we bear therisk if actual project costs exceed the amounts we are paid under thecontracts. A material percentage of our revenues are derived from fixed pricecontracts and our reliance on fixed price contracts may grow.

 

A significant portion of our business depends on alimited number of large, public-sector contracts, which are generally subjectto termination for convenience, as determined by the subject agency, or forlack of budgetary appropriation provided for the subject agency.  Some government contracts also may beone-time events, such as in the case of some personal identification systems innon-U.S. markets involving voter registration programs. In such cases, we maygenerate substantial revenue that may not be subject to future renewal.Moreover, government contracts result from purchasing decisions made by publicsector agencies that may be subject to political influence, unusual procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain largerestricted cash reserves as a guarantee, reducing our ability to use thesefunds for our other business purposes. Even with the availability of such cashreserve guarantees, we may not be able to obtain such performance bondunderwriting at a favorable rate or at all. Our failure to be able to provide such performance bonds may precludeour ability to bid on new government contracts or maintain our existingcontracts for the entirety of their full terms. The size, nature and purpose of, and the risks and uncertaintiesassociated with, public sector contracts can potentially cause our quarterlyresults to fluctuate and anticipated revenue to decrease significantly.

 

*We may decline to pursue new, or renew existing,business opportunities in secure identification markets due to objectionableterms required by the contracting agencies, or we may agree to objectionablecontract terms for competitive reasons.*

 

Government agencies sometimes insist on unduly onerousterms in their contracts with vendors of secure identification issuancesystems.  For example, it is customaryfor state agencies to require that a vendor fund the capital-intensive initialdeployment of a driver license issuance system (the costs of which the vendornormally recoups over the life of the contract in per-card fees), whilereserving the right to terminate the contract. Similarly, in connection with intellectual property rights, a contractmay require that our pre-existing issuance system software be written in adifferent language and a state may then argue that it falls within the class ofworks for which it owns the copyright, enabling the state to turn theDigimarc-authored software over to one of our competitors, dedicate it to thepublic domain, or otherwise use the software in a manner detrimental to ourbusiness.  Objectionable contract termsmay lead us to decline to bid on identification issuance systems to newcustomers, or to decline to retain business with customers we have historicallyserved, which could reduce ourmarket share and lower our revenues or profits. In addition, if we decline to retain business with customers we havehistorically served, it could result in the accelerated depreciation ofintangible assets. Alternatively, we may decide to accept at least some level ofobjectionable terms rather than cede an important contract to a competitor, which could also lower our revenues or profits.

 

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

 

We have invested significant time and resources inproduct development activities for new secure identification markets, includingdesigning and building numerous enhancements to our driver license systems andimproving our cards’ ability to withstand intrusions or alterations withoutdetection. If we do 

 

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notexperience a timely, positive reaction from issuing authorities to our new offerings,our projected revenues, margins and earnings may be negatively impacted and,consequently, the future market price of our common stock might experiencesignificant volatility.

 

In addition, we are developing new sales channels indomestic and foreign markets for certain components and subsystems of ourdomestic driver license solutions. During 2004 we increased our initiatives inthese areas and anticipate continuing to do so in future periods. We believethese new sales channels may contribute significantly to our future results, asour products get placed into other programs and start generating recurringrevenue streams. However, given that this is an emerging area of our business,involving significant time and effort in connection with the development of newproducts and distribution relationships, there are ongoing risks that thesemarket areas will not develop in the manner or along the timeline that we areprojecting, or at all, resulting in significant costs and expenses withoutcorresponding increases in any revenues and profits.

 

*Our identification systems business expects toexperience variability in gross margins*

 

Our DIDS business will likely experience variabilityin gross margins on its contracts due to numerous factors, including, amongother things, the following:

 

•                  Pricing pressures in competitive bids, andcontract renewals and contract extensions;

 

•                  Variations in costs of materials andmanufacturing variances;

 

•                  Varying levels of efficiency of our workforcein delivering, implementing, and servicing contracts;

 

•                  Seasonality of issuance volumes;

 

•                  Sales mix related to card issuance revenuescompared to product sales;

 

•                  Sales mix related to domestic sales comparedto international sales;

 

•                  Sales mix related to adoption of new productscompared to sales of current products;

 

•                  Strategic decisions on new business; and

 

•                  Depreciation and amortization of capitalizedproject costs related to new or upgraded programs.

 

The numerous factors affecting gross margins makesuch margins complex and difficult to predict. We are continually refining our predictive tools and increasing ourunderstanding of what drives these various factors.   However, we nevertheless expect toexperience fluctuations in our future operating results as a result of thevariability in margins on DIDS business contracts.

 

*Recent and ongoing leadership and staffing changesmay result in disruptions and inefficiencies in our business during transitionperiods, may require process changes in our business, and will likely causeadditional costs to our business before benefits from such changes may berealized*

 

During the second quarter of 2004, we madesignificant changes in our management and staff as a result of a detailedreview of our business processes.   Manyof these changes were initiated following the hiring of our new Chief FinancialOfficer in June 2004 and other senior managers, and in conjunction withthe continuing implementation of our new accounting and material requirementsplanning systems and work on Sarbanes-Oxley compliance. In addition, our ChiefOperating Officer assumed direct control and responsibility for ouridentification systems business on an interim basis in order to make day-to-dayimprovements to the efficiency, effectiveness, and predictability of itsoperations. Meanwhile, we are recruiting for a permanent president of the DIDSbusiness.  While we anticipate that thesechanges in leadership and staffing will improve operations, there is a risk thatthese changes may disrupt the operations 

 

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ofour business and, consequently, may result in some short-term inefficiencies aspersonnel complete their transitions and new leaders implement their new plansand procedures. We also expect that these changes may require furthermodifications of our finance and business processes and will likely causeadditional costs to our business in the short term before any benefits fromsuch changes, if any, may be realized.

 

*We may encounter significant employee turnover thatcould reduce our ability to sell, deliver, and support future commitments.*

 

Due to concerns related to our restatement, late SECfilings, possible delisting from the Nasdaq National Market, shareholderlitigation and the SEC’s informal inquiry, we could encounter significantdepartures of key employees from the Company. While we are taking steps to support employee retention, there can be noassurances that key employees will not leave the Company for other jobs, thusimpairing our ability to meet commitments and sustain revenue.   In addition, these events may have anegative impact on the market price of our common stock, and employees andprospective employees may factor in the uncertainties relating to our stabilityand the value of any equity-based incentives in their decisions regardingemployment opportunities and decide to leave our employ.  These uncertainties also could result in anerosion of morale, and affect the focus and productivity of our remainingemployees, including those directly responsible for revenue generation, whichin turn may affect our revenue in the future. Additionally, current employeesmay seek future employment with our business partners, customers orcompetitors.  Although we generallyattempt to control access to and distribution of our proprietary information byour employees, there can be no assurances that the confidential nature of ourproprietary information will be maintained in the course of such futureemployment.  Any of these events couldhave a material adverse effect on our financial and business prospects.  For more information about the shareholderlitigation and the SEC’s informal inquiry, see   Item 1 of Part II of this Form 10-Q.

 

*We depend on key employees for our future success dueto the high level of technical expertise that our industry requires and theloss of any of them could delay projects or undermine customer relationships*

 

Our success depends to a significant extent on theperformance and continued service of our senior management. Except for ourChief Executive Officer, our senior management do not have employmentagreements. Although our employees generally have executed agreementscontaining non-competition clauses, there is no assurance that a court wouldenforce all of the terms of these clauses or the clauses generally. If theseclauses were not fully enforced, our employees could be able to freely join ourcompetitors. The loss of the services of any of our senior management or any ofour other key employees could delay projects or undermine customerrelationships.

 

*If we are not able to retain, hire or integratequalified personnel, we may not be able to deliver the products and servicesthat our customers require*

 

Our ability to develop, market, sell and licensesuccessfully our products, services, and intellectual property depends to asignificant degree upon the continued contributions of our key personnel inengineering, sales, marketing, operations, legal and licensing, many of whomwould be difficult to replace.  Similarly, without the continued contributionsof our key finance personnel, we believe that our ability to meet our reportingobligations and operate successfully as a public company may be limited.  We believe our future success will dependin large part upon our ability to retain our current key employees and ourability to attract, integrate and retain such personnel in the future. It maynot be practical for us to match the compensation certain of our employeescould garner at other employment.  Ourbusiness is also based in part on patented technology, which is unique and notgenerally known. New employees require substantial training, involvingsignificant resources and management attention. Competition for experiencedpersonnel in our business can be intense. If we do not succeed in attractingnew, qualified personnel or in integrating, retaining and motivating ourcurrent personnel, our growth and ability to deliver products and services thatour customers require may be hampered.

 

*We are engaged in litigation from time to time whichis unpredictable and can lead to unplanned expenses*

 

From time to time we are engaged in litigation withthird parties. For example, wecurrently are engaged in litigation relatingto the initial public offering of our securities,one case involving an alleged 

 

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impropergrant of a driver license contract to a competitor, and various other routineactions, in addition to the class actionsfiled against us in connection with our recently announced accounting errors.  Litigation typically is an expensive processand, due to its inherent uncertainties and because the settlement and trialpreparation processes are lengthy and potentially inconclusive, the ultimatecost and outcome of such matters cannot be predicted.  As a result, while we believe that litigationoften is necessary to preserve the interests of our company, it also can leadto additional expense and thus lower profits to our business without generatingoffsetting and lasting benefits.

 

*We may not be able to protect adequately ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could reduce the perceived valuation of the company andresult in a lower stock price*

 

Our success depends in part on licensing ourproprietary technologies. To protect our growing intellectual propertyinvestments, we rely on a combination of patent, copyright, trademark and tradesecret rights, confidentiality procedures and licensing arrangements.Unlicensed copying and use of our intellectual property or illegalinfringements of our intellectual property rights represent losses of revenueto our company.

 

We face risks associated with our patent position,including the potential and sometimes actual need from time to time to engagein significant legal proceedings to enforce our patents, the possibility thatthe validity or enforceability of our patents may be denied, the possibilitythat third parties will be able to compete against us without infringing ourpatents, and the possibility that our products may infringe patent rights ofthird parties. Budgetary concerns may cause us not to file, or continue,litigation against known infringers of our patent rights, or may cause us notto file for, or pursue, patent protection for all of our inventive technologiesin jurisdictions where they may have value. Some governmental entities thatmight infringe our intellectual property rights may enjoy sovereign immunityfrom such claims. Failure to reliably enforce our patent rights againstinfringers may make licensing more difficult. If we fail to protect ourintellectual property rights and proprietary technologies adequately, if thereare changes in applicable laws that are adverse to our interests, or if webecome involved in litigation relating to our intellectual property rights andproprietary technologies or relating to the intellectual property rights ofothers, our business could be seriously harmed because the value ascribed toour intellectual property could diminish and result in a lower stock price.

 

As part of our confidentiality procedures, wegenerally enter into non-disclosure agreements with our employees, directors,consultants and corporate partners, and attempt to control access to anddistribution of our technologies, solutions, documentation and otherproprietary information. Despite these procedures, third parties could copy orotherwise obtain and make unauthorized use of our technologies, solutions orother proprietary information or independently develop similar technologies,solutions or information. The steps that we have taken to preventmisappropriation of our solutions, technologies or other proprietaryinformation may not prevent their misappropriation, particularly outside theUnited States where laws or law enforcement practices may not protect ourproprietary rights as fully as in the United States.

 

Effective protection of intellectual property rightsmay be unavailable or limited, both in the United States and in othercountries. Patent protection throughout the world is generally established on acountry-by-country basis. We have applied for patent protection both in theUnited States and in various other countries. However, we cannot assure youthat pending patents will be issued or that issued patents will be valid orenforceable. Failure to obtain such patents or failure to enforce those patentsthat are obtained may result in a loss of revenue to us. We cannot assure youthat the protection of our proprietary rights will be adequate or that ourcompetitors will not independently develop similar technologies, duplicate ourservices or design around any of our patents or other intellectual propertyrights we hold.

 

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. If aninfringement arose in a context governed by such a contract, we may have torefund to our customer amounts already paid to us or we may be sued by theparty allegedly infringed upon,our exposure could be large, and we may incur significant litigation,settlement, or judgment expenses. Similarly, as we seek to broaden the numberof companies licensed under our patent portfolio, some may seek contractualassurances that we will pursue—by litigation if necessary—their competitors 

 

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whouse our patented technology but are not licensed to do so. Compliance with anysuch contract provisions may require that we pursue litigation where our costsexceed our likely damages award.

 

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

 

We have registered “DIGIMARC”, “MARCSPIDER”, “MEDIABRIDGE”,“IMAGEBRIDGE”, “PICTUREMARC”, and the “D” logo, among other marks, astrademarks in the United States as well asother countries.  We arepursuing the registration of “DIGIMARC” in additional countries, and we are pursuing the registration ofcertain other trademarks including ”IDMARC”, “EXIAN” and “CENTRIAN”.   However, our tradenames or trademarks may be registered by third partiesin other countries, impairing our ability to enter and compete in thesemarkets. In the United States, the trademark “Digimark” and the domain names “Digimark.com”and “Mediabridge.com” have been registered by unrelated companies. While wehave put in place formal arrangements for co-existence with one of theseunrelated companies, and while we have co-existed successfully to date with theother, if we were forced to change our name or were prevented from using ourother brand names, we would lose a significant amount of our brand equity.

 

As more companies engage in business activitiesrelating to personal identification technologies and digital watermarking, anddevelop corresponding intellectual property rights, it is increasingly likelythat claims may arise which assert that some of our products or servicesinfringe upon other parties’ intellectual property rights. These claims couldsubject us to costly litigation, divert management resources and result in theinvalidation of our intellectual property rights. These claims may require usto pay significant damages, cease production of infringing products, terminateour use of infringing technologies or develop non-infringing technologies. Inthese circumstances, continued use of our technologies may require that weacquire licenses to the intellectual property that is the subject of thealleged infringement, and we might not be able to obtain these licenses oncommercially reasonable terms or at all. Our use of protected technologies mayresult in liability that threatens our continuing operation. In addition, weoffer indemnification against intellectual property infringement for somecontracts to which we are a party. As deployment of our technology increases,and more companies enter our markets, the likelihood of a third party lawsuitresulting from such indemnification increases. If a claim were made under suchan indemnity provision, we could incur significant expense.

 

*The security systems used in our product and serviceofferings may be circumvented or sabotaged by third parties, which could resultin the disclosure of sensitive government information or private personalinformation or cause other business interruptions that could damage ourreputation and disrupt our business*

 

Our business relies on computers and otherinformation technologies, both in-house and at customer and vendorlocations.   In addition, many of thesystems we sell manage private personal information and protect informationinvolved in sensitive government functions. The protective measures that we use in these systems may not preventsecurity breaches, and failure to prevent security breaches may disrupt ourbusiness, damage our reputation, and expose us to litigation and liability. Aparty who is able to circumvent security measures used in these systemscould misappropriate sensitive or proprietary information or materials or cause interruptions orotherwise damage our products, services and reputation, and the property of ourcustomers.  If unintended parties obtain sensitivedata and information, or create bugs or viruses or otherwise sabotage thefunctionality of our systems, we may receive negative publicity, incurliability to our customers or lose the confidence of our customers, any ofwhich may cause the termination or modification of our contracts.  Further, our insurance coverage may beinsufficient to cover losses and liabilities that may result from such events.

 

In addition, we may be required to expendsignificant capital and other resources to protect ourselves against the threatof security breaches or to alleviate problems caused by these breaches.However, protection or remedial measures may not be available at a reasonableprice or at all, or may not be entirely effective if commenced.

 

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

 

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Products and systems as complex as those we offer ordevelop frequently contain undetected defects or errors. Despite testing,defects or errors may occur in existing or new products, which could result in delays in the development and implementation ofproducts and systems, loss of revenue or market share, failure toachieve market acceptance, diversion of development resources, injury to ourreputation, increased insurance costs and increased service and warranty costs.Furthermore, we often provide implementation, integration, customization,consulting and other technical services in connection with the implementationand ongoing maintenance of our products. The performance of these productstypically involves working with sophisticated software, computing andcommunications systems. Our inability to meet customer expectations or projectmilestones 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 toour reputation, increased costs and potential claims of breach of contract andcompensatory and/or liquidated damages.

 

Because many customers rely on our products forcritical security applications, defects or errors in our products or servicesmight discourage customers from purchasing future products and services. These defectsor errors could also result in product liability or warranty claims. Althoughwe attempt to reduce the risk of losses resulting from these claims throughwarranty disclaimers and liability limitation clauses in our sales agreementswhen we can, these contractual provisions are sometimes not included and maynot be enforceable in every instance. Furthermore, although we maintain errorsand omissions insurance, this insurance coverage may not adequately cover theseclaims. If a court refuses to enforce the liability-limiting provisions of ourcontracts for any reason, or if liabilities arose that were not contractuallylimited or adequately covered by insurance, the expense associated withdefending such actions or paying the resultant claims could be significant anddecrease our profits.

 

As our watermarking solutions are more broadlydeployed by our customers, our potential exposure to litigation may increase.For example, as we provide technology solutions to customers, our offerings mayface product liability or intellectual property infringement claims (as is thepossibility with any technology), either alone or in conjunction with ourcustomers.

 

*If our operating structure is not effective, or if weare required to restructure to address changes in our business, we mayencounter higher expenses and reduced margins*

 

As of September 30, 2004 we had 378 employeesand 186 contract workers.  To effectivelymanage our operations, management must continue to improve our operational andfinancial systems and train, improve and manage our employee base. As part ofour goal to continue to improve operating efficiencies, we organized ouroperations into a portfolio of peer-level operating units under a corporateumbrella, consisting of two units, the first of which is Digital Watermarkingand the second of which is ID Systems, both of which are overseen by acorporate staff. While our management anticipates that this operating structurewill facilitate effective management of the continuing growth and expansion ofour business, we have had setbacksrecently at the operating-unit leadership level, and we cannot assureyou that the operating structure will be effective or achieve the desiredresults. Additionally, less than optimal rates of growth of our product linesand areas of business may require us to restructure our business from time totime, which, in turn, could significantly strain our managerial and financialresources. If we cannot manage our growth effectively, we may not be able tocoordinate the activities of our technical, legal, accounting and marketingstaffs and, as a result, we may experience higher expenses and reduced margins.

 

*We may acquire other businesses or technologies and,if we do, we may be unable to integrate them with our own business, or we mayhave reduced earnings from doing so and we may never achieve any of thebenefits that we might anticipate from such acquisitions*

 

From time to time we may acquire other businesses,assets and technologies. Such acquisitions involve certain risks. We may not beable to identify, negotiate or finance any future acquisition successfully. Wemay incur additional or one-time charges related to the pursuit of acquisitionsor restructurings or other matters in connection with acquisitions. Other than theacquisition of LGP in 2001, we have limited experience in integrating anacquired business into our existing business. The process of integration mayproduce operating difficulties (like thoseexperienced with the LGP acquisition) and may require significantattention of our management that otherwise would be available for the ongoingdevelopment of our business. In the end, we may be unsuccessful in integratingan acquired business, technology or other asset with our existing business.Moreover, if we make acquisitions, we may issue 

 

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sharesof our stock that would dilute the equity holdings of our existingstockholders, incur debt, assume contingent liabilities or create additionalexpenses related to amortizing intangible and other acquired assets. Any ofthese may result in reduced earnings and cause our stock price to decline. Ourdue diligence of acquired companies may fail to reveal material risks orliabilities. Additionally, in order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, orcredit facilities, and we may not be successful in doing so on satisfactoryterms. Any financing that we might need for future acquisitions may also placerestrictions on our business. Furthermore, we may never achieve any of thebenefits that we might anticipate from a future acquisition.

 

*As international customers have accounted forapproximately 22% of our total revenue during the nine months ended September 30,2004, the loss of these customers or the failure to find new customers mayresult in a decline in our international revenue, which could lower ourprofitability and slow our growth*

 

We expect revenue from sales of products andservices to governments and other customers outside the U.S. to represent agrowing percentage of our total revenue in the future. International sales andservices are subject to a number of risks, including the following:

 

•                  changesin foreign government regulations and security requirements;

 

•                  exportlicense requirements, tariffs and taxes;

 

•                  tradebarriers;

 

•                  difficultyin protecting intellectual property;

 

•                  difficultyin collecting accounts receivable;

 

•                  currencyfluctuations;

 

•                  difficultyin managing foreign operations; and

 

•                  politicaland economic instability.

 

If our customers are affected by currencydevaluations or general economic downturns or persistent economic difficulties,their ability to purchase our products and subscriptions and services could bereduced significantly. Payment cycles for international customers typically arelonger than those for customers in the United States. Foreign customers maydecide to terminate or delay the implementation of our products and services.Any action like this by foreign customers, in particular foreign governmentauthorities, could potentially delay or reduce our anticipated revenue underour contracts with such customers, and we may have limited recourse againstthem to recover any potential losses.

 

We generally do not invoice our foreign sales inU.S. dollars, and, consequently, we are materially exposed to currency exchangefluctuations.  We currently do not engagein foreign currency hedging transactions. We may in the future choose to limitour exposure by the purchase of forward foreign exchange contracts, collaredoptions, currency swap agreements or through similar hedging strategies.However, no currency hedging strategy can fully protect againstexchange-related losses.

 

***Risks Related to the Restatement of Our PriorFinancial Results and Internal Controls***

 

*We have identified certain issues relating to ourcontrols and procedures, which, if not remedied effectively, could impede ourability to run and monitor our business*

 

Management concluded that certain problems in ourinternal controls and procedures****resultedin the restatement of ourfinancial statements and the inability totimely file reports with the SECthat constitute   material weaknesses as of September 30, 2004. Wemade this determination in consultation with the audit committee of the Company’sboard of directors. We have acted promptly to address these issues and areengaged in an ongoing design and implementation process of new and enhancedcontrols and procedures. If we are unable to identify and remedy all suchissues promptly and effectively, it could have a material adverse effect on ourbusiness, as well as impair our ability to meet our quarterly and annualreporting requirements in a timely manner. While we are completing the design, 

 

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implementationand testing of our enhanced controls environment, the controls and procedureson which we currently rely may fail to be sufficiently effective, and such controlsand procedures may not be adequate to prevent or detect irregularities orensure the accuracy of our financial statements or reports filed with theSEC.  Further, any system of controls,however well designed and operated, is based in part on certain assumptions andcan provide only reasonable, and not absolute, assurances that the objectivesof the system are met. The failure or circumvention of our controls, policiesand procedures could have a material adverse effect on our compliance withdisclosure and listing requirements, and if they were to lead to a financialloss, could negatively affect the results of our operations and financialcondition. For more information about the material weaknessesin our internal control over financial reporting, see Item 4 of this Form 10-Q.

 

*We were not**successful in meeting the requirements under Section 404 of theSarbanes-Oxley Act of 2002 in a timely basis and themarket price of our common stock and our regulatory compliance may be adverselyaffected as a result.  Moreover, o**ur assessment of theeffectiveness of our internal controlover financial reporting as required by Section 404 has identifiedadditional issues relating to our internal controls and will result in anattestation with an adverse or disclaimed opinion from our independentregistered public accounting firm, which may adversely affect the market priceof our common stock.*

 

We are currently evaluating andtesting our internal control over financial reporting asrequired by Section 404 of the Sarbanes-Oxley Act of 2002.  In orderfor management to issue its report on our internal control over financialreporting, we must document both the design of our internal control overfinancial reporting and the operating effectiveness of our controls andprocedures.  Our management hasundertaken the necessary processes and procedures for issuing its report.  However, the focused application of criticalresources to our separate and on-going accounting review and the preparation offilings with the SEC reflecting the restatement have had a significant impacton our Section 404 compliance efforts. Moreover, our on-going accounting review has resulted in remediationefforts with respect to some of our accounting processes, in particular with regard to projectaccounting at DIDS.  Wecannot be certain at this time as to the timing of the completion of our evaluation, testing and remediation actions (as necessary or appropriate) or theimpact these activities will have on ouroperations.  Upon the completion of ourremaining testing and documentation, internal control matters that we discover mayneed or may require additional remediation efforts, which may requireestablishing, implementing and testing additional controls, the time and costof which are not presently known.  As a result of our failureto meet our compliance and reporting obligations, we may be subject tosanctions or investigation by regulatory authorities, such as the SEC, and further review by The Nasdaq StockMarket, Inc. (“Nasdaq”), which mayresult in the delisting of our common stock from the Nasdaq NationalMarket.  Any such action could adverselyaffect the market price of our common stock.

 

Our internal control assessmentwill confirm materialweaknesses in our internal control over financial reporting that wehave disclosed in this Form 10-Q and may identify additionalissues relating to our internal control over financial reporting.Consequently, we expect our assessment will result in an attestation report with an adverse opinion, ora disclaimer of an opinion, from our independent registered public accountingfirm as to the effectiveness of our internalcontrol over financial reporting.  Anysuch consequences of our Section 404 assessment could have an adverseeffect on investor perceptions of the Company and cause a decline in the marketprice of our common stock.

 

*We are investing**significant**time and resources to implement the requirements of Section 404of the Sarbanes-Oxley Act of 2002, which may increase our operating expensesand reduce our profitability in the near future*

 

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Changes in the laws and regulations that haverecently been enacted, including provisions of the Sarbanes-Oxley Act of 2002,are likely to continue to increase our expenses as we devote resources inresponse to them. For example, we already have deployed significant resourcesto document, implement and test our financial processes as part of ourimplementation of the requirements under Section 404 of the Sarbanes-OxleyAct of 2002, and we expect to incur additional time and expenses as we meet therequirements under Section 404 for our management to report on, and ourindependent registered public accounting firm to attest to, our internal control over financial reporting.Moreover, compliance with these rules could also cause us to furthermodify our existing review processes or divert our management’s time andattention away from otherwise running our business, either of which couldresult in our company experiencing additional costs and expenses withoutcorresponding increases in revenue. Consequently, as we take steps to furtherimprove and strengthen our financial management and controls, we anticipatecorresponding increases in our operating expenses that may reduce ourprofitability in the near future.

 

*We face risks related to securities litigation andinvestigations that could have a material adverse effect on our business,financial condition and results of operations*

 

We announced in September 2004 that we likelywould be required to restate certain previously reported financial statementsand that such financial statements should no longer be relied upon until suchtime as we completed our review of certain possible accounting errors.   Following this announcement, three classaction lawsuits were commenced against us and certain of our current and formerofficers by persons claiming to have purchased or otherwise acquired oursecurities at specified dates.  Inaddition, two purportedshareholder derivative lawsuits were filed against the Company and certain ofour officers and directors, claiming that certain of our officers and directorsbreached their fiduciary duties to the Company’s stockholders and to theCompany.  Moreover, a letter was mailedto the chairman of the Company’s board of directors by a law firm purporting torepresent a shareholder of the Company demanding that the board commence aninvestigation and civil action against designated current and former directorsand officers on behalf of the Company to recover for damages alleged to havebeen incurred as a result of alleged breaches of fiduciary duties. Additional lawsuits may be filed against us.  Finally, we have received a notice from thestaff of the SEC stating that it is conducting an informal inquiry relating toour previous announcement that we were restating our prior financialresults.  The inquiry focuses on the errors made in thecapitalization of certain software and other project costs.  The staff hasrequested that we voluntarily produce documents and information related to itsinquiry, and we are cooperating with the staff’s request. Defendingagainst existing and potential litigation relating to the restatement of ourconsolidated financial statements, and cooperating with the SEC’s requests,will likely require significant time, attention and resources of management,which may adversely affect our business, results of operations and financialcondition.

 

Our response to the foregoing legal matters willlikely result in significant future legal expenses, some of which will not becovered by insurance.  Predicting theresolution of legal claims is inherently uncertain.  Accordingly, it is not possible to state withcertainty the remedies that may be sought or obtained in the foregoing legalproceedings.  There is a risk that theseproceedings could have a material impact on the Company’s financial performanceor its business in the future.

 

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

 

Our director and officer liability insurancepolicies provide liability protection relating to the securities class actionand derivative lawsuits against us and certain of our officers and directors upto prescribed policy limits. If these policies do not adequately cover expensesand certain liabilities relating to these lawsuits, our financial conditioncould be materially harmed. In addition, if this insurance coverage becomesunavailable to us or premiums increase significantly in the future, it couldmake it more difficult for us to retain and attract officers and directors andcould expose us to potentially self-funding certain future liabilitiesordinarily mitigated by director and officer liability insurance.

 

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*We couldface adverseconsequences as a result of our late SEC filingsand the restatement of our historical financial statements*

 

We failed to timely file this Form 10-Q and our Form 10-K for the year ended December 31,2004.  In addition, our 2004 Form 10-K does notinclude the report on management’s assessment ofthe effectiveness of internalcontrol over financial reporting or the related attestation reports of ourindependent registered public accounting firm as required by Section 404 of theSarbanes-Oxley Act.   We intend to filean amendment to our 2004 Form 10-K that includes such reports within 45 days ofthe initial filing deadline for such Form 10-K.  As a result, we will not be eligible to use a“short form” registration statement on Form S-3 for a period of12 months after becoming current in our filings. Our inability to use a short form registration statementfor a period of 12 months after becoming current inour SEC reporting obligations may impair our ability, orincrease the costs and complexity of our efforts, to raise funds in the publicmarkets should we desire to do so during this one year period.  In addition, if we are unable to remaincurrent in our financial filings, we may face additional adverse consequences,including (1) an inability to have a registration statement under theSecurities Act of 1933 covering a public offering of securities declaredeffective by the SEC, (2) an inability to make offerings pursuant toexisting registration statements (including registration statements on Form S-8covering employee stock plans) or pursuant to certain “private placement” rules ofthe SEC under Regulation D to any purchasers not qualifying as “accreditedinvestors,” (3) the possible delisting of our common stock from the NasdaqNational Market, and (4) limitations on the ability of our affiliates tosell our securities pursuant to Rule 144 under the Securities Act.  These restrictions may adversely affect ourability to attract and retain key employees and may further impair our abilityto raise funds in the public markets should we desire to do so.

 

In addition, our future success depends largely uponthe support of our customers, suppliers and investors. The restatement and lateSEC filings have resulted in negative publicity and a Nasdaq delistingproceeding, and may have a negative impact on the market price of our commonstock. The effects of the restatement and late SEC filings could cause some ofour customers or potential customers to refrain from purchasing or deferdecisions to purchase our products and services. Additionally, current orpotential suppliers may re-examine their willingness to do business with us, todevelop critical interfaces to our products or to supply products and servicesif they lose confidence in our ability to fulfill our commitments. Any of theselosses could have a material adverse effect on our financial and businessprospects.

 

***Risks Related to Our Industry***

 

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

 

Our future success will depend in part on ourability to enhance and improve the responsiveness, functionality and features ofour products and services in accordance with regulatory or industry standards.Our ability to remain competitive will depend in part on our ability toinfluence and respond to emerging industry and governmental standards, in atimely and cost-effective manner. If we are unable to influence these or otherstandards or respond to such standards effectively, our growth and thedevelopment of certain products and services could be delayed.

 

Our market is characterized by new and evolvingtechnologies. The success of our business will depend on our ability to developand integrate new technologies effectively and address the increasinglysophisticated technological needs of our customers in a timely andcost-effective manner. Our ability to remain competitive will depend in part onour ability to:

 

•               Enhance and improve the responsiveness,functionality and other features of the products and services we offer or planto offer;

 

•               Continue to develop our technical expertise;and

 

•               Develop and introduce new services,applications and technologies to meet changing customer needs and preferencesand to integrate new technologies.

 

We cannot assure you that we will be successful inresponding to these technological and industry challenges in a timely andcost-effective manner. If we are unable to develop or integrate newtechnologies 

 

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effectivelyor respond to these changing needs, our margins could decrease and our releaseof new products and services could be slowed.

 

*If leading companies in our industry orstandard-setting bodies or institutions downplay, minimize, or reject the useof digital watermarking, its deployment may be slowed and our revenue growthmay be diminished*

 

Many of our business endeavors, such as ourlicensing of intellectual property in support of audio and video andcopy-control applications, can be impeded or frustrated by larger, moreinfluential companies or by standard-setting bodies or institutionsdownplaying, minimizing or rejecting the value or use of watermarkingtechnology or any of our other technologies. Such a negative position by thesecompanies, bodies or institutions, if taken, may result in obstacles for usthat we would be incapable of overcoming and may make achieving our businessobjectives difficult or impossible, potentially diminishing our anticipatedrevenue growth as a result.

 

*The market for our products is highly competitive,and as a result, alternative technologies or larger companies may undermine,limit or eliminate the market for our products’ technologies,which would decrease our revenue and profits*

 

The markets in which we compete for business areintensely competitive and rapidly evolving. We expect competition to continuefrom both existing competitors and new market entrants. We face competitionfrom other companies and from alternative technologies. As we expand theapplications for our technologies, we will experience more competition fromproducts and services that are substitutes for our applications. Because ourdigital watermarking business is new and emerging, we also may face competitionfrom unexpected sources. Alternative technologies that may directly orindirectly compete with particular applications of our watermarkingtechnologies include:

 

•               Encryption—securing data during distributionusing a secret code so it cannot be accessed except by authorized users;

 

•               Containers—inserting a media object in anencrypted wrapper, which prevents the media object from being duplicated and isused for content distribution and transaction management;

 

•               DataGlyphs®—a slightly visible modificationof the characteristics of an image or document that is machine-readable;

 

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

 

•               Traditional anti-counterfeitingtechnologies—a number of solutions used currently by many governments (and thatcompete for budgetary outlays) designed to deter counterfeiting, includingoptically sensitive ink, magnetic threads and other materials used in theprinting of currencies;

 

•               Radio frequency tags—embedding a chip thatemits a signal when in close proximity with a receiver, which is being used inphoto identification credentials, labels and tags;

 

•               Internet technologies—numerous existing andpotential Internet access and search methods are competitive with the DigimarcMediaBridge system and the searching capabilities of Digimarc ImageBridge;

 

•               Digital fingerprints and signatures—a metric,or metrics, computed solely from a source image or audio or video track, thatcan be used to uniquely identify an image or track, or authenticate the imageor track;

 

•               Smart cards—badges and cards including asemiconductor memory and/or processor used for authentication and relatedpurposes; and

 

•               Bar codes—a data-carrying code, typicallyvisible in nature (but invisible if printed in ultraviolet- orinfrared-responsive inks).

 

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In addition, as we more broadly apply our digitalwatermarking technologies to the Internet through new commercial solutionsapplications, we may begin to compete with a wide range of other types ofcompanies beyond those companies using digital watermarking technologies andalternative technologies. Moreover, many of the companies that currentlycompete with us for some of our business, as well as other companies with whomwe may compete in the future, are larger and national or international in scopeand may have greater technical, financial, marketing, and political resourcesthan we do. These resources could enable these companies to initiate severeprice cuts or take other measures in an effort to gain market share orotherwise impede our progress. We cannot assure you that digital watermarkingtechnologies, and our products and services using these technologies, will gainwidespread market acceptance.

 

New developments are expected to continue, and wecannot assure you that discoveries by others, including current and potentialcompetitors, will not render our services and products noncompetitive.Moreover, because of rapid technological changes, we may be required to expendgreater amounts of time and money than currently anticipated to develop newproducts and services, which in turn may necessitate us to require greaterrevenue streams on such products and services to cover developmental costs. Wecannot assure you that we will be able to compete successfully against currentor future participants in our market or against alternative technologies, norcan we assure you that the competitive pressures we face will not decrease ourrevenue and profits in the future.

 

*Terrorist attacks and threats of, or actual, war maynegatively impact all aspects of our operations, revenue, costs and stock price*

 

Threats of terrorist attacks in the United States,as well as future events occurring in response to or in connection with them,including, without limitation, future terrorist attacks or threats againstUnited States targets, rumors or threats of war, actual conflicts involving theUnited States or its allies, or military or trade disruptions, may impact ouroperations by leading to deferred or cancelled projects, which may reduce ourrevenue and profits. While any of these terrorist-related events could resultin an increased need for new security features that may, as a result, favorablyimpact our revenue from our DIDS operations and our sales of product andsubscription and service in connection with our digital watermarkingtechnology, any of these events could also, or alternatively, result inincreased volatility in the United States and worldwide financial markets andeconomies, or drive up our research, development and engineering costsassociated with attempting to achieve heightened effectiveness in new products.Also, any of these terrorist-related events could result in economic recessionin the United States or abroad. If such negative consequences were to occur,they could reduce our revenue and profits without the effect of reducing costs inthe short-term and might result in the volatility of the future market price ofour common stock.

 

***Risks Related to Our Common Stock***

 

Our future quarterly operating results may not meet our, our analysts’or our investors’ expectations or predictions and may fluctuate significantly,which could decrease our stock price or subject our stock price to volatility. 

 

Our quarterly operating results have fluctuatedsignificantly in the past and may do so in the future. Our operating resultsare difficult to forecast because of our limited operating history and thenature and scale of our business. Accordingly, you should not rely onquarter-to-quarter comparisons of our historical results as an indication offuture performance or any trend in our performance. If our quarterly operatingresults do not meet the expectations of analysts or investors, the market priceof our common stock will likely decline.

 

Our quarterly results may fluctuate in the future as aresult of several factors, many of which are outside our control, including,among other things:

 

•              The timing, introduction and successfulcommercialization of our new products and services;

 

•              The loss of or reduction in revenue from anylarge customer;

 

•              The market’s acceptance of our products andservices;

 

•              Our ability to establish and maintain strategicrelationships;

 

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•              The potential costs of litigation andintellectual property protection;

 

•              The operating costs and capital expendituresrelated to the expansion of our business operations and infrastructure,domestically and internationally, including the hiring of key personnel and newemployees;

 

•              The introduction of similar or substitutetechnologies by our competitors;

 

•              The unpredictability and irregularity of ourrevenue from government contracts due to political factors, budgetaryappropriations, resident migrations, changes in driver license expirationperiods, card renewal seasonal effects (particularly in the fourth quarter ofeach year when license renewals are lower), purchasing and deliveryconstraints, potential cost overruns, or delays in contract implementation orperformance resulting indamages having to be paid for such delays;

 

•              The timing of future licensing revenue;

 

•              The costs associated with marketing arrangementsthat we enter into during early market development;

 

•              The manufacturing yield losses that we may incuras we develop new products;

 

•              Excess and obsolete inventory adjustments andcharges that we determine may be appropriate at the termination of governmentcontracts or during the course of those contracts; and

 

•              The failure of or delay in efforts to establishindustry standards involving watermarking.

 

In addition, because the market demand for certain ofour products and services is new and rapidly evolving, it is difficult for usto predict certain aspects of our future financial results. Much of ourresearch and development, sales and marketing efforts and business expendituresare based in part on our predictions regarding developments involvingcounterfeiting and piracy, as well as other security and intelligence needs,and on our estimates as to the use of digital watermarking as a solution tothose problems. To the extent that these predictions and estimates proveinaccurate, our actual revenue and operating results will fluctuate from ouranticipated results, which could decrease our stock price or increase thevolatility of our stock price.

 

*Our common stock may be delisted from theNasdaq National Market, which may, among other things, reduce the price of ourcommon stock and the levels of liquidity available to our stockholders*

 

On November 10, 2004, we were advised by Nasdaqthat our common stock may be delisted from the Nasdaq National Market becausewe were no longer in compliance with Nasdaq’s continued listing requirements asa result of our failure to timely file this Form 10-Q for thequarter ended September 30, 2004. The Nasdaq Listing Qualifications Panel haddetermined to continue the listing of our common stock on the Nasdaq NationalMarket provided that we filed this Form 10-Q for thequarter ended September 30, 2004 and our 2004 Form 10-K on orbefore March 31, 2005, and that we timely file all periodic reports withthe SEC and Nasdaq for all reporting periods ending on or before December 31,2005.  We did notfile  thisForm 10-Q and our 2004  Form 10-K untilApril 7, 2005.  In addition, our 2004 Form 10-K does not include the report on management’s  assessment ofthe effectiveness ofinternal control over financial reporting or the related attestation reports of ourindependent registered public accounting firm as required by Section 404 of theSarbanes-Oxley Act.  Although we haverequested that Nasdaq continue the listing of our common stock because webelieve we are now in substantial compliance with Nasdaq’s conditions forcontinued listing on the Nasdaq National Market, there can be no assurance thatNasdaq will grant our request.  If Nasdaqdoes not grant our request or we fail to timely file such other reports and ourcommon stock is delisted from the Nasdaq National Market, ourcommon stock would be listed on some other quotation medium, such as the “pinksheets,” depending upon our ability to meet the specific listing requirementsof those quotation systems.  In the eventour common stock is delisted from the Nasdaq National Market, the visibility,liquidity and price of our common stock may be reduced, and our stockholdersmay find it more difficult to dispose of, or to obtain accurate pricequotations for, our shares.  In addition,if our common stock is delisted from the Nasdaq National Market, it may alsoresult in other negative implications, including the potential loss ofconfidence by suppliers, customers and employees, the loss of institutionalinvestor interest and fewer business development opportunities.

 

*Anti-takeover provisions in our charterdocuments could prevent or delay transactions that could be profitable for ourstockholders*

 

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The anti-takeover provisions of Delaware law and ourcertificate of incorporation and bylaws may make a change of control of us moredifficult, even if a change of control would be beneficial to our stockholders.These provisions may allow our board of directors to prevent changes inmanagement and control of the Company. Under Delaware law, our board may adoptadditional anti-takeover measures in the future.

 

We have the following anti-takeover provisions in ourcharter documents:

 

•              Our board of directors is divided into threeclasses of directors, with a separate class of directors being elected at eachsuccessive annual meeting for a term of three years;

 

•              Special meetings of the stockholders may becalled only by our president or our secretary, or at the discretion of ourboard of directors;

 

•              Vacancies on our board of directors may befilled by a majority of directors in office, without the approval of thestockholders; and

 

•              Our board of directors may issue preferred stockand determine the price, designations, rights and preferences as well asqualifications, limitations, and restrictions of those shares without any voteor further action by the stockholders.

 

In addition, on November 16, 2004, our board ofdirectors authorized and declared a dividend of one right for each outstandingshare of our common stock to stockholders of record at the close of business onNovember 29, 2004, and authorized the issuance of one right for each shareof common stock issued by us under certain circumstances in the future.  Each right entitles the registered holder,subject to the terms of the Rights Agreement between us and the rights agent,to purchase from us one one-hundredth of a share (a unit) of Series APreferred Stock, par value $0.001 per share, at a purchase price of $100.00 perunit, under circumstances described in the Rights Agreement.  The purchase price, the number of units ofpreferred stock and the type of securities issuable upon exercise of the rightsare subject to adjustment.  The rights willexpire at the close of business November 16, 2014 unless earlier redeemed orexchanged.  Until a right is exercised,the holder thereof, as such, will have no rights as one of our stockholders,including the right to vote or to receive dividends.  The rights are not immediatelyexercisable.  Subject to the terms andconditions of the Rights Agreement, they will become exercisable ten businessdays after a person or group acquires, or commences a tender or exchange offerwhich would lead to the acquisition of beneficial ownership of 15% or more ofour outstanding common stock, subject to prior redemption or exchange andsubject to exceptions specified in the Rights Agreement, including an exceptionfor certain existing large shareholders that have historically held ownershippositions in excess of 15 percent. Subject to these exceptions, once a person or group acquires beneficialownership of 15% or more of our outstanding common stock, each right not ownedby that person or group or certain related parties will entitle its holder topurchase, at the right’s then-current purchase price, units of Series Apreferred stock or, at our option, shares of common stock or cash, property orother securities of our company having a market value equal to twice thethen-current purchase price, subject to terms and conditions of the RightsAgreement.

 

Our anti-takeover provisions as well as our RightsAgreement could have the effect of discouraging a third party from making atender offer or otherwise attempting to gain control of us, even though thetransactions could be profitable for our stockholders.  In addition, these provisions could limit theprice that investors might be willing to pay in the future for shares of ourcommon stock.

 

**Safe Harbor Statement under the Private SecuritiesLitigation Reform Act of 1995**

 

Because this Report on Form 10-Q containsforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, any of the risk factors set forth above orelsewhere in this Report on Form 10-Q or incorporated herein by referencecould cause our actual results to differ materially from those resultsprojected or suggested in such forward-looking statements. Statements that arenot historical facts are hereby identified as “forward-looking statements” forthe purposes of thesafe harbor provided by Section 21E of the Securities Exchange Act of 1934and Section 27A of the Securities Act of 1933. Such forward-lookingstatements include but are not limited to statements relating to trends andexpectations in revenue growth, including with regard to programs in Florida,Ohio, Alabama and Mexico, 

 

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statementsregarding anticipated expenses, costs, margins and investment activities in theforeseeable future, statements regarding anticipated revenue to be generatedfrom current contracts and as a result of new programs, statements regardingour profitability in future periods, statements regarding businessopportunities that could require that we seek additional financing, statementsregarding the existence of international growth opportunities and our futureinvestment in such opportunities, statements regarding the continuance ofoperational pressures on our identification systems business in futurequarters, statements regarding the source of a majority of our future revenue,statements regarding the contribution of new sales channels to our futureresults, statements regarding futureeffects on our business in connection with the continuing implementation of ournew accounting and material requirements planning systems and modifications toour inventory management and controls systems and procedures or other reviewprocesses, statements regarding the timing of the completion of the design andimplementation of new and enhanced controls and procedures, statementsregarding the anticipated improvement in operations as a result of recentchanges in leadership and staffing, statements regarding the impact on theCompany of our restatement, late SEC filings, possible delisting from Nasdaq,shareholder litigation and the informal inquiry by the SEC, statementsregarding our expected short-term and long-term liquidity positions, statements relating to the Company’s compliancewith Nasdaq’s  conditions for continuedlisting on the Nasdaq National Market, statements related to the anticipatedfiling date of the Company’s Form 10-K/A that includes management’s report oninternal control over financial reporting and the related attestation reports of the Company’sindependent registered public accounting firm  and other statements containing words such as “anticipate,” “estimate,”“expect,” “management believes,” “we believe,” “we intend” and similar words orphrases, which are intended to identify forward-looking statements. Actualresults may vary materially due to, among other things, inherent limitations inall control systems and related procedures, risks as to litigation and relatedmatters in connection with our restatement of financial results, the actualtiming and impact of our compliance with Section 404 of the Sarbanes-OxleyAct of 2002, the actual filing date ofthe Company’s Form 10-K/A, changes resulting from any keypersonnel additions or changes, as well as changes in economic, business,competitive, technology and/or regulatory factors and trends.  All forward-looking statements arenecessarily only estimates of future results and there can be no assurance thatactual results will not differ materially from expectations, and, therefore,investors are cautioned not to place undue reliance on such statements. Investorsshould understand that it is not possible to predict or identify all riskfactors and that the risks discussed above should not be considered a completestatement of all potential risks and uncertainties. We undertake no obligationto update any forward-looking statements as a result of future events ordevelopments.

 

**Item 3****. Quantitative andQualitative Disclosures About Market Risk.**

 

The Company’s market risk disclosures set forth inItem 7A of its Annual Report on Form 10-K for the year ended December 31,2003 have not changed materially.

 

**Item 4****. Controls and Procedures.**

 

As described elsewhere in this Form 10-Q, weidentified during the third quarter of 2004 certain errors in the accountingfor software development costs and project capitalization at DIDS, and wepostponed the release of our financial results for the quarter ended September 30,2004 pending the completion of our review of these accounting errors.  We identified these errors as a result of ourreview of our accounting and our review of our internal control over financialreporting in preparation for compliance with Section 404 of theSarbanes-Oxley Act of 2002 and its implementing regulations.  This reviewinvolves a detailed analysis and documentation of the processes that impact thepreparation of our financial statements, an assessment of the risks that couldadversely affect the accurate and timely preparation of those financialstatements and the identification of the controls that are in place to mitigatethe risks of untimely or inaccurate preparation of those financialstatements.  During the course of ourreview, we determined that certain prior period financial statements requiredrestatement.  As a result, the Form 10-Kfiled contemporaneously with this Form 10-Q includes restated consolidatedfinancial statements as of and for (1) the fiscal year ended December 31,2003, including each of the quarterly periods in the fiscal year ended December 31,2003, and (2) the quarterly periods ended March 31, 2004 and June 30,2004.  

 

In connection with our restatement, we identifiedand reported to our audit committee the following areas for improvement in our internal controlover financial reporting.   Thesematters constitute “material weaknesses” asdefined under standards established by the Public Company Accounting OversightBoard or “PCAOB”.

 

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•                    *Inadequate supervision andtechnical accounting expertise within the accounting and finance department.* Therewas not adequate supervision and technical accounting expertise within ouraccounting and finance department. The personnel resources and technicalaccounting expertise in the accounting and finance department were notsufficient to adequately resolve non-routine matters or complex accountingprocesses, such as those matters andprocesses relating to the recording of softwarecapitalization, standard costing, and revenue recognition in accordance with U.S. generally acceptedaccounting principles (“U.S. GAAP”).

 

•                    *Inadequate design andimplementation of new accounting system.*  The new accounting system webegan to implement in the second quarter of 2002, and which was placed inservice during the fourth quarter of 2003, was not designed or implementedproperly.  There was a lack of accountingexpertise within our accounting and finance department; as a result ourinternally developed guidelines were not properly implemented during the setupand configuration of the new accounting system. Implementation of the new accounting system also was flawed because someof our accounting and finance employees were not properly trained in the use ofthe new accounting system.   In addition,the new and old accounting systems were not operated in parallel prior to the Company’s reliance on the newsystem.  Running new and old accountingsystems in parallel helps validate that the new system is correctly recordingaccounting entries.  These implementationissues resulted in errors with respect to fixedassets and inventory, including theduplicate recording of purchases, thecapitalization of assets thatshould have been expensed and theexpensing of assets thatshould have been capitalized.

 

•                    *Inadequate quarterly andyear-end financial statement close and review process.*For each quarterly and fiscal year-endperiod, a financial statement close and review process occurs.  Our staffing for the quarterly and year-endfinancial statement close process was not sufficient, and in some instances, wefailed to have adequate management review and supervision over the financialstatement close and review process, including timely reconciliation ofinventory, tax and accounts payable accounts toensure our financial statements were prepared in accordance withU.S. GAAP.

 

•                    *Insufficient controls bothfor determining the nature and types of costs that should be capitalized andfor ensuring allocation of costs to particular projects are appropriate.* Controls for determining the nature and types of costs that should becapitalized in accordance with U.S. GAAP, and for ensuring thatcosts were allocated to appropriate projects, were inadequate, which affectedour fixed asset and research and development accounts.  We lacked enough personnel with sufficientexpertise in complex software capitalization and project accounting rules under U.S. GAAP  andthere was not a clear understanding regarding the application of our internalpolicies in these areas.  Some of ouremployees who performed accounting functions were not adequately trained andsupervised, and there were deficiencies in communication between functionaldepartments within the Company.  Suchcontrols also were insufficient because the documentary support for thehistorical capitalization of certain software development costs  and thesystem for tracking costs that qualify for capitalization needed improvement,and the detective controls related to the capitalization of internallydeveloped software were not adequate.

 

•                    *Insufficient controls toensure that various international tax exposures were quantified and properlyaccrued on a timely basis*.  Internal controls related to thequantification and accrual of international taxes incurred by the Company wereinsufficient.  There was not sufficientstaff to properly quantify, accrue, and record such taxes on a timelybasis in accordance with U.S.  GAAP.  This affected our income tax payable andincome tax expense accounts.

 

•                    *Insufficient training andinadequate reconciliation processes for complex revenue recognitionrequirements primarily related to international transactions. *Training and reconciliation processes related to complex revenue recognition requirementsregarding distributor discounts, partial deliveries of goods and the acceptance criteria for shipped goods were insufficient to ensure these transactions were recorded inaccordance with U.S.  GAAP.  This affected our revenue and our deferredrevenue accounts.

 

•                    *Insufficient controlsrelated to system access and segregation of duties.*Insufficient internal controls resulted in a lack of segregation of duties among employees. Users of our new accountingsystem had access to multiple accountingprocesses within the system instead ofonly those processes that were the 

 

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responsibility of such user.  Inthe absence of such controls, inappropriate or unauthorized journal entriescould be entered into the system.

 

•                    *Inadequacies related toentity-level controls. *Management has concluded that there are deficiencies in the design andexecution of our entity-level controls relating to training, job descriptions, managing of employeeturnover, application of  U.S.  GAAP, and communication betweendepartments that constitute “material weaknesses” in our internal controlover financial reporting. These deficiencies contributed to the restatement ofour previously issued financial statements as discussed herein, delays incompliance efforts with Section 404 of the Sarbanes-Oxley Act of 2002 andthe rules issued thereunder, and the delayed filing of this Form 10-Q.

 

**Remediation Activities**

 

Digimarc places the highest priority on addressing these matters.  Under the direction of our senior managementand the participation and oversight of our audit committee, we have implementedsignificant changes to our infrastructure and related processes over the pasteight months, and continue to address these matters and will make changes asappropriate.  The numbers set forthopposite each identified area for improvement in the chart below correspond tothe numbered descriptions of the changes we have implemented, or are in theprocess of implementing, to improve such areas of our internal controls whichappear immediately following the chart.

 
| **Identified Areas for Improvement in Internal Controls**                                                                                                                    | ** ** | **Changes Implemented** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|
| ** **                                                                                                                                                                   | ** ** | ** **              |
| Inadequate supervision and technical accounting expertise within the  accounting and finance department                                                                      |       | 1, 2, 3, 4, 8           |
|                                                                                                                                                                         |       |                    |
| Inadequate design and implementation of new accounting systems                                                                                                               |       | 1, 2, 3, 4, 6, 9        |
|                                                                                                                                                                         |       |                    |
| Inadequate quarterly and year-end financial statement close and  review process                                                                                              |       | 1, 2, 3, 4, 5, 6, 7, 8  |
|                                                                                                                                                                         |       |                    |
| Insufficient controls for determining the nature and types of costs  that should be capitalized and for ensuring allocation of costs to particular  projects are appropriate |       | 1, 2, 3, 4, 8           |
|                                                                                                                                                                         |       |                    |
| Insufficient controls to ensure that various international tax  exposures were quantified and accrued on a timely basis                                                      |       | 1, 2, 4, 7              |
|                                                                                                                                                                         |       |                    |
| Insufficient training and inadequate reconciliation processes for  complex revenue recognition requirements primarily related to international  transactions                 |       | 1, 2, 4, 7              |
|                                                                                                                                                                         |       |                    |
| Insufficient controls related to system access and segregation of  duties                                                                                                    |       | 1, 2, 9                 |
|                                                                                                                                                                         |       |                    |
| Inadequacies related to entity-level controls                                                                                                                                |       | 1, 2, 4, 5              |

 

Description of ChangesImplemented to Improve Internal Controls

 

1.                 We hired a new Chief Financial Officer in June 2004and a number of other personnel and consultants who have expertise in financialcontrols or accounting, and we are actively recruiting other senior level membersof the finance and accounting organization to improve the overall quality andlevel of experience in our finance and accounting organization.

 

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2.                 We have made, and will continue to make,changes in our finance and accounting organization to provide clearersegregation of responsibilities and supervision with regard to, among others,documentation supporting our quarterly and annual financial statements.

 

3.                 We have initiated additional training of ourmanagement and other employees at DIDS regarding timekeeping practices andother best practices.

 

4.                 We are implementing an enhanced quarterly andannual financial review close process to include additional analysis andsupport for the financial accounts.

 

5.                 We have deployed significant internal andexternal resources directed at documenting and testing our internal controlover financial reporting as contemplated by Section 404 of Sarbanes-Oxley, and such efforts have been helpful inimproving our overall process and control environment.

 

6.                 We have strengthened our inventory managementand controls systems and procedures, including those governing the usabilityand disposition of slow-moving or excess inventories, by performing timelyphysical inventory counts that reconcile to the general ledger, analyzinghistorical and expected usage levels, and reviewing manufacturing standardcosts.

 

7.                 We have enhanced our review and documentationof accounting estimates.  This includeschanges in people, processes, and documentation in areas such as inventoryreserves, allowance for bad debt, long-lived asset impairment analyses,estimated revenue amounts, estimated international taxes, and estimates relatedto percentage of completion contracts.

 

8.                 We have continued to implement steps,including changes to our processes and systems, to improve the information flowamong the various personnel that have a role in the determination of propercost capitalization as well as to improve the review and approval process relatingto such determination, and we are implementing processes to improvecommunication among our various functional groups, which include sales,manufacturing, customer support, engineering, accounting, and legal, during thecontract negotiation, implementation and fulfillment phases.

 

9.                 We have established a staff position toimplement preventive control procedures related to system access and to monitorand control access to system modules in accordance with appropriate guidelinesin order to ensure safeguarding of assets, and are in the process ofimplementing such preventative controls at the system and procedurallevels.  In addition, we have implementeddetective controls such as the enhanced review of accounting transactions andfinancial statements.

 

We continue to take remedial steps to strengthen ourinternal controls and enhance our reporting processes.   We will also address items that have been ormay be identified through our internal controls assessment under Section 404of the Sarbanes-Oxley Act of 2002 and related work, which is continuing.

 

In connection with the requirements of Section 404of the Sarbanes-Oxley Act of 2002, we continue the process of documenting andtesting our systems of internal controls over financial reporting in order toprovide the basis for our evaluation and report on our system of internalcontrol over financial reporting as of the end of our fiscal year.  However, the focused application of critical resources onour separate and on-going accounting review in connection with the restatementof our financial statements is having a significant impact on our Section 404compliance efforts.   Moreover, ouron-going accounting review has resulted in some, and may result in further,remediation efforts with respect to some of our accounting processes, inparticular with regard to cost capitalization and project accounting.

 

Our 2004 Form 10-K does not include the report of management’s assessment of the effectiveness of internal control over financial reporting or therelated attestation reports of our independentregistered public accounting firm, KPMG LLP, as required by Section 404 of the Sarbanes-OxleyAct. We currently expect that on or before May 2,2005 we will file an amendment to our Form 10-K to include both management’sassessment of internal controls over financial reporting and the relatedattestation reports of our independentregistered public accountants.  Given the time requirements 

 

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necessary to test our processes, there can be no assurance that there will besufficient time and resources available for us to be fully compliant with the requirementsrelating to internal controls over financial reporting and other aspects of Section 404by May 2,2005. Additionally, due to the nature of and the timenecessary to effectively remediate the deficiencies identified, these issueswere not being effectively remediated as of December 31, 2004, the date ofour assessment of internal control over financial reporting.  As a result, based on the material weaknessesidentified, it is currently anticipated that management’s assessment and KPMG’sReport will conclude that the Company’s internal control over financialreporting was not effective as of December 31, 2004.

 

Our current management, with the participation ofour principal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls andprocedures (as defined in Rules 240.13a-15(e) and 240.15d-15(e) ofthe Securities Exchange Act of 1934) as of September 30, 2004, whichincluded an evaluation of disclosure controls and procedures applicable to theperiod covered by the filing of this periodic report. As noted above, we haveidentified a number of areas for improvement in our internal controls and procedures,as they existed as of September 30, 2004. Based on the evaluation of the effectiveness of our disclosure controlsand procedures as of September 30, 2004, and subject to the informationset forth in this Item 4, our principal executive officer and principalfinancial officer have concluded that our disclosure controls and procedureswere not effective based on the matters described in this Item 4. However,subsequent to September 30, 2004, and up to the filing date of thisreport, we implemented a detailed review and analysis of our accountingrecords, including a reconstruction of certain accounting records,****in support of the financial statementscontained herein utilizing consultants with expertise in accounting under thedirection of new financial management. As internal control issues have been identified, management has takensteps to remediate such matters.  Ifadditional internal control issues come to light, management intends to addressthem promptly.

 

Other than as described above, since the evaluationdate by our management of its internal controls, management does not believethere have been any changes in the internal control over financial reportingthat have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

 

As described above, we currently are designing andimplementing new controls to address the weaknessesidentified in our internal controls and procedures.  Notwithstanding these improvements, ourinternal controls and procedures may not be capable of preventing all instancesof error or fraud.  Any control system,no matter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met.  Further, the design of a control system mustreflect the fact that there are knowledge and resource constraints in any suchsystem, and a large number of complex permutations of facts, circumstances,accounting policies, procedural implications and business practices that mustbe considered. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, have been detected. These inherent limitationsinclude the realities that judgments in decision-making can be faulty, andbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the controls. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.Over time, the control systems we develop may become inadequate because ofchanges in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

The certifications of our principal executiveofficer and the principal financial officer required in accordance with Section 302of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Form 10-Q.  The disclosures set forth in this Item 4contain information concerning the evaluation of our disclosure controls andprocedures, and changes in internal control over financial reporting, referredto in paragraph 4 of the certifications. This Item 4 should be read inconjunction with the officer certifications for a more complete understandingof the topics presented.

 

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**PART II****. OTHER INFORMATION.**

 

**Item 1****. Legal Proceedings.**

 

Beginning in September 2004, three purportedclass action lawsuits were commenced against us and certain of our current andformer directors and officers by or on behalf of persons claiming to havepurchased or otherwise acquired our securities during the period from April 17,2002 to July 28, 2004.   Theselawsuits were filed in the United States District Court for the District ofOregon and were consolidated into one action for all purposes on December 16,2004.  The complaints assert claims under the federalsecurities laws, specifically Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, relating to our announcement that we had discovered errors in our accounting for softwaredevelopment costs and project capitalization and other project costcapitalization accounting practices at our DIDS business unit, and that welikely would be required to restate our previously reported financialstatements for full fiscal year 2003 and the first two quarters of 2004.  Specifically, these actions allegethat we issued false and misleadingfinancial statements in order to inflate the value of Digimarc stock, whichresulted in insider sales of personal holdings at inflated values, and that wemaintained insufficient accounting controls, which created an environment whereimproper accounting could be used to manipulate financial results.  The complaints seek unspecified damages.  We believe that we have substantial legal andfactual defenses to the claims, which we intend to pursue vigorously.   Due to the inherent uncertainties oflitigation and because the lawsuits are still at a preliminary stage, theultimate outcome of the matter cannot be predicted.

 

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of our officers anddirectors, naming the Company as a nominal defendant, in the Superior Court ofthe State of California for the County of San Luis Obispo.  The suits claim that these officers anddirectors breached their fiduciary duties to our shareholders and to theCompany.  The complaints are derivativein nature and do not seek relief from the Company.  On November 8, 2004, a letter was mailedto the chairman of our board of directors by a law firm purporting to representa shareholder of the Company, demanding that the board commence a civil actionagainst each of the directors and officers on behalf of the Company to recoverfor damages alleged to have been incurred as a result of alleged breaches offiduciary duties.   The Company has appointed a committee toinvestigate the claims asserted in the demand letter and in the derivativelawsuits.

 

We have received a notice from the staff of the SECstating that it is conducting an informal inquiry relating to our previousannouncement that we were restating our prior financial results.  The inquiry focuses on the errors made in thecapitalization of certain software and other project costs.  The staff has requested that we voluntarilyproduce documents and information related to the SEC’s inquiry.  We are cooperating with the staff’srequest.  It is not possible to predictwhether this inquiry will have any impact on the Company or its financialresults.

 

On August 24, 2004, we settled the lawsuitfiled in October 2003 bya former president of the Company who wasalso chief executive officer and a former member of the Company’s board ofdirectors.   As previously disclosed, theformer president had asserted in his complaint that he had the right to 56,000 shares of the Company’scommon stock, or the value thereof, because the Company had failed to timelyexercise its right of repurchase with regard to such shares followingtermination of his employment with the Company in 1997.  In connection with the settlement, theCompany issued 40,000 shares of its common stock.  The terms of the settlement areconfidential.

 

Beginning in May 2001, a number ofsubstantially identical class action complaints alleging violations of thefederal securities laws were filed in the United States District Court for theSouthern District of New York naming approximately 300 companies, including theCompany, certain of its officers and directors, and certain underwriters of theCompany’s initial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensationarrangements (such as 

 

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undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices to artificiallyinflate the price of the Company’s stock in the after-market subsequent to theCompany’s initial public offering. The Company and certain of its officers anddirectors are named in the amended complaint pursuant to Section 11 of theSecurities Act of 1933, and Section 10(b) and Rule 10b-5 of theSecurities Exchange Act of 1934 on the basis of an alleged failure to disclosethe underwriters’ alleged compensation arrangements and manipulative practices.The complaint seeks unspecified damages. The individual officer and directordefendants entered into tolling agreements and, pursuant to a court order datedOctober 9, 2002, were dismissed from the litigation without prejudice.Furthermore, in July 2002, the Company and the other defendants in the consolidatedcases filed motions to dismiss the amended complaint for failure to state aclaim. The motion to dismiss claims under Section 11 was denied as tovirtually all the defendants in the consolidated actions, including theCompany. The claims against the Company under Section 10(b), however, weredismissed. In June 2003, a committee of the Company’s board of directorsconditionally approved a proposed partial settlement with the plaintiffs inthis matter. In June 2004, anagreement of settlement was submitted to the court for preliminaryapproval.   The settlement would provide, among otherthings, a release of the Company and of the individual defendants for theconduct alleged in the amended complaint to be wrongful. The Company wouldagree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’sinsurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. The parties are directed to report back to the court regarding themodifications.  If the parties are ableto agree upon the required modifications, and such modifications are acceptableto the court, notice will be given to all class members of the settlement, a “fairness”hearing will be held and if the court determines that the settlement is fair tothe class members, the settlement will be approved.  There can be no assurance that this proposedsettlement would be approved and implemented in its current form, or atall.  Due to the inherent uncertaintiesof litigation, the ultimate outcome of the matter cannot be predicted.

 

The Company is subject from time to time to otherlegal proceedings and claims arising in the ordinary course of business.Although the ultimate outcome of these matters cannot be determined, managementbelieves that the final disposition of these proceedings will not have amaterial adverse effect on the consolidated financial position, results ofoperations, or liquidity of the Company.

 

**Item 2****.  Changes in Securities, Use of Proceeds andIssuer Purchasers.**

 

On August 24, 2004, in connection with thesettlement of a disputed claim with a former president of the Company, who wasalso the former chief executive officer and a former director, the Company issued 40,000 shares of its commonstock, with a value of $348,000.  Theissuance of shares was exempt from registration under Section 4(2) ofthe Securities Act as a transaction not involving a public offering.

 

**Item 6****. Exhibits.**

 

See attached exhibit index.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                       |   | DIGIMARC CORPORATION                                                                                                                 |
|----------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|                       |   |                                                                                                                                 |
|  Date:  April 7, 2005 | By:    | /s/ Michael McConnell                                                                                                                |
|                       |   | Michael McConnell  *Chief  Financial Officer and Treasurer  (Duly Authorized Officer*  *and Principal  Financial Officer)* |

 

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**EXHIBITINDEX**

 
| **Exhibit ****Number** | ** ** | **Document**                                                                                                                                                                                                                                                                                                       |
|-----------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                         |       | Second Amended and  Restated Certificate of Incorporation of the Registrant (incorporated by  reference to Exhibit 3.1 of Exhibits to the 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 the 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 the Registrant’s Annual Report on Form 10-K, as filed  with the Securities and Exchange Commission on March 15, 2004)                                                     |
|                        |       |                                                                                                                                                                                                                                                                                                               |
| 31.1                        |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                       |
|                        |       |                                                                                                                                                                                                                                                                                                               |
| 31.2                        |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                       |
|                        |       |                                                                                                                                                                                                                                                                                                               |
| 32.1                        |       | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                                        |
|                        |       |                                                                                                                                                                                                                                                                                                               |
| 32.2                        |       | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                        |

 

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