**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

(Mark One)

| **(Mark One)**                                                                                                                                                                                                                |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| x                                                                                                                                                                                                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the quarterly period ended JUNE 30, 2005**                                                                                                                                                                              |
| **OR**                                                                                                                                                                                                                        |
| o                                                                                                                                                                                                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the transition period from                   to                ** |

 

**CommissionFile Number: 000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                     | **94-3342784**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **9405 SW Gemini Drive, Beaverton, Oregon**                      | **97008**                             |
| (Address of  principal executive offices)                        | (Zip Code)                            |

 

**(503) 469-4800**

(Registrant’s telephonenumber, including area code)

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

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

As of July 31, 2005,there were 20,765,620 shares of the registrant’s common stock, par value $0.001per share, outstanding.

 

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**Table of Contents**
| **PART I FINANCIAL  INFORMATION** |                                                                                                                                                    |
|----------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           | Financial Statements:                                                                                                                                   |   |
|                                   | Condensed Consolidated Balance Sheets as of  June 30, 2005 and December 31, 2004. (Unaudited)                                            | 3 |
|                                   | Condensed Consolidated Statements of Operations for  the three- and six-months ended June 30, 2005 and June 30, 2004  (restated). (Unaudited) | 4 |
|                                   | Condensed Consolidated Statements of Cash Flows for  the six months ended June 30, 2005 and June 30, 2004 (restated).  (Unaudited)            | 5 |
|                                   | Notes to Condensed Consolidated Financial Statements.  (Unaudited)                                                                                      | 6 |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations.                                                            | 16 |
| Item 3.                                | Quantitative  and Qualitative Disclosures About Market Risk.                                                                                            | 56 |
| Item 4.                                | Controls and  Procedures.                                                                                                                               | 56 |
| **PART II  OTHER INFORMATION**    |                                                                                                                                                    |
| Item 1.                                | Legal Proceedings.                                                                                                                                      | 60 |
| Item 4.                                | Submission of  Matters to a Vote of Security Holders.                                                                                                   | 61 |
| Item 6.                                | Exhibits.                                                                                                                                               | 62 |
| **SIGNATURES**                         | 63                                                                                                                                                      |

 

2

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**PART I. FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDBALANCE SHEETS(IN THOUSANDS)(UNAUDITED)**
| ** **                                       | ** ** | **June 30,  2005** | ** ** | **December 31,  2004(1)** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|
| **ASSETS**                                       |       |                    |       |                           |       |   |   |
| Current assets:                                  |       |                    |       |                           |       |   |   |
| Cash and cash equivalents                        |       | $                       | 21,232     |                           |       | $ | 18,489 |   |   |
| Short-term investments                           |       | 8,375                   |       |                           | 25,068     |   |   |
| Trade accounts receivable, net                   |       | 9,416                   |       |                           | 9,666      |   |   |
| Unbilled trade receivables                       |       | 5,615                   |       |                           | 5,008      |   |   |
| Inventory, net                                   |       | 8,414                   |       |                           | 8,858      |   |   |
| Other current assets                             |       | 2,958                   |       |                           | 1,779      |   |   |
| Total current assets                             |       | 56,010                  |       |                           | 68,868     |   |   |
| Restricted cash                                  |       | 7,287                   |       |                           | 8,279      |   |   |
| Property and  equipment, net                     |       | 66,581                  |       |                           | 63,975     |   |   |
| Intangibles                                      |       | 19,086                  |       |                           | 21,162     |   |   |
| Other assets, net                                |       | 871                     |       |                           | 1,003      |   |   |
| Total assets                                     |       | $                       | 149,835    |                           |       | $ | 163,287 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |                    |       |                           |       |   |   |
| Current liabilities:                             |       |                    |       |                           |       |   |   |
| Accounts payable                                 |       | $                       | 7,443      |                           |       | $ | 11,424 |   |   |
| Accrued payroll and related costs                |       | 3,497                   |       |                           | 2,161      |   |   |
| Deferred revenue                                 |       | 4,820                   |       |                           | 4,854      |   |   |
| Other current liabilities                        |       | 1,698                   |       |                           | 1,492      |   |   |
| Total current liabilities                        |       | 17,458                  |       |                           | 19,931     |   |   |
| Other long-term  liabilities                     |       | 1,047                   |       |                           | 1,112      |   |   |
| Total liabilities                                |       | 18,505                  |       |                           | 21,043     |   |   |
| Commitments and  contingencies (Note 6)          |       |                    |       |                           |       |   |   |
| Stockholders’ equity:                       |       |                    |       |                           |       |   |   |
| Common stock                                     |       | 21                      |       |                           | 21         |   |   |
| Additional  paid-in capital                      |       | 209,179                 |       |                           | 206,979    |   |   |
| Deferred stock  compensation                     |       | (1,823                  | )          |                           | —     |   |   |
| Accumulated other  comprehensive income          |       | 193                     |       |                           | 147        |   |   |
| Accumulated  deficit                             |       | (76,240                 | )          |                           | (64,903    | ) |   |
| Total stockholders’ equity                  |       | 131,330                 |       |                           | 142,244    |   |   |
| Total liabilities  and stockholders’ equity |       | $                       | 149,835    |                           |       | $ | 163,287 |   |   |

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(1)          Derived from the Company’sDecember 31, 2004 audited consolidated financial statements

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**
| ** **                                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | ** **                                      | ** ** | **(Restated)**                                | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Revenue:                                          |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Service                                           |       | $                                               | 21,616     |                                          |       | $ | 18,462 |   |   | $ | 41,212 |   |   | $ | 35,529 |   |   |
| Product and subscription                          |       | 3,137                                           |       |                                          | 5,012      |   |   | 7,920 |   |   | 11,603 |   |   |
| Total revenue                                     |       | 24,753                                          |       |                                          | 23,474     |   |   | 49,132 |   |   | 47,132 |   |   |
| Cost of revenue:                                  |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Service                                           |       | 14,878                                          |       |                                          | 11,292     |   |   | 28,018 |   |   | 21,255 |   |   |
| Product and subscription                          |       | 1,089                                           |       |                                          | 3,472      |   |   | 3,442 |   |   | 8,353 |   |   |
| Total cost of revenue                             |       | 15,967                                          |       |                                          | 14,764     |   |   | 31,460 |   |   | 29,608 |   |   |
| Gross profit                                      |       | 8,786                                           |       |                                          | 8,710      |   |   | 17,672 |   |   | 17,524 |   |   |
| Operating expenses:                               |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Sales and marketing                               |       | 3,898                                           |       |                                          | 2,840      |   |   | 7,713 |   |   | 5,403 |   |   |
| Research, development and engineering             |       | 3,001                                           |       |                                          | 1,550      |   |   | 5,484 |   |   | 3,272 |   |   |
| General and administrative                        |       | 6,999                                           |       |                                          | 5,027      |   |   | 14,003 |   |   | 9,855 |   |   |
| Amortization of intangibles                       |       | 1,339                                           |       |                                          | 552        |   |   | 2,150 |   |   | 1,189 |   |   |
| Total operating expenses                          |       | 15,237                                          |       |                                          | 9,969      |   |   | 29,350 |   |   | 19,719 |   |   |
| Operating loss                                    |       | (6,451                                          | )          |                                          | (1,259     | ) |   | (11,678 | ) |   | (2,195 | ) |   |
| Other income (expense):                           |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Interest income                                   |       | 273                                             |       |                                          | 208        |   |   | 537 |   |   | 427 |   |   |
| Interest expense                                  |       | (58                                             | )          |                                          | (30        | ) |   | (120 | ) |   | (51 | ) |   |
| Other                                             |       | 82                                              |       |                                          | (6         | ) |   | 64 |   |   | (4 | ) |   |
| Total other income, net                           |       | 297                                             |       |                                          | 172        |   |   | 481 |   |   | 372 |   |   |
| Loss before  provision for income taxes           |       | (6,154                                          | )          |                                          | (1,087     | ) |   | (11,197 | ) |   | (1,823 | ) |   |
| Provision for  income taxes                       |       | (63                                             | )          |                                          | (184       | ) |   | (140 | ) |   | (234 | ) |   |
| Net loss                                          |       | $                                               | (6,217     | )                                             |       | $ | (1,271 | ) |   | $ | (11,337 | ) |   | $ | (2,057 | ) |   |
| Net loss per  share—basic                    |       | $                                               | (0.30      | )                                             |       | $ | (0.06 | ) |   | $ | (0.55 | ) |   | $ | (0.10 | ) |   |
| Net loss per  share—diluted                  |       | $                                               | (0.30      | )                                             |       | $ | (0.06 | ) |   | $ | (0.55 | ) |   | $ | (0.10 | ) |   |
| Weighted average  shares outstanding—basic   |       | 20,468                                          |       |                                          | 20,276     |   |   | 20,461 |   |   | 20,244 |   |   |
| Weighted average shares  outstanding—diluted |       | 20,468                                          |       |                                          | 20,276     |   |   | 20,461 |   |   | 20,244 |   |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS(IN THOUSANDS)(UNAUDITED)**
| ** **                                                                                 | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30,  2005**        | ** ** | **   June 30,     2004** | ** ** |
| ** **                                                                                 | ** ** | ** **                     | ** ** | **(Restated)** | ** ** |
| Cash flows from operating  activities:                                                     |       |                           |       |   |   |   |   |
| Net loss                                                                                   |       | $                              | (11,337    | ) |   | $ | (2,057 | ) |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                           |       |   |   |   |   |
| Depreciation and amortization                                                              |       | 8,554                          |       |   | 5,784 |   |   |
| Stock-based compensation expense                                                           |       | 202                            |       |   | — |   |   |
| Change in allowance for doubtful accounts                                                  |       | 72                             |       |   | 88 |   |   |
| Other non-cash charges                                                                     |       | (8                             | )          |   | (7 | ) |   |
| Changes in  operating assets and liabilities:                                              |       |                           |       |   |   |   |   |
| Restricted cash                                                                            |       | 992                            |       |   | (4 | ) |   |
| Trade and unbilled accounts receivable                                                     |       | (429                           | )          |   | (2,915 | ) |   |
| Inventory                                                                                  |       | 444                            |       |   | 255 |   |   |
| Other current assets                                                                       |       | (1,179                         | )          |   | 139 |   |   |
| Other assets, net                                                                          |       | 132                            |       |   | 75 |   |   |
| Accounts payable                                                                           |       | (3,981                         | )          |   | 3,492 |   |   |
| Accrued payroll and related costs                                                          |       | 1,336                          |       |   | 548 |   |   |
| Deferred revenue                                                                           |       | (34                            | )          |   | 1,051 |   |   |
| Other liabilities                                                                          |       | 324                            |       |   | (103 | ) |   |
| Net cash provided by (used in) operating activities                                        |       | (4,912                         | )          |   | 6,346 |   |   |
| Cash flows from investing  activities:                                                     |       |                           |       |   |   |   |   |
| Purchase of property and equipment                                                         |       | (4,024                         | )          |   | (15,781 | ) |   |
| Capitalization of labor costs                                                              |       | (4,955                         | )          |   | (6,432 | ) |   |
| Sale or maturity of short-term investments                                                 |       | 91,538                         |       |   | 84,006 |   |   |
| Purchase of short-term investments                                                         |       | (74,845                        | )          |   | (73,701 | ) |   |
| Net cash provided by (used in) investing activities                                        |       | 7,714                          |       |   | (11,908 | ) |   |
| Cash flows from  financing activities:                                                     |       |                           |       |   |   |   |   |
| Net proceeds from issuance of common stock                                                 |       | 175                            |       |   | 1,850 |   |   |
| Principal payments under capital lease obligations                                         |       | (234                           | )          |   | (90 | ) |   |
| Net cash provided by (used in) financing activities                                        |       | (59                            | )          |   | 1,760 |   |   |
| Net increase (decrease) in cash and cash equivalents                                       |       | 2,743                          |       |   | (3,802 | ) |   |
| Cash and cash equivalents at beginning of period                                           |       | 18,489                         |       |   | 33,626 |   |   |
| Cash and cash equivalents at end of period                                                 |       | $                              | 21,232     |   |   | $ | 29,824 |   |   |
| Supplemental disclosure of cash flow information:                                          |       |                           |       |   |   |   |   |
| Cash paid for interest                                                                     |       | $                              | 120        |   |   | $ | 51 |   |   |
| Cash paid for income taxes                                                                 |       | $                              | 104        |   |   | $ | 160 |   |   |
| Summary of  non-cash investing and financing activities:                                   |       |                           |       |   |   |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       | $                              | 51         |   |   | $ | 77 |   |   |
| Grant of  restricted stock                                                                 |       | $                              | 2.025      |   |   | $ | — |   |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARC CORPORATIONNOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**

**1.  The Company, Basis of Presentation**

*Description ofBusiness*

Digimarc Corporation (“Digimarc,” “the Company,” “our”or “we”) is a leading supplier of secure identity solutions and advancedtechnologies for use in media management. Our solutions enable governments andbusinesses around the world to deter counterfeiting and piracy, enhance trafficsafety and national security, combat identity theft and fraud, facilitate theeffectiveness of voter identification programs, and improve the management ofmedia content. The Company is the leading supplier of driver licenses in theUnited States, producing nearly two-thirds of all driver licenses issued.

Digimarc also is a pioneer and leading owner ofintellectual property in a signal processing technology innovation known as “digitalwatermarking,” which allows imperceptible digital codes to be embedded in allforms of media content, including personal identification documents, financialinstruments, photographs, movies, music and product packages. The embeddedcodes within various types of media content can be detected and read bysoftware or hardware detectors in personal computers and other digital devices.As of July 2005, the Company holds 200 issued United States (“U.S.”)patents on this technology and related technologies, applications, systems, andprocesses and has more than 400 additional applications pending.

Digimarc’s solutions and technologies are deployed bythe Company and its business partners in media objects and digital devicesaround the world. Hundreds of millions of people carry secure credentials fromissuance systems produced by Digimarc. The substantial majority of the Company’srevenues arise from provision of critical infrastructure pursuant to long-termcontracts with government agencies—primarily U.S. state government agenciesengaged in the issuance of driver licenses, a consortium of leading CentralBanks, and national governments of certain foreign countries. The remainder ofour revenues is generated primarily from patent and technology license feespaid by business partners, providing media and rights management solutions tomajor movie studios and music labels, television and radio broadcasters,corporations, and creative professionals around the world.

In December 2001, theCompany acquired the assets and assumed certain liabilities of the U.S. largegovernment programs identification systems and international digitalidentification systems businesses of Polaroid Corporation and certain otheraffiliated entities of Polaroid Corporation. The acquisition was accounted forusing the purchase method of accounting.

*Interim FinancialStatements*

The condensed consolidated financial statementsinclude the accounts of Digimarc and its wholly-owned subsidiaries. Allsignificant inter-company transactions and balances have been eliminated. Thecondensed consolidated financial statements have been prepared from the Company’srecords without audit and, in management’s opinion, include all adjustments(consisting of only normal recurring adjustments) necessary to fairly reflectthe financial condition and the results for the periods presented, except for a$0.2 million inventory adjustment which resulted in a decrease in the net lossfor the six-month period ended June 30, 2005, with no effect for thethree-month period ended June 30, 2005. The adjustment should have beenrecorded in a prior period, but the Company believes the amount to beimmaterial to both the current period and prior period. Certain information andfootnote disclosures 

6

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normally included infinancial statements prepared in accordance with U.S. generally acceptedaccounting principles have been condensed or omitted under the Securities andExchange Commission’s rules and regulations.

These condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004, which wasfiled with the Securities and Exchange Commission (the “SEC”) on April 7,2005 and amended in a Form 10-K/A filed on June 1, 2005 and includesrestated financial results for the fiscal year ended December 31, 2003,including each of the quarters in the fiscal year ended December 31, 2003,and the quarterly periods ended March 31, 2004 and June 30, 2004 (seeNote 2 “Restatement”). The results of operations for the interim periodspresented in these condensed consolidated financial statements are not necessarilyindicative of the results for the full year.

*Use of Estimates*

The preparation ofconsolidated financial statements in accordance with U.S. generally acceptedaccounting principles requires Digimarc to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenue and expenses, andrelated disclosure of contingent assets and liabilities. Certain of the Company’saccounting policies require higher degrees of judgment than others in theirapplication. These include revenue recognition on long-term service contracts,impairments and estimation of useful lives of long-lived assets, inventoryvaluation, reserves for uncollectible accounts receivable, and contingenciesand litigation. Digimarc bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

*Reclassifications*

Certain prior periodamounts in the accompanying condensed consolidated financial statements andnotes thereto have been reclassified to conform to current period presentation.These reclassifications had no effect on the results of operations or financialposition for any period presented. These reclassifications include thereclassification of market auction preferred investments from cash equivalentsto short-term investments and amortization of intangibles from general andadministrative to a separate line item on the Statement of Operations.

**2.  Restatement**

The Company restated its consolidated financialstatements as of and for the fiscal year ended December 31, 2003,including 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.

The key impacts of therestatement adjustments for the three- and six-month periods ended June 30,2004 were to reduce net loss from $0.10 per share to $0.06 per share for thethree-month period, and to increase net loss from $0.07 per share to $0.10 pershare for the six-month period. Revenue decreased by $199 and $31 for thethree-month and six-month periods ended June 30, 2004, respectively.

7

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Thefollowing tables set forth the restatement adjustments to our financialstatements for the periods indicated. The amounts in the tables are expressedin thousands.

***As of and for the three months ended June 30,2004:***

**Statement ofoperations**
| ** **                  | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other ** | ** ** | **As  restated** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------------|------------|------------------|------------|
| Revenue                     |       |                             | $          | 23,673                       |       |                    |       | $           | —     |    |       |            | $          | —           |       |   |   | $ | (251 | ) |   | $ | — |   | $ | 52 |   | $ | 23,474 |   |
| Cost of revenue             |       |                             | 15,826     |                         |       |                    | 21         |        |       |    | (855       | )               |       |             | (47        | ) |   | — |   | (181 | ) | 14,764 |   |
| Gross profit                |       |                             | 7,847      |                         |       |                    | (21        | )           |       |    | 855        |            |       |             | (204       | ) |   | — |   | 233 |   | 8,710 |   |
| Operating expense           |       |                             | 9,741      |                         |       |                    | 320        |        |       |    | 19         |            |       |             | (11        | ) |   | — |   | (100 | ) | 9,969 |   |
| Operating income  (loss)    |       |                             | (1,894     | )                            |       |                    | (341       | )           |       |    | 836        |            |       |             | (193       | ) |   | — |   | 333 |   | (1,259 | ) |
| Other income, net           |       |                             | 172        |                         |       |                    | —     |        |       |    | —     |            |       |             | —     |   |   | — |   | — |   | 172 |   |
| Provision for income  taxes |       |                             | (222       | )                            |       |                    | —     |        |       |    | —     |            |       |             | —     |   |   | 38 |   | — |   | (184 | ) |
| Net income (loss)           |       |                             | $          | (1,944                       | )          |                    |       | $           | (341       | )       |       |            | $          | 836              |       |   |   | $ | (193 | ) |   | $ | 38 |   | $ | 333 |   | $ | (1,271 | ) |

 

***As of and for the six months ended June 30, 2004:***

**Statement ofoperations**
| ** **                  | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other** | ** ** | **As  restated ** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------------------|------------|
| Revenue                     |       |                             | $          | 47,163                       |       |                    |       | $           | —     |    |       |      | $          | —                 |       |   |   | $ | 29 |   |   | $ | — |   | $ | (60 | ) | $ | 47,132 |   |
| Cost of revenue             |       |                             | 29,540     |                         |       |                    | 42         |        |       |    | 284        |      |       |                   | (47        | ) |   | — |   | (211 | ) | 29,608 |   |
| Gross profit                |       |                             | 17,623     |                         |       |                    | (42        | )           |       |    | (284       | )         |       |                   | 76         |   |   | — |   | 151 |   | 17,524 |   |
| Operating expense           |       |                             | 19,142     |                         |       |                    | 702        |        |       |    | 26         |      |       |                   | (11        | ) |   | — |   | (140 | ) | 19,719 |   |
| Operating income  (loss)    |       |                             | (1,519     | )                            |       |                    | (744       | )           |       |    | (310       | )         |       |                   | 87         |   |   | — |   | 291 |   | (2,195 | ) |
| Other income, net           |       |                             | 372        |                         |       |                    | —     |        |       |    | —     |      |       |                   | —     |   |   | — |   | — |   | 372 |   |
| Provision for  income taxes |       |                             | (272       | )                            |       |                    | —     |        |       |    | —     |      |       |                   | —     |   |   | 38 |   | — |   | (234 | ) |
| Net income (loss)           |       |                             | $          | (1,419                       | )          |                    |       | $           | (744       | )       |       |      | $          | (310                   | )          |   |   | $ | 87 |   |   | $ | 38 |   | $ | 291 |   | $ | (2,057 | ) |

 

**Statement of cash flows**
| ** **                                           | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other** | ** ** | **As  restated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------------|------------|
| Net cash provided  by (used in) operating activities |       |                             | $          | 8,651                        |       |                    |       | $           | (867       | )       |       |      | $          | (941             | )          |   |   | $ | — |   |   | $ | — |   | $ | (497 | ) | $ | 6,346 |   |
| Net cash provided  by (used in) investing activities |       |                             | (14,213    | )                            |       |                    | 867        |        |       |    | 941        |      |       |             | —     |   |   | — |   | 497 |   | (11,908 | ) |
| Net cash provided  by financing activities           |       |                             | 1,760      |                         |       |                    | —     |        |       |    | —     |      |       |             | —     |   |   | — |   | — |   | 1,760 |   |
| Net decrease in cash and  cash equivalents           |       |                             | $          | (3,802                       | )          |                    |       | $           | —     |    |       |      | $          | —           |       |   |   | $ | — |   |   | $ | — |   | $ | — |   | $ | (3,802 | ) |

 

**3.  Net Income (Loss) Per Share Computation**

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

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share including the effectof potentially dilutive common shares. For all periods presented, basic anddiluted shares were the same. Shares are expressed in thousands.

Common stock equivalentsrelated to stock options of 6,658 and 6,371 were excluded from diluted net lossper share calculations for the three- and six-month periods ended June 30,2005, respectively, as their exercise price was higher than the average marketprice of the underlying common stock for the period and therefore their impactwould be anti-dilutive. In addition, common stock equivalents related to stockoptions of 407 and 351 for the three- and six-month periods ended June 30,2005, respectively, were excluded from diluted net loss per share as theCompany was in a loss position and their inclusion would be anti-dilutive. Theeffect of 5,819 and 5,695 outstanding stock options and warrants for the three-and six-month periods ended June 30, 2004, respectively, are excluded fromthe calculation of diluted net income per share because their exercise pricewas higher than the average market price of the underlying common stock for theperiod and therefore their inclusion would be anti-dilutive. In addition,common stock equivalents related to stock options of 317 and 361 for the three-and six-month periods ended June 30, 2004, respectively, were exclude fromdiluted net loss per share as the Company was in a loss position and theirinclusion would be anti-dilutive.

**4.** Stock-BasedCompensation

The Company has various stock-based compensationplans, including stock incentive plans and an employee stock purchase plan. TheCompany continues to apply the recognition and measurement principles ofAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including Financial Accounting Standards Board (“FASB”)Interpretation No. 44, *Accounting forCertain Transactions involving Stock Compensation, an Interpretation of APBOpinion No. 25*, as allowed by FASB Statement No. 123, *Accounting for Stock-Based Compensation*.FASB Statement No. 123 and FASB Statement No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, an amendment of FASB Statement No. 123*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. Under APBOpinion No. 25, stock-based compensation expense is recognized for stockawards granted with an exercise price below fair market value on the date ofgrant.

The following tableillustrates the effect on net loss and net loss per share if the Company hadapplied the fair value recognition provisions of SFAS No. 123 tostock-based employee compensation for the three- and six-month periods ended June 30,2005 and 2004, respectively (in thousands, except per-share amounts):
| ** **                                                                                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                             | ** ** | ** **                                      | ** ** | **(Restated)**                                | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Net loss, as reported                                                                                                  |       | $                                               | (6,217     | )                                             |       | $ | (1,271 | ) |   | $ | (11,337 | ) |   | $ | (2,057 | ) |   |
| Add: Stock-based compensation expense determined  under the intrinsic value method                                     |       | 151                                             |       |                                          | —     |   |   | 202 |   |   | — |   |   |
| Deduct: Total stock-based employee compensation expense  determined under fair value based method for all awards  |       | (1,834                                          | )          |                                          | (3,187     | ) |   | (3,510 | ) |   | (5,959 | ) |   |
| Pro forma net loss                                                                                                     |       | $(7,900                                         | )          |                                          | $          | (4,458 | ) |   | $ | (14,645 | ) |   | $ | (8,016 | ) |   |
| *Earnings  per share:*                                                                                                 |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Basic—as  reported                                                                                                |       | $                                               | (0.30      | )                                             |       | $ | (0.06 | ) |   | $ | (0.55 | ) |   | $ | (0.10 | ) |   |
| Diluted—as  reported                                                                                              |       | $                                               | (0.30      | )                                             |       | $ | (0.06 | ) |   | $ | (0.55 | ) |   | $ | (0.10 | ) |   |
| Basic—pro  forma                                                                                                  |       | $                                               | (0.39      | )                                             |       | $ | (0.22 | ) |   | $ | (0.72 | ) |   | $ | (0.40 | ) |   |
| Diluted—pro  forma                                                                                                |       | $                                               | (0.39      | )                                             |       | $ | (0.22 | ) |   | $ | (0.72 | ) |   | $ | (0.40 | ) |   |

 

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Stock-basedcompensation expense relates to restricted stock granted in the current year,as described below, and is based on the fair market value of the Company’scommon stock on the measurement date, and is being recognized over thefour-year vesting period of the related restricted stock.

On February 23, 2005, the Compensation Committeeof the Board of Directors approved the form of the restricted stock agreementto be used in connection with restricted stock awards to be granted to officersof the Company under the terms of the Company’s 1999 Stock Incentive Plan. TheCompensation Committee adopted a form of restricted stock agreement to be usedin connection with such restricted stock awards. The agreement provides, amongother things, that the shares will vest in full upon the termination of theofficer’s employment without cause or the officer’s resignation for good reasonfollowing a change in control of the Company. Notwithstanding the foregoing,the plan administrator has discretionary authority, among other things, todetermine the terms and conditions of any award granted under the Plan. A copyof the agreement was previously filed by the Company with the SEC as an exhibitto the Company’s current report on Form 8-K filed on March 1,2005. The Compensation Committee approved grants of restricted stock awards tocertain of its named executive officers, effective as of March 1, 2005,totaling 270 shares (expressed in thousands). One-quarter of therestricted shares granted to these executive officers will vest each December 31beginning on December 31, 2005. The Company recorded $151 and $202 ofstock-based compensation related to the issuance of restricted stock for thethree- and six-month periods ended June 30, 2005. The Company did notincur any stock-based compensation expense for the three- and six-month periodsended June 30, 2004.

**5.  Segment Information**

TheCompany derives its revenue from a single reporting segment, secure identityand media management. Revenue is generated in this reporting segment throughlicensing and subscription of its various products and the delivery ofcontracted and consulting services related to these products. The Companymarkets its products in the United States and in non-U.S. countries through itssales personnel and its subsidiaries.

Therewas no single customer in the three- and six-month periods ended June 30,2005 or 2004 that accounted for more than 10% of total revenue. There was onecustomer who accounted for 12% of trade and unbilled accounts receivable, netat June 30, 2005, while no customer accounted for more than 10% of trade andunbilled accounts receivable, net at June 30, 2004.

Starting in the third quarter of 2004, the Companybegan to disclose information on two of its operating units, DIDS and DWM, on avoluntary basis. These operating units were part of the Company’s singlereporting segment, secure media solutions. Recently, the Company organizeditself along the lines of the major markets and customers served, creating aGovernment Programs product group and a Media and Entertainment product groupthat will be served by common functional elements, such as sales and marketing,engineering, research and development, and general and administrativedepartments. The Government Programs group makes up more than 95% of theCompany’s revenue. As such, the Company believes the voluntary disclosure ofDIDS and DWM information is no longer applicable to our business andaccordingly we have discontinued disclosing the information.

**6.** Commitments andContingencies

Beginning in September 2004,three purported class action lawsuits were commenced against the Company andcertain of its current and former directors and officers by or on behalf ofpersons claiming to have purchased or otherwise acquired Digimarc’s securitiesduring 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. On May 16, 2005, plaintiffs filed an amended complaint. Thecomplaint asserts claims under the federal securities laws, specificallySections 10(b) and 20(a) of the Securities Exchange Act of 1934,relating to the Company’s announcement that it 

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had discovered errors in its accounting for softwaredevelopment costs and project capitalization and other project costcapitalization accounting practices, and that it likely would be required torestate its previously reported financial statements for full fiscal year 2003and the first two quarters of 2004. Specifically, the action alleges that theCompany issued false and misleading financial statements and created amisperception regarding the profitability of the Company 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 complaint seeks unspecifieddamages. The Company believes that it has substantial legal and factualdefenses to the claims, which it intends to pursue vigorously. On June 15,2005, the Company filed a motion to dismiss the complaint. Plaintiffs filed aresponse on August 1, 2005. Due to the inherent uncertainties oflitigation and because the lawsuits are still at a preliminary stage, theultimate outcome of the matter cannot be predicted.

Onor about October 19, 2004, two purported shareholder derivative lawsuitswere filed 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. These lawsuits were consolidatedinto one action for all purposes on March 14, 2005. On July 19, 2005,the court granted the Company’s motion to stay these consolidated actions infavor of a shareholder derivative action to be filed by plaintiffs in theCircuit Court of the State of Oregon for the County of Washington. 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 and officerson behalf of the Company to recover for damages alleged to have been incurredas a result of alleged breaches of fiduciary duties. On or about April 6,2005, this shareholder filed a purported shareholder derivative suit againstcertain of the Company’s officers and directors, naming the Company as anominal defendant, in the Circuit Court of the State of Oregon for the Countyof Washington. These suits claim that certain of these officers and directorsbreached their fiduciary duties to the Company’s shareholders and to theCompany. The complaints are derivative in nature and do not seek relief fromthe Company. The Company has appointed a committee of its Board of Directors toinvestigate the claims asserted in the demand letter and in the derivativelawsuits.

Beginning in May 2001,a number of substantially identical class action complaints alleging violationsof the federal securities laws were filed in the United States District Courtfor the Southern District of New York naming approximately 300 companies,including the Company, certain of its officers and directors, and certainunderwriters of the Company’s initial public offering as defendants. Thecomplaints have since been consolidated into a single action, and aconsolidated amended complaint was filed in April 2002. The amendedcomplaint alleges, among other things, that the underwriters of the Company’sinitial public offering violated securities laws by failing to disclose certainalleged compensation arrangements (such as undisclosed commissions or stockstabilization practices) in the Company’s initial public offering registrationstatement and by engaging in manipulative practices to artificially inflate theprice of the Company’s stock in the after-market subsequent to the Company’sinitial public offering. The Company and certain of its officers and directorsare named in the amended complaint pursuant to Section 11 of theSecurities 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 

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other things, a release of the Company and of theindividual defendants for the conduct alleged in the amended complaint to bewrongful. The Company would agree to undertake other responsibilities under thepartial settlement, including agreeing to assign away, not assert, or releasecertain potential claims the Company may have against its underwriters. Anydirect financial impact of the proposed settlement (other than defense costsincurred and expensed prior to May 31, 2003) is expected to be borne bythe Company’s insurers. The court granted the preliminary approval motion on February 15,2005, subject to certain modifications. If such modifications are acceptable tothe 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 assurancethat this proposed settlement would be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation, the ultimateoutcome of the matter cannot be predicted.

TheCompany, in its normal course of business, from time to time experiences delaysin identification system implementation, timely acceptance for identificationsystems programs, concerns regarding identification system program performance,and other contractual disputes. Management believes that such contingenciescould have a material effect on the results of operations from time to time. Inaddition, from time to time, customers have given notice of their intention toassert claims for liquidated damages. Management believes that these assertionsare part of the resolution process involving commercial disagreements over thedelivery terms of these contracts. Such disputes are not uncommon and tend tobe resolved over time. To date, we have not paid any material amounts inconnection with a dispute with a customer. While there is always risk thatliquidated damages could be assessed in the future, management does not believethat it is probable that material amounts will be paid nor can we predict whatthe amount of any such damages would be if they were to be imposed.

Certainof the Company’s product license and services agreements include anindemnification provision for claims from third parties relating to the Company’sintellectual property. Such indemnification provisions are accounted for inaccordance with SFAS No. 5, *Accountingfor Contingencies*. To date, there have been no claims made undersuch indemnification provisions.

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 amountsare not probable or reasonably estimable in accordance with SFAS No. 5, *Accounting for Contingencies*.

**7.** Comprehensive Loss

The Company has adoptedSFAS No. 130, *Reporting ComprehensiveIncome*, which establishes standards of reporting and displayingcomprehensive income (loss) and its components of net income (loss) and othercomprehensive income (loss). Other comprehensive income (loss) refers torevenues, expenses, gains and losses that are not included in net income (loss)but rather are recorded directly in stockholders’ equity. Comprehensive income(loss) is defined as changes in stockholders’ equity exclusive of transactionswith owners. To date, only foreign currency translation adjustments arerequired to be reported in comprehensive income (loss). The following tableprovides a summary of comprehensive loss for the three- and six-month periodsended June 30, 2005 and 2004, respectively (in thousands):
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                               | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss                                 |       | $                                | (6,217     | )                              | $          | (1,271 | ) | $ | (11,337 | ) | $ | (2,057 | ) |
| Foreign currency  translation adjustment |       | 29                               |       | 19                             |       | 46 |   | (65 | ) |
| Comprehensive loss                       |       | $                                | (6,188     | )                              | $          | (1,252 | ) | $ | (11,291 | ) | $ | (2,122 | ) |

 

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**8.** RecentAccounting Pronouncements

In November 2004,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 151, *InventoryCosts—anamendment of ARB 43, chapter 4*(FAS 151). FAS 151 clarifies theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage) in the determination of inventorycarrying costs. The statement requires such costs be recognized as acurrent-period expense. FAS 151 also requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. This statement is effective for fiscal yearsbeginning after July 15, 2005. The Company does not expect that theadoption of this standard will have a material impact on its financialcondition or results of operations.

InMay 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections: a replacement of APB Opinion No. 20 and FASB StatementNo. 3,” which requires companies to apply most voluntary accountingchanges retrospectively to prior financial statements. SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. Any future voluntary accounting changesmade by us will be accounted for under SFAS No. 154.

On December 16, 2004, the FASB issued StatementNo. 123(R) *Share-Based Payment*,which is a revision of Statement No. 123 and supersedes APB OpinionNo. 25. Statement No. 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be valued at fairvalue on the date of grant, and to be expensed over the applicable vestingperiod. Pro forma disclosure of the income statement effects of share-basedpayments is no longer an alternative. Statement No. 123(R) iseffective for all stock-based awards granted on or afterJanuary 1, 2006. In addition, companies must also recognizecompensation expense related to any awards that are not fully vested as of theeffective date. Compensation expense for the unvested awards will be measuredbased on the fair value of the awards previously calculated in developing thepro forma disclosures in accordance with the provisions of StatementNo. 123. The Company is currently assessing the impact of adoptingStatement 123(R) to its consolidated results of operations.

**9.** Revenue Recognition

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 which has not been invoiced is classified asunbilled trade receivables in the condensed consolidated balance sheets.Revenue related to an enhancement of or upgrade to an existing system isdeferred and recognized over the remaining life of the contract.

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

Revenue from professionalservices arrangements is generally determined based on time and material or acost plus a profit margin measure. Revenue for professional services isrecognized as the services are performed. Progress towards completion ismeasured using costs incurred compared to the budgeted amounts contained in thecontract. 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 

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the services are provided. Revenue earned which hasnot been invoiced is classified as unbilled trade receivables in the condensedconsolidated balance sheets.

Royaltyrevenue is recognized when the royalty amounts owed to the Company have beenearned, are determinable, and collectibility is probable. Subscriptions arepaid in advance and revenue is recognized ratably over the term of thesubscription.

Maintenancerevenue is recognized when the maintenance amounts owed to the Company havebeen earned, are determinable, and collectibility is probable. Maintenancecontracts are, at times, paid in advance and revenue is recognized ratably overthe term of the service period.

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

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 toCertain Transactions*. Revenue for licenses of the Company’s softwareproducts is recognized upon the Company meeting the following criteria:persuasive evidence of an arrangement exists; delivery has occurred; the vendor’sfee is fixed or determinable; and collectibility is 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 delivered elements.

Certain customer arrangements encompass multipledeliverables, such as hardware sales, consumables sales, maintenance fees, andsoftware development fees. The Company accounts for these arrangements inaccordance 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 forseparation, the deliverables are divided into separate units of accounting andrevenue is allocated to the deliverables based on their relative fair values.The criteria specified in EITF Issue No. 00-21 are as follows: (i) thedelivered item has value to the customer on a stand-alone basis, (ii) thereis objective and reliable evidence of the fair value of the undelivered item,and (iii) if the arrangement includes a general right of return relativeto the delivered item, delivery or performance of the undelivered item isconsidered probable and substantially in the control of the vendor. For ourpurposes, fair value is generally defined as the price at which a customercould purchase each of the elements independently from other vendors or as theprice at which the Company has sold the element separately to another customer.Applicable revenue recognition criteria are considered separately for eachseparate unit of accounting. Management applies judgment to ensure appropriateapplication of EITF Issue No. 00-21, including value allocation amongmultiple deliverables, determination of whether undelivered elements are essentialto the functionality of delivered elements and timing of revenue recognition,among others.

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**10.** Inventory

Inventoryconsists primarily of the components used to manufacture identification cards,such as inks, laminates, and adhesives (considered raw material) and hardwarefor sale (considered finished goods). Inventories are valued on a first-in,first-out basis at the lower of cost or market value (net realizable value).
| ** **                             | ** ** | **June 30,**                                                    | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **     2005     ** | ** ** | **2004**              | ** ** |
| Equipment and  deferred contract costs |       |                                                                 | $          | 1,404                 |       |   |   | $ | 1,033 |   |   |
| Consumable  materials                  |       |                                                                 | 7,010      |                  |       |   | 7,825 |   |   |
| Inventory, net                         |       |                                                                 | $          | 8,414                 |       |   |   | $ | 8,858 |   |   |

 

The reserve for slowmoving and obsolete items was $410 and $271 at June 30, 2005 and December 31,2004, respectively. While we do not currently expect to be able to sell orotherwise use the reserved inventory we have on hand based upon our forecastand backlog, it is possible that a customer or customers will decide in thefuture to purchase a portion of the reserved inventory. It is not possiblecurrently to predict if or when this will happen, or how much we may sell. Suchsales have not had a significant impact on gross profit margin, nor does theCompany expect such sales to have a significant impact in future periods.

**11.** SoftwareDevelopment Costs

Under SFAS No. 86, *Accounting for the Cost of Computer Software to BeSold, Leased, or Otherwise Marketed*, software development costs areto be capitalized beginning when a product’s technological feasibility has beenestablished and ending when a product is made available for general release tocustomers. To date, the establishment of technological feasibility of theCompany’s products has occurred shortly before general release and, therefore,software development costs qualifying for capitalization have been immaterial.Accordingly, the Company has not capitalized any such software developmentcosts and has charged all such costs to research and development expense.

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

**12.** RelatedParty Transactions

During the three- andsix-month periods ended June 30, 2005 the Company recognized revenue of$113 and $255, respectively, from a holder of common stock (expressed inthousands). In addition, the Company recognized revenue of $363 and $413 forthe three- and six-month periods ended June 30, 2004, respectively, fromthis holder. Net accounts receivable from this holder was $55 and $763 at June 30,2005 and 2004, respectively.

The Company entered intotwo loans in 2002 with a former executive officer of the Company prior to suchofficer’s departure from the Company. Both loans were entered into inconnection with the former officer’s relocation to the Company’s facilities inMassachusetts. The first loan was entered into on July 1, 2002, and has aprincipal amount of $100 and an interest rate of 6.75% per year. Such loan isnot 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 onJuly 1, 2002, and has a principal amount of $260 and an interest rate of4.99% per year. The second loan provides that it will be forgiven in full on apro-rata basis over a term of four years; provided, however, that if the formerofficer voluntarily left the Company’s employment for any reason, or 

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if theformer officer was terminated “for cause,” then the outstanding balance of theloan accelerates and the former officer shall be responsible for paying theoutstanding principal balance, plus any interest that is accrued and unpaid, infull within 90 days of the date of his departure. The former executive officer’semployment with the Company was terminated in July 2004. The Company hasreserved an amount equal to the remaining amount of the loans and is no longeraccruing interest on the loans.

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

*The following Management’s Discussion and Analysisof Financial Condition and Results of Operations contains forward-lookingstatements relating to future events or the future financial performance ofDigimarc, which involve risks and uncertainties. Our actual results coulddiffer materially from those anticipated in these forward-looking statements.Please see the discussion regarding forward-looking statements included in thisquarterly report on Form 10-Q under the caption “Safe HarborStatement under the Private Securities Litigation Reform Act of 1995.”*

*Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and the related notes and other financial informationappearing elsewhere in this Form 10-Q. Readers are also urged tocarefully review and consider the various disclosures made by us which attemptto advise interested parties of the factors which affect our business,including without limitation the disclosures made under the caption “RiskFactors” in this Form 10-Q and the audited and restated consolidatedfinancial statements and related notes included in our Annual Report on Form 10-K forthe year ended December 31, 2004 filed on April 7, 2005, and otherreports and filings made with the SEC.*

**Overview**

Digimarc Corporation is a leading supplier of secureidentity solutions and advanced technologies for use in media management. Oursolutions enable governments and businesses around the world to detercounterfeiting and piracy, enhance traffic safety and national security, combatidentity theft and fraud, facilitate the effectiveness of voter identificationprograms, and improve the management of media content while supporting newdigital media distribution models that provide consumers with more choice andaccess to media content. The Company is the leading supplier of driver licensesin the U.S., producing nearly two-thirds of all driver licenses issued.

Digimarc also is a pioneerand leading owner of intellectual property in a signal processing technologyinnovation known as “digital watermarking,” which allows imperceptible digitalcodes to be embedded in all forms of media content, including personalidentification documents, financial instruments, photographs, movies, music andproduct packages. The embedded codes within various types of media content canbe detected and read by software or hardware detectors in personal computers andother digital devices. We provide solutions based on this technology directlyand through our licensees. As of July 2005, the Company holds 200 issuedU.S. patents on this technology and related technologies, applications,systems, and processes and has more than 400 applications pending. Digimarc’ssolutions and technologies are deployed by the Company and its businesspartners in media objects and digital devices around the world. Hundreds ofmillions of people carry secure credentials from issuance systems produced byDigimarc.

The substantial majorityof the Company’s revenues arise from provision of critical infrastructure andservices pursuant to long-term contracts with government agencies—primarilyU.S. state government agencies responsible for driver license issue (“State DLIssuers”), a consortium of leading Central Banks, and national governments of anumber of foreign countries. In this area of our business, document issuersaround the world take advantage of our systems design, integration andmaterials science expertise, as well as new security innovations, such asdigital watermarking, to implement issuance systems and processes, and advancedtechnologies needed to improve the security of identity documents and banknotes. The remainder of our revenues isgenerated primarily from patent and technology license fees paid by business 

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partnersproviding media and rights management solutions to major movie studios andmusic labels, television and radio broadcasters, corporations, and creativeprofessionals around the world. Private sector media and entertainment industrycustomers use secure media management solutions from the Company and itsbusiness partners to identify, track, manage and protect content as it isdistributed and consumed—eitherdigitally or physically—andto enable new consumer applications to access networks and information from PCsand mobile devices.

The secure identity andmedia management solutions provided by Digimarc and its business partners arebuilt upon innovative combinations of basic technologies, software, hardware,materials, and systems designs, supplemented by an extensive portfolio ofintellectual property that we use or license, as appropriate, to stimulategrowth in our core markets. The Company’s mission is to profitably deliver itssecure identity and media management solutions to a diverse range of customersdirectly and through business partners. Our goals include being a market leaderin all that we do, demonstrating a “customer for life” mentality to create long-termprofitable relationships with our customers, and, through market leadership andsatisfied customers, make digital watermarking a standard feature of all mediacontent.

**Vision and History**

Digimarc’s vision is toimprove the value of media content through technology. The Company’s businesswas founded to commercialize a signal processing innovation known as “digitalwatermarking.”  Digital watermarking is aunique technology breakthrough that allows our customers to infuse digital datainto all media content that is digitally-processed at some point during itslifecycle. The technology can be applied to printed materials, video, audio,and images. The inclusion of such digital data enables a wide range ofimprovements in security and media management, and enables new business models.We use digital watermarking as a value driver and differentiator in nearly allof our product offerings.

Banknote counterfeitdeterrence was the first commercially successful use of digital watermarking. Digimarc,in cooperation with an international consortium of leading Central Banks,developed a system to deter the use of digital technologies in the unauthorizedreproduction of banknotes. Innovations based on the Company’s technology andexperience have been leveraged to create new products to deter counterfeitingand tampering of diver licenses and other government-issued secure credentials.Simultaneously, Digimarc’s business partners, under patent license fromDigimarc, are delivering solutions to track and monitor the distribution ofmusic, television, movies and radio to consumers. The Company’s growing patentportfolio contains 200 issued U.S. patents, including more than 4,000 claims ondigital watermarking and related technologies, applications, systems andprocesses as of July 2005, as well as 54 patents in additionalcountries around the world.

The Company has madesignificant progress in its first decade. Its proprietary technologies aredeployed in media objects and digital devices around the world, enhancing thesecurity of banknotes, government-issued credentials, music, movies, images,and television and radio broadcasts.

Digimarc’s secure identityand media management solutions are built upon an extensive portfolio ofintellectual property, and combine innovative software, hardware and materialsthat we deliver, together with carefully selected and qualified best-of-breedthird-party components, to our government and commercial customers. The rootsof these technologies are in the pioneering and commercialization of digitalwatermarking and in the acquisition of the Large Government Programs (“LGP”)business unit of Polaroid Corporation (“Polaroid”) in late 2001, following theterrorist attacks of September 11, 2001. The primary focus of thisbusiness is the production of driver licenses and other identificationdocuments (“IDs”) on behalf of government agencies. The acquired assetsincluded all relevant software, hardware, services, materials science anddistribution assets of the government-issued photo identification business ofPolaroid Corporation.

On theheels of 9/11, we realized that our expertise in security printing and digitalimaging technologies and systems placed us in a position to understand  both the digital threats to identity 

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management credential’s and the issuer’s environment. Inthe strategic acquisition of the LGP business unit of Polaroid , we saw aunique opportunity to assist in efforts to deter identity theft and fraud and enhanceHomeland Security through the combination of a new layer of security using ourdigital watermarking innovations and market-leading competence in secure IDsolutions from Polaroid, furthering our strategy of delivering innovativecustomer-focused solutions. The resulting business has more than 47 years ofexperience from the production of more than 2 billion issued IDs. Customershave trusted Digimarc to guide them through numerous major upgrades andtechnology migrations in ID security. We are the leader in deployingnew solutions to meet driver license security and service challenges. Thisincludes being first to

·       Producedriver licenses with digital portraits

·       Deployfacial recognition and State-wide fingerprint matching in 1995 and 1996

·       Introducemarket leading security features, including digital watermarking, Kinegrams, andsecure card materials

·       Producedriver licenses in secure, networked central issuance factories

·       Offerdriver license renewal by Internet

·       Offera comprehensive and modular ID validation and archiving suite toaddress the recently enacted REAL ID legislation

With increasing interestin issues surrounding Homeland security, prevention of identity theft andfraud, traffic safety, copyright and intellectual property protection andestablishment of new business models for digital distribution and use of mediacontent, Digimarc has evolved from its early years as a technology-driven earlystage company to an important supplier of critical infrastructure to governmentagencies and a strategic business partner to solution providers supporting themedia and entertainment industry.

**Our Business**

More than 95% of theCompany’s current revenues are derived from government programs that involvelong-term contracts with government agencies in North America and around theworld. Most of the remaining revenues are generated from patent and technologylicense fees paid by business partners providing media and rights management solutionsto the media and entertainment industry. Our licensing business is built uponour extensive patent portfolio, which reached the milestone of 200 issued U.S.patents in July 2005. We expect patent licensing to continue to contributemost of the revenues in the media and entertainment area of our business forthe foreseeable future. We view our patent licensees and the governmentagencies with which we contract as long-term business partners. The Companyrecognizes that customer satisfaction is the foundation of long-term customerrelationships that will foster future growth and improved financialperformance.

Digital watermarking is a strategiccomponent of nearly all of our product offerings. Digital watermarking hasalready proven to be a powerful differentiator in banknote security, givingrise to a long-term relationship with leading Central Banks and many leadingcompanies in the IT industry. We are working to develop a similar success insecure identity management systems. So far, the technology has been adopted bytwelve state government agencies that issue driver licenses, representing morethan 20% of annual U.S. driver license volume and one foreign issuer. TheUnited States Department of Transportation has provided a grant to pilotimprovements in traffic safety through the authentication of driver licensesusing digital watermarking-based security features. The study is scheduled tobe completed by the end of 2005.

In recent years, theCompany and its business partners have successfully propagated digitalwatermarking in music, movies, television and radio broadcasts, images andprinted materials, providing 

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improvedmedia rights and asset management, reduced piracy and counterfeiting losses,improved marketing programs, and more efficient and effective distribution ofvaluable media content.

**Markets andCompetition**

The Company’s products andsolutions touch a variety of media objects, from movies and music, to banknotesand secure credentials. The aggregation of these print and digital contentmarkets is huge, creating an enormous overall opportunity for the Company toaddress. Each media object produced by or enabled by the Company’s technologycreates the potential for several applications, such as tracking and monitoring,authentication, anti-counterfeiting, or linking to networks and enhancedservices. The Company believes these are only the early signs of marketpenetration, representing a nominal share of the potential market for Digimarc’sproducts, services, and technologies. The Company believes that the globalmarket for secure identity management solutions is in the early adoption stage,characterized by a fragmented supply chain with no dominant brands, emergingstandards, and increasing concerns about national and economic security,  entitlement programs, and requirements forcontrolling access to information and physical assets. Serving this identitymanagement solutions market involves successfully delivering a wide range ofproducts ranging from data capture systems, applicant data and biometricverification systems, secure credentials incorporating a multitude of securityfeatures and ID validation systems for authentication of IDs deployed atvarious points of inspection. It also requires the expertise to integrate thevarious solution sets with existing government agency databases and systems andthe service, support and training to secure long-term customer relationships.

The Company cannot providereliable estimates of the size of these markets as of the date of this report. Wherereasonably reliable means to estimate application markets within these largermarkets become available to the Company, we will endeavor to share theseestimates with investors unless such disclosures create unreasonablecompetitive risks or would violate confidentiality of its businessrelationships.

Digimarc estimates thesize of the U.S. driver license issuance market at more than $100 million. On May 11,2005, the REAL ID provision of Public Law No: 109-13 (the “REAL ID Act”),an emergency supplemental appropriations bill, was signed into law by thePresident, mandating federal requirements for driver licenses. Congress isconsidering providing $40 million-$100 million of funding for grants to statesin fiscal year 2006 to make upgrades mandated by the REAL ID Act. The Companybelieves that these mandates and additional funding may create significantgrowth in the size of this market.

Digimarc has a unique,broad vision of improving media content through technology. Thus, our competitiontends to be fragmented and application-specific. In secure identity management,our primary competition is from IT systems integrators, security printers,biometric suppliers, smart card chips and systems suppliers, plastic cardproducers, and industrial grade printer vendors. For example, in the U.S.driver license market, our competitors include companies like DeLaRue, aUK-based security printer; Viisage, a biometrics supplier with an evolvingbusiness model; Canadian Banknote, a security printer; and Unisys, an IT systemintegrator. The primary basis of competition in this market has beentechnology, price, and relationships. The weighting of these factors tends tovary from customer to customer. In other applications, such as banknotecounterfeit deterrence and media and entertainment solutions, we generallycompete with alternative technologies for the security budget of the producersand distributors of the media objects. Our competitive position within certain marketsmay also be affected by factors such as inertia of the status quo and changesin government regulations.

**Government Programs**

More than 95% of ourcurrent revenues are derived from the sale of our products and services to variousgovernment programs. In this sector, document issuers around the world takeadvantage of our systems design, integration and materials science expertise aswell as new security innovations like digital 

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watermarkingto implement the systems, processes and technologies needed to produce secure,highly durable identity documents such as driver licenses, national IDs andvoter IDs, and banknotes.

*Secure Identity Management*

As the leading provider of secure ID solutions inNorth America, Digimarc systems produce more than 60 million driver licensesand other secure personal identification documents per year. Nearly two-thirdsof the U.S. states and many foreign governments, including Russia, Latvia,Mexico, and Canada, utilize Digimarc secure ID solutions. Many aspects of ouradvanced technology solutions anticipate both the mandate of therecently-passed REAL ID Act and the emerging consensus on best practicesconsistent with our product and service strategy.

Some of the requirementsof the REAL ID Act that may require States to upgrade to be in complianceinclude:

*Applicant DataCapture*

·       Capturedigital images of identity source documents in a transferable format

·       Retaincopies of source documents—7 years for paper or 10 years for image

·       Conductmandatory facial image capture

*IdentityVerification*

·       Verify,with the issuing agency, the issuance, validity, and completeness of eachdocument

·       Verifythe legal presence status of a person

·       Confirmor verify a renewing applicant’s information

·       Confirmwith Social Security Administration all applicant Social Security Numbers usingthe full 9-digit number

·       Confirmtermination of previous license in another state before issuance

·       Provideelectronic access to all other states to information contained in the motorvehicle database of the state

*SecureCredential and ID Validation*

·       Limitvalidity period of IDs

·       Implementphysical security features designed to prevent tampering, counterfeiting, orduplication

·       Deploycommon machine-readable technology, with defined minimum data elements

Digimarc hasanticipated and is working with its state government customers to deploysolutions that can help them achieve compliance with the REAL ID Act.  We currently provide components and subsystemsthat

·       Digitallycapture and archive applicants documents

·       Validatethe authenticity of documents that an applicant presents as proof of identity

·       Verifyapplicant information by referencing various Social Security, immigration orcommercial databases

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·       Capturedigital facial images and fingerprints of individuals

·       Verifydigital facial image and fingerprint biometrics

·       Providesecure production of driver licenses and other IDs

·       Delivertechnologically advanced and sophisticated machine-readable ID securityfeatures such as Digimarc® IDMarcTM digital watermarks to preventcounterfeiting, tampering or duplication along with barcodes, mag stripes andother machine-readable technologies that have publicly defined data elements

·       Authenticatedriver licenses and other IDs at points of inspection within states and acrossjurisdictions

Issuers of government photo IDs invest time andresources to ensure that their organizations follow effective processes andguidelines for verifying each applicant. These processes often prescribe thatstate personnel verify the identity of the person applying for a state-issuedID and the authenticity of the various forms of identification the person haspresented. State personnel, law enforcement, retailers and other inspectorsusually rely on visual inspection matched against catalogs of design andsecurity features to assess whether the identity documents presented aregenuine.

Digimarc has workedextensively with driver license issuers across the United States to strengthentheir ID systems. As a result, we have identified and implemented numerous “bestpractices” throughout our processes and developed modular, flexible solutionsdesigned to improve security within each component of the secure ID lifecycle—fromthe time an applicant applies for or renews his or her driver license to thesecure production and issuance of the ID to the legitimate cardholder to theauthentication of that document at a traffic stop, a store or the DMV. Thechart below outlines the secure ID lifecycle.

*Applicant Data Capture andIdentity Verification*

Validation of document and verification of applicantidentity is key to the secure intake process, and a critical step towardensuring that driver licenses are only issued to legitimate applicants. In2005, Digimarc 

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introduced the Digimarc IDValidation Suite, a new product in its solution set designed to validate breederdocuments and verify the data presented to establish an applicant’s identity.

Digimarc’s**ID Validation Suite (IDVS)scans, authenticates and archives images of ID credentials, such asout-of-state driver licenses, passports, birth certificates and othergovernment-issued IDs. IDVS scans documents submitted by applicants and authenticateskey security features to determine whether the identity document is genuine,altered or counterfeit. It examines such features as covert digital watermarks,barcodes, magnetic stripes and other machine-readable features. Documents arethen archived digitally for use in appropriate subsequent investigations, andto meet the requirements of the new REAL ID Act.

Recently, the Companyannounced upgrades to IDVS to facilitate customer compliance with new Homeland Securityrequirements for improving the validation of identities of federal employeesand contractors. Under Homeland Security Presidential Directive 12, federalagencies have until October 27, 2005 to acquire the operationalcapability to collect, verify and archive the documents presented to establishthe identity of all current and new federal employees and contractors. Webelieve that IDVS could be a valuable tool for use by federal agencies inachieving compliance with these requirements. The chart below outlines the workflowof Digimarc’s IDVS solution. 

The REAL ID Act requiresthat the source of each breeder document and key demographic data be verified. Digimarcwas the first in the nation to deploy applicant verification, and its systemhas helped find hundreds of fraudulent attempts to obtain driver licenses. TheDigimarc Applicant Verification Server aggregates access to key third-partyverification services, such as Social Security verification and national 

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driverregisters. The verification step is integrated into Digimarc’s secureend-to-end workflow, allowing efficient identification and processing ofexceptions and potential fraud cases, while ensuring timely processing of validapplications.

*Image Capture*

The Digimarc Image CaptureStation enables U.S. driver license issuers to capture high-quality portraits,signatures and fingerprints needed to complete the intake process. This step isessential to reliable biometric verification, and crucial to producing aportrait that serves the security function and provides a high-quality image ofthe applicant.

*BiometricVerification*

Another critical check toverify identity is to ensure that the applicant has not already been issued adriver license under another name or identity. The Digimarc BiometricVerification Suite is a modular, scalable component of our secure IDsolution that incorporates both fingerprint and facial recognition capabilities.Digimarc was the first to employ facial recognition as a verification step fordriver license issuance. We apply our years of system design and deliveryexperience to select top-rated, best-of-breed algorithms and integrate theminto the Biometric Verification Suite to help our customers to identifyapplicants who are already in the system—by automatically comparing facialfeatures or fingerprints to the issuer’s biometric databases and, forcommercial drivers of Hazardous Materials, against FBI databases. The DigimarcBiometric Verification Suite is a quick and effective way of reducingapplicant fraud without adversely impacting workflow and has been successfullydeployed—catching hundreds of fraudulent applicants per year—in multiple states.

*Secure IDProduction*

Once an applicant’sinformation and image have been captured, screened and verified, our systemsenable issuers to securely produce and personalize a secure and highly-durabledriver license. Digimarc offers secure over-the-counter instant issue systems,central issuance systems, and hybrid over-the-counter / central issue options. Centralizedproduction of driver licenses can enhance the security of the ID lifecycle byallowing additional time to verify documents and identity, and by allowing forincreased access controls and secure material management. We believe that our centralissuance systems effectively address both the security and customer service needsof our customers.

*Secure and durableID credentials*

An integral part of enhancingID security is at the card level itself. The most effective way to createsecure ID credentials is through a card architecture that combines multiplelayered and linked security features such as digital watermarks and Kinegramswith durable, counterfeit-resistant materials such as our line of proprietaryindustry-leading Exian card products.  Digimarc has developed and incorporated newand innovative security elements in driver license credentials. Our securecredentials often contain more than a dozen separate overt and covert securityelements that protect against tampering or counterfeiting.

*Point of InspectionValidation*

Validating IDs at the point of inspection closes theloop in the secure ID lifecycle. With the introduction of security features suchas digital watermarks, today’s secure IDs carry machine-readable features thatallow for cross-jurisdictional authentication of identity documents, taking theguesswork out of determining if a presented ID matches one of the more than 240valid driver license designs. Digimarc is pioneering the use of point ofinspection validation in its work with the U.S. Department of 

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Transportation, whichprovided the Company with a grant of approximately $1 million to study the useof digital watermarking in driver license authentication in the state of Nebraska.

We believe that ourproprietary card materials and security features, verification and validationsolutions, and expertise in issuance system design and production, allow ourcustomers to produce the most secure, counterfeit and tamper resistant driverlicenses available. We also believe that, because of our customer focus,expertise, proprietary technologies, and investments in research anddevelopment, we are well positioned to compete effectively within the marketsfor these products and services.

***Financial Document Security***

The Company has amulti-year contract with an international consortium of Central Banks todevelop, deploy and support a system to deter digital counterfeiting ofcurrency using personal computers and digital reprographics. Work on the systembegan in 1997. Details of the system are confidential for security reasons.

**Media &Entertainment**

In the media and entertainmentsector, customers use secure media solutions from Digimarc and its businesspartners to identify, track, manage and protect content as it is distributedand consumed—either digitally or physically—and to enable new consumerapplications to access networks and information from PCs and mobile devices. Manymajor movie studios, record labels, broadcasters, corporations and creativeprofessionals rely on digital watermarking as a cost-effective means to:

·       Deterpiracy and illegal use of movies, music and images

·       Protectentertainment content from copyright infringement

·       Trackand monitor entertainment content for rights usage and licensing compliance

·       Monitoradvertisements to verify ad placement and measure return on investment, and

·       Enablefair and legitimate use of content by consumers

Our business partners in this area include ActivatedContent, AudioAudit (recently acquired by Nielsen Media Research), MediaGrid RoyalPhilips Electronics, Signum, Teletrax (under sublicense from Philips),Technicolor (under sublicense from Philips), Verance and Verimatrix. While eachpartner addresses particular customer needs, as a whole they are propagatingdigital watermarking in music, movies, images, and television and radio as ameans to improve media rights and asset management, reduce piracy losses,improve marketing programs, and provide more efficient and effectivedistribution of valuable media content.

Digital watermarking solutions in this sector fromDigimarc and our business partners include the following:

*Forensic Tracking:  *Forensictracking allows content owners to determine when and where a unit of mediacontent leaves its authorized distribution channel. The most common use offorensic tracking is in the entertainment industry, where music and movies areroutinely distributed to executives, critics and other media outlets forpromotion before they’re released to the public. In recent years, copies ofthese ‘pre-release’ products have been leaked onto the Internet, or copied ontoCDs and DVDs, and sold as “bootlegs” well ahead of their commercial release.These unauthorized activities result in loss of revenues for the artists, thestudios and the music labels.

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To combat pre-release piracy, music companies andmovie studios embed pre-release content with digital watermarks that are uniqueto each authorized recipient. This allows the content creators to forensicallytrack the source of leaks and take appropriate actions. As a result, recipientsof pre-release music and movies have begun to police themselves in order toavoid liability for unauthorized use.

The use of digital watermarking solutions from ourbusiness partners for forensic tracking of pre-release movies and music hasgained a strong foothold in Hollywood. Digital watermarking is incorporated inmore than 2 million audio tracks from major record labels to identify and trackleaks of promotional, pre-release music onto the Internet. Customers of thesesolutions from Digimarc and business partners such as Activated Content includeSonyBMG, Universal Music Group and Warner Music, mastering studios, diskduplicators and online business-to-business music distributors. In a similarapplication for movies, digital watermarking has been identified byrepresentatives of the movie studios as dramatically reducing piracy of moviesin the Academy Award screener program.

Digital watermarking may also play a role in the movieindustry’s transition from film reel distribution to digital file formatdistribution for theatrical release. In July 2005, the Digital CinemaInitiative, which is supported by Disney, Fox, MGM, Paramount, Sony PicturesEntertainment, Universal and Warner Bros. Studios, released its Digital CinemaSystem Specification, which details industry guidelines designed to help spurdeployment of digital cinema systems for the hundreds of thousands of movietheater screens in the United States and around the world while establishinguniform levels of security, distribution, performance, reliability and qualitycontrol. The specification requires that digital cinema systems be capable ofapplying digitial watermarks in both the video and audio streams of digitalmovies upon request of the studios or other content providers. The digitalwatermarks can be used as a forensic tool to help identify the theater,location, production version and even the date and time that a film plays in aspecific theater.

*Broadcast Monitoring:  *Broadcastmonitoring allows clients to identify where, when and how their media contentis being aired. This type of information is important to many different typesof users. For example, every day, thousands of advertisements run in thousandsof markets across the country. With highly regionalized cable, satellite andterrestrial delivery, advertising agencies and their clients need to know thatthe advertisements they pay for are actually being broadcast. By using digitalwatermarking-based services, these companies can monitor broadcasts in majormedia markets around the world, verify compliance by broadcast partners, andmeasure the effectiveness of the campaign.

As another example of how such information is used,advertisers such as Coca Cola and Pepsi, and broadcast networks such as ABCTelevision Network, NBC News Channel, BBC and Reuters Television, currentlyapply solutions from these Digimarc partners to monitor broadcasts on over athousand channels in more than 50 countries worldwide, studying thedistribution of their content, verifying compliance by broadcast partners, andmeasuring the effectiveness of broadcasts.

*Copy Prevention:  *Digitalwatermarks allow companies to control the use of copyrighted image, audio andvideo content. A watermark travels with the content, persisting through thechanges in file format, and through transformation between digital and analogform. This allows the content owner to specify whether or how often the workcan be legally copied or shared without visually or audibly impairing the work.It also allows greater and safer dissemination of copyrighted works while atthe same time ensuring appropriate compensation to the owners.  Digital watermarking from Verance, a Digimarcbusiness partner, has been deployed in conjunction with licensed DVD-audioimplementations to prevent unauthorized copying. Digital watermarking iscurrently under consideration as an important security layer for additionalaudiovisual media content.

*Digital Image Management:  *Inour own digital watermarking product portfolio, focused on digital imagemanagement, Digimarc announced earlier this year upgrades to its imageprotection products 

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targeted to creativeprofessionals, and published a beta version of an enhanced desktop image searchmade possible by digital watermarking

MyPictureMarc 2005, an update to oursubscription-based offering available at www.digimarc.com/mypicturemarc, wasreleased this spring to give photographers and other creative professionals newand enhanced layers of security for protecting their digital image collections—includingdigital watermarking for copyright communication, enhanced digital rightsmanagement tracking, online image backup and the capability to add visualwatermarking identifiers.

With a MyPictureMarc subscription, customers can takeadvantage of the Digimarc plug-in functionality available in major imageediting software programs, including Adobe Photoshop 7 and higher products, aswell as Photoshop Elements 1.0, 2.0 and 3.0, to place digital watermarks intoimages as a means to communicate ownership, track distribution and provide alink from the image back to the owner for purchasing or licensingopportunities.

In addition to these solutions, Digimarc anticipatesadditional digital watermark media solutions will emerge such as the following:

*Rights Management:  *Becausedigital watermarks can be applied and detected at various points betweendistribution and playback, they can be valuable for rights management andre-association. Among other things, new applications could be developed toallow consumers to move their digitally watermarked content through theirvarious playback devices (e.g. personal computers and CD players) and differentDRM encryption and decryption environments while preserving the identity of thecontent through use of a digital watermark and enabling rights re-associationas appropriate in downstream devices.

*Filtering/Classification:  *Thepopularity of Napster, a free peer-to-peer (P2P) music swapping service,brought the issue of content and rights management to a crisis point. BecauseP2P systems have difficulty determining which audio files are copyrighted andwhich are not, it is relatively easy for content to be illegally distributedacross these networks. Digital watermarks could allow P2P systems to easilyidentify and distinguish copyrighted from non-copyrighted audio or video filesand thereby facilitate legal file sharing. Digital watermarks could alsoenhance P2P systems by enabling them to collaborate with record labels andother audio retailers to link to and market legitimate copyrighted songs. A June 2005U.S. Supreme Court ruling (Metro-Goldwyn-Mayer Studios vs. Grokster)  identified digital watermarking as one of thesolutions that could help curb copyright infringement and illegal distributionof music or movies shared across P2P networks. The ruling recognizes thepossibility that digital watermarks could be used to identify media content andassociated rights and enable downstream consumers and systems to actappropriately as they access such content.

Digital watermarking technology can also enableconsumers to more effectively control digital content. Digital watermarking canbe used to sort and search through audio, image and video files. For example,digital images could be embedded with digital watermarks that allow devices toclassify or filter them in order to help parents better manage the media intakeof their children, especially over the web.

*Remote Triggering:  *Anotherpotential application of digital watermarking is use as a trigger—to make aplayback device, such as a cell phone or a digital video recorder, perform anautomatic action. When images, audio files or video files are distributed orreceived, digital watermarks can signal these playback devices to displaynotification that the content is copyrighted, trip a download counter, ordisplay additional related content and choices to consumers.

*E-Commerce:*   Digimarcbelieves that digital watermarking could also be used to further enhance theconsumer experience through improved electronic- and mobile-commerceapplications. For example, if a digitally watermarked song is played on a cellphone, a content ID could be used to look up information about the artist orfind other songs that can be purchased with the click of a button. In such anapplication, 

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digitalwatermarking has the potential to give consumers more choices, better accessand faster delivery of the products and entertainment they want.

**Customers**

The bulk of Digimarc’srevenues arise from supplying infrastructure pursuant to long-term contractswith government agencies, primarily U.S. state Departments of Motor Vehicles, aconsortium of leading Central Banks, and national governments of various foreigncountries. Our contract with the Central Banks is in its eighth year. Last yearwe agreed upon a 5-year extension, with two additional 3-yearextensions that we expect to be implemented. The retention rate for our driverlicense customers is high. The remainder of the Company’s revenues is generatedprimarily from patent license fees paid by business partners providing mediaand rights management solutions to major movie studio and music labels,television and radio broadcasters, corporations, and creative professionalsaround the world. A sample of representative customers and business partnersfollows:

·       Stateand national government agencies that issue driver licenses, national IDs andvoter credentials, including 32 U.S. states, the District of Columbia, twoCanadian provinces, Latvia, Mexico and Russia.

·       Aninternational consortium of the world’s leading Central Banks

·       ActivatedContent, AudioAudit (recently acquired by Nielsen Media Research), MediaGrid RoyalPhilips Electronics, Signum, Teletrax (under sublicense from Philips),Technicolor (under sublicense from Philips), Verance and Verimatrix

**Growth Prospects**

The Company believes that there are significant growthopportunities in both the public and private sectors. With respect to secureidentity management, we believe that we have good opportunities for revenuegrowth in the third and fourth quarter of 2005 as a result of our marketingsuccesses in 2003 and 2004, (including new programs for voter IDs in Mexico and digital driver licensesystems in Florida, Alabama and Ohio that are expected to reach full productionlevels during 2005) and as a result of anticipated opportunities to provideexisting domestic customers with products and upgrades to facilitate theirefforts to comply with the REAL ID Act. We also expect to bid on some newcontract opportunities during the upcoming months. We are encouraged by theinterest of the federal government in promoting more secure driver licenses andthe possibility of federal funding to support systems upgrades by our statecustomers. The Company also anticipates continued interest in mediacontent and digital rights management, Homeland Security andanti-theft/anti-fraud solutions. While there can be no assurance that thisinterest will result in more widespread adoption of solutions from Digimarc andits business partners, we believe that our patented technologies and solutionsand established expertise in large-scale secure ID systems will enable us tocompete effectively for business opportunities that arise in these areas. Inthe first six months of 2005, Digimarc introduced new products and solutionsthat help:

·       Stateand federal government agencies to help meet federal ID security requirementsof the REAL ID Act and Homeland Security Presidential Directive 12

·       Creativeprofessionals and consumers better protect and manage their works amidst an explosionin the popularity and use of digital photography

Digimarc’s businesspartners, whose success translates into licensing royalties for the Company,are actively developing and delivering solutions to media and entertainmentindustry customers that help:

·       Majorbroadcasters like NBC News Channel, ABC, Reuters and others track and monitorTV programming and promotions to ensure compliance with marketing programs andusage rights

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·       Majormovie and music studios track and identify pre-release copies of content todeter piracy and illegal distribution

**Restatementof Prior Financial Results**

In our Form 10-K for the year ended December 31,2004 we restated our audited consolidated financial statements as of and forthe year ended December 31, 2003, including each of the quarterly periodsin the year ended December 31, 2003, and the quarterly periods ended March 31,2004 and June 30, 2004. We restated our financial statements to correcterrors in the accounting for software development costs, project accounting,revenue recognition, and tax accruals, among other areas. Please see Note 2 tothe condensed consolidated financial statements of the Company includedherewith as well as our Form 10-K for the year ended December 31,2004 for additional information about the restatement.

Thefollowing tables set forth the restatement adjustments to our financialstatements for the periods indicated. The amounts in the tables are expressedin thousands.

***As of and for the three months ended June 30,2004:***

**Statement ofoperations**
| ** **                  | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other ** | ** ** | **As  restated** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------------|------------|------------------|------------|
| Revenue                     |       |                             | $          | 23,673                       |       |                    |       | $           | —     |    |       |            | $          | —           |       |   |   | $ | (251 | ) |   | $ | — |   | $ | 52 |   | $ | 23,474 |   |
| Cost of revenue             |       |                             | 15,826     |                         |       |                    | 21         |        |       |    | (855       | )               |       |             | (47        | ) |   | — |   | (181 | ) | 14,764 |   |
| Gross profit                |       |                             | 7,847      |                         |       |                    | (21        | )           |       |    | 855        |            |       |             | (204       | ) |   | — |   | 233 |   | 8,710 |   |
| Operating expense           |       |                             | 9,741      |                         |       |                    | 320        |        |       |    | 19         |            |       |             | (11        | ) |   | — |   | (100 | ) | 9,969 |   |
| Operating income  (loss)    |       |                             | (1,894     | )                            |       |                    | (341       | )           |       |    | 836        |            |       |             | (193       | ) |   | — |   | 333 |   | (1,259 | ) |
| Other income, net           |       |                             | 172        |                         |       |                    | —     |        |       |    | —     |            |       |             | —     |   |   | — |   | — |   | 172 |   |
| Provision for  income taxes |       |                             | (222       | )                            |       |                    | —     |        |       |    | —     |            |       |             | —     |   |   | 38 |   | — |   | (184 | ) |
| Net income (loss)           |       |                             | $          | (1,944                       | )          |                    |       | $           | (341       | )       |       |            | $          | 836              |       |   |   | $ | (193 | ) |   | $ | 38 |   | $ | 333 |   | $ | (1,271 | ) |

 

***As of and for the six months ended June 30, 2004:***

**Statement ofoperations**
| ** **                  | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other** | ** ** | **As  restated ** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------------------|------------|
| Revenue                     |       |                             | $          | 47,163                       |       |                    |       | $           | —     |    |       |      | $          | —                 |       |   |   | $ | 29 |   |   | $ | — |   | $ | (60 | ) | $ | 47,132 |   |
| Cost of revenue             |       |                             | 29,540     |                         |       |                    | 42         |        |       |    | 284        |      |       |                   | (47        | ) |   | — |   | (211 | ) | 29,608 |   |
| Gross profit                |       |                             | 17,623     |                         |       |                    | (42        | )           |       |    | (284       | )         |       |                   | 76         |   |   | — |   | 151 |   | 17,524 |   |
| Operating expense           |       |                             | 19,142     |                         |       |                    | 702        |        |       |    | 26         |      |       |                   | (11        | ) |   | — |   | (140 | ) | 19,719 |   |
| Operating income  (loss)    |       |                             | (1,519     | )                            |       |                    | (744       | )           |       |    | (310       | )         |       |                   | 87         |   |   | — |   | 291 |   | (2,195 | ) |
| Other income, net           |       |                             | 372        |                         |       |                    | —     |        |       |    | —     |      |       |                   | —     |   |   | — |   | — |   | 372 |   |
| Provision for  income taxes |       |                             | (272       | )                            |       |                    | —     |        |       |    | —     |      |       |                   | —     |   |   | 38 |   | — |   | (234 | ) |
| Net income (loss)           |       |                             | $          | (1,419                       | )          |                    |       | $           | (744       | )       |       |      | $          | (310                   | )          |   |   | $ | 87 |   |   | $ | 38 |   | $ | 291 |   | $ | (2,057 | ) |

 

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**Statement of cashflows**
| ** **                                           | ** ** | **As previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Tax** | ** ** | **Other** | ** ** | **As  restated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------------|------------|
| Net cash provided  by (used in) operating activities |       |                             | $          | 8,651                        |       |                    |       | $           | (867       | )       |       |      | $          | (941             | )          |   |   | $ | — |   |   | $ | — |   | $ | (497 | ) | $ | 6,346 |   |
| Net cash provided  by (used in) investing activities |       |                             | (14,213    | )                            |       |                    | 867        |        |       |    | 941        |      |       |             | —     |   |   | — |   | 497 |   | (11,908 | ) |
| Net cash provided  by (used in) financing activities |       |                             | 1,760      |                         |       |                    | —     |        |       |    | —     |      |       |             | —     |   |   | — |   | — |   | 1,760 |   |
| Net decrease in cash and  cash equivalents           |       |                             | $          | (3,802                       | )          |                    |       | $           | —     |    |       |      | $          | —           |       |   |   | $ | — |   |   | $ | — |   | $ | — |   | $ | (3,802 | ) |

 

**CriticalAccounting Policies and Estimates**

The preparation of our condensed consolidatedfinancial statements in accordance with U.S. generally accepted accountingprinciples requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to bad debts, inventories, intangibleassets, income taxes, restructuring, long-term service contracts, warranties,investments, and contingencies and litigation. We base our estimates onhistorical experience and on various other assumptions we believe to bereasonable under the circumstances. Actual results may differ from theseestimates under different assumptions or conditions.

Certain of our accounting policies require higherdegrees of judgment than others in their application. These include revenuerecognition on long-term service contracts, impairments and estimation ofuseful lives of long-lived assets, inventory valuation, reserves foruncollectible accounts receivable and contingencies and litigation. We believethe following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our condensed consolidatedfinancial statements:

**Revenue recognition on long-termservice 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. Any estimated amounts are included inunbilled receivables on the balance sheet until the actual productioninformation is available and the billing occurs. Any estimation processinvolves inherent risk. We reduce the inherent risk relating to productionestimation through our approval and monitoring processes related to accountingestimates.

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.

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**Impairments and estimation of usefullives of long-lived assets:  **We periodically assesslong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable inaccordance with the provisions of SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets.*Thisstatement requires that long-lived assets and certain identifiable intangiblesbe reviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future net undiscounted cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Fair value is determined based ondiscounted cash flows or appraised values, depending on the nature of theasset. If our estimates of projected future cash flows were too high by 10%, webelieve there would be no material impact on the reported value of long-livedassets on our condensed consolidated balance sheets. Also, we periodicallyreview the useful lives of long-lived assets whenever events or changes incircumstances indicate that the useful life may have changed. If the estimateduseful lives of such assets do change, we adjust the depreciation oramortization period to a shorter or longer period, based on the circumstancesidentified.

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

**Reserves for uncollectible accountsreceivable:  **We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust whenappropriate, our allowance for doubtful accounts on at least a quarterly basis.If the financial condition of our customers were to deteriorate, resulting inan impairment of their ability to make payments, additional allowances may berequired. If our estimate of uncollectible accounts were too low by 10%, therewould be no material impact on the reported value of accounts receivable on ourcondensed consolidated balance sheets.

**Contingencies and Litigation:  **Weperiodically evaluate all pending or threatened contingencies or commitments,if any, that are reasonably likely to have a material adverse effect on ouroperations 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 available prior to the issuance of our financialstatements indicates that it is probable that an asset has been impaired or aliability has been incurred at the date of our financial statements, and theamount of the loss, or the range of probable loss can be reasonably estimated,then such loss is accrued and charged to operations. If no accrual is made fora loss contingency because one or both of the conditions pursuant to SFAS No. 5are not met, but the probability of an adverse outcome is at least reasonablypossible, we will disclose the nature of the contingency and provide anestimate of the possible loss or range of loss, or state that such an estimatecannot be made.

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**Results of Operations**

During the three- and six-month periods ended June 30,2005, we invested in capital equipment and software development for several newprograms, including programs based in Florida and Alabama which, when combinedwith our net loss, caused our working capital to decrease for the periods.These programs are expected to be fully deployed in 2005. Operating resultswere negatively impacted by higher staffing levels, higher depreciation andamortization expenses, increased efforts on non-capitalizable projects, andincreased legal, accounting, and consulting expenses for our general andadministrative areas.

Thefollowing table presents our condensed consolidated statements of operationsdata for the periods indicated as a percentage of total revenue.
| ** **                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                              | ** ** | **2005**                                        | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                              | ** ** | ** **                                      | ** ** | **(Restated)**                                | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Revenue:                                |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Service                                 |       | 87                                              | %          |                                          | 79         | % |   | 84 | % |   | 75 | % |   |
| Product and subscription                |       | 13                                              |       |                                          | 21         |   |   | 16 |   |   | 25 |   |   |
| Total revenue                           |       | 100                                             |       |                                          | 100        |   |   | 100 |   |   | 100 |   |   |
| Cost of revenue:                        |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Service                                 |       | 60                                              |       |                                          | 48         |   |   | 57 |   |   | 45 |   |   |
| Product and subscription                |       | 5                                               |       |                                          | 15         |   |   | 7 |   |   | 18 |   |   |
| Total cost of revenue                   |       | 65                                              |       |                                          | 63         |   |   | 64 |   |   | 63 |   |   |
| Gross profit                            |       | 35                                              |       |                                          | 37         |   |   | 36 |   |   | 37 |   |   |
| Operating  expenses:                    |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Sales and marketing                     |       | 16                                              |       |                                          | 12         |   |   | 16 |   |   | 11 |   |   |
| Research, development and engineering   |       | 12                                              |       |                                          | 7          |   |   | 11 |   |   | 7 |   |   |
| General and administrative              |       | 28                                              |       |                                          | 21         |   |   | 29 |   |   | 21 |   |   |
| Amortization of intangibles             |       | 5                                               |       |                                          | 2          |   |   | 4 |   |   | 3 |   |   |
| Total operating expenses                |       | 61                                              |       |                                          | 42         |   |   | 60 |   |   | 42 |   |   |
| Operating loss                          |       | (26                                             | )          |                                          | (5         | ) |   | (24 | ) |   | (5 | ) |   |
| Other income  (expense):                |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Interest income                         |       | 1                                               |       |                                          | 1          |   |   | 1 |   |   | 1 |   |   |
| Interest expense                        |       | —                                          |       |                                          | —     |   |   | — |   |   | — |   |   |
| Other                                   |       | —                                          |       |                                          | —     |   |   | — |   |   | — |   |   |
| Total other income, net                 |       | 1                                               |       |                                          | 1          |   |   | 1 |   |   | 1 |   |   |
| Loss before  provision for income taxes |       | (25                                             | )          |                                          | (4         | ) |   | (23 | ) |   | (4 | ) |   |
| Provision for  income taxes             |       | —                                          |       |                                          | (1         | ) |   | — |   |   | — |   |   |
| Net loss                                |       | (25                                             | )%         |                                          | (5         | )% |   | (23 | )% |   | (4 | )% |   |

 

*Revenue*

Total revenue was $24.8 million and $49.1 millionfor the three- and six-month periods ended June 30, 2005, respectively,compared to total revenue of $23.5 million and $47.1 million for the three- andsix-month periods ended June 30, 2004, respectively, and represented a 5%and 4% increase over the three- and six-month periods ended June 30, 2005and 2004 respectively. The changes in total revenue between the comparablethree- and six-month periods of 2005 and 2004 resulted primarily fromadditional programs added in late 2004 and early 2005, such as Florida, Mexicoand Ohio.

In addition, we haveobserved seasonality in our revenues, with larger revenues in the second andthird quarter of the year, and generally lower revenues in the first and fourthquarters.

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**Backlog**

Based on projected driver license production volumesand other commitments we have for the periods under contract with our respectivecustomers, we anticipate our current contracts as of June 30, 2005 willgenerate more than $225 million in revenue during the contractual terms ofsuch contracts, currently up to eight years. We expect approximately $40million of this amount to be recognized as revenue during the remainder of2005. This amount includes production volumes reasonably expected to beachieved under currently effective contracts, government orders that are firmbut not yet funded, and government contracts awarded but not yet signed.

Some factors thatlead to increased backlog are:

·       Competitivebid wins,

·       Renewalswith current customers,

·       Add-onsales to current customers, and

·       Contractswith longer contractual periods replacing contracts with shorter contractualperiods.

Some factors thatlead to decreased backlog are:

·       Recognitionof revenue associated with backlog currently in place,

·       Periodsfollowing low bid activity,

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

·       Changesin the revenue model for a particular customer (e.g., from a “price-per-card”model with a large associated backlog to a “consumables” model with a smallassociated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period. For example,we are currently in a period following low bid activity, and as a result haveconsumed backlog over the past few quarters without large replenishments fromcompetitive bid wins. Over the next year or so, we anticipate several states torequest bids on their driver license issuance system programs. This period ofexpected high bid activity could lead to additional backlog if we aresuccessful with our bids. Another example is the variable revenue model. Two ofour recent domestic driver license issuance system sales were not ourcharacteristic price-per-card model, but instead included hardware andconsumable sales. Although these types of revenue models are positive growthindicators for our business, they can lead to lower reported backlog.

There can be no assurance that our backlog will resultin actual revenue in any particular period, because the orders, awards andcontracts included in our backlog may be subject to modification, cancellationor suspension. We may not realize revenue on certain contracts, orders orawards included in our backlog or the timing of such recognition may change.

Many of our secure identity management contracts havesignificant capital requirements. The general industry model for supplyingdriver license issuance systems to state DL Issuers is for the system supplierto develop and install the issuance system using the supplier’s capital and tocharge the customer on a per-card issued basis. This means that, during timesof substantial competitive wins and/or substantial system upgrades, the Companymay experience significant working capital needs that may exceed cash flow fromoperations. To date, the Company has relied upon cash reserves to fund suchexpenditures.

In non-U.S. markets, where we provide driver license,national identification, and voter identification systems, services, andcomponents in partnership with local card producers, security printers, systemintegrators, and others, we may serve as prime contractor or sub-contractor,depending on the circumstances. As a sub-contractor, we are responsible fordelivering hardware, software, or consumables 

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to the prime contractor;and, as a prime contractor, we are responsible for integrating the componentsof the system to the customer’s specifications. Revenue from internationalcustomers was $4.6 million and $9.1 million for the three- and six-monthperiods ended June 30, 2005, respectively, compared to $5.1 million and$11.1 million for the three- and six-month periods ended June 30, 2004,respectively. International sales represented 19% and 21% of our total revenueduring the three-month periods ended June 30, 2005 and 2004, respectively,and 18% and 23% of our total revenue during the six-month periods ended June 30,2005 and 2004, respectively. International sales for us have typically takenthe form of an outright sale of equipment and/or consumables to non-U.S.government agencies or their prime contractors. These sales often can be large,carry relatively low margins and may cause noticeable spikes in quarterlyrevenue and variations in gross profit trends. We enter into such contractsfrom time to time to maintain market presence and customer and partnerrelationships, as such programs often transition to more profitable digitaltechnologies over time. Due to the nature of such international programs andcustomers, the timing of these sales is somewhat less predictable than areservice revenues provided by domestic customers and, consequently,international sales can occur unevenly during the course of a year. We believethat international growth opportunities exist for us and we expect to continueto invest in personnel and resources to support our potential revenue growth outsideof the U.S.

*Service.  *Servicerevenue consists primarily of card production on a price-per-card basis,software development services, and hardware and software maintenance. Themajority of service revenue arrangements are typically structured asprice-per-card product agreements, time and materials consulting agreements, orfixed price consulting agreements. Service revenue is an umbrella categoryconsisting of both service revenue and contract-based service revenue. Thedistinction between these two subcategories is that service revenue isgenerated from long-term identification and driver license productioncontracts, while contract-based service revenue is generated from otherlong-term, time-and-materials service contracts.

Service revenue was $21.6 million and $41.2 millionfor the three- and six-month periods ended June 30, 2005, respectively,compared to $18.5 million and $35.5 million for the three- and six-monthperiods ended June 30, 2004, respectively. The $3.1 million or 17%increase for the three-month period and the $5.7 million or 16% increase forthe six-month period ended June 30, 2005, respectively, as compared to thecorresponding three- and six-month periods of 2004, were primarily due toissuance revenue from new programs for Mexico and Latvia which started generatingrevenue in the second quarter of 2004, Florida which started in third quarterof 2004, and Ohio which started in the first quarter of 2005, offset partiallyby contracts that ended and contracts that converted to consumable sales.

*Product and subscription.  *Productand subscription revenue consists primarily of the sale of equipment andconsumables related to identification card production systems, software licensesales, and subscriptions related to various software products.

Product and subscriptionrevenue was $3.1 million and $7.9 million for the three- and six-month periodsended June 30, 2005, respectively, compared to $5.0 million and $11.6million for the three- and six-month periods ended June 30, 2004,respectively. The $1.9 million or 37% decrease for the three-month period and$3.7 million or 32% decrease for the six-month period ended June 30, 2005,respectively, as compared to the corresponding three- and six-month periods of2004, were due primarily to a non-recurring sale in 2004 to a domestic driverlicense customer and a foreign customer of voter identification supplies andhardware, offset partially by the sale of equipment to a different domesticcustomer in the current year.

*Cost of Revenue*

*Service.  *Costof service revenue primarily includes costs of consumables used in delivering aservice, compensation for software developers, quality assurance personnel,product managers, field operations 

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personnel, and businessdevelopment personnel, outside contractors, depreciation charges for machinery,equipment, capitalized software, and deployment costs used specifically forservice delivery, provisions for obsolete and excess inventories, and travelcosts directly attributable to service and development contracts.

Cost of service revenue was $14.9 million and $28.0million for the three- and six-month periods ended June 30, 2005,respectively, compared to $11.3 million and $21.3 million for the three- andsix-month periods ended June 30, 2005, respectively. The $3.6 million or32% increase for the three-month period and $6.7 million or 32% increase forthe six-month period ended June 30, 2005, respectively, as compared to thecorresponding three- and six-month periods of 2004 were primarily the result ofhigher consumables and general support costs related to the higher revenueidentified above, higher depreciation on revenue-generating assets, increasedcosts to deliver support and maintenance for new and existing programs,increased expense to property taxes, and increased freight costs related tohigher shipping activity, partially offset by lower inventory reserves. Fieldoperations employees totaled 136 and 152 at June 30, 2005 and 2004,respectively.

*Product and subscription.  *Costof product and subscription revenue primarily includes compensation foroperations personnel, costs of consumables sold to third parties, costs ofmachinery sold to third parties, and Internet service provider connectivitycharges and image search data fees to support the services offered to oursubscription customers.

Cost of product andsubscription revenue was $1.1 million and $3.5 million for the three- and six-monthperiods ended June 30, 2005, respectively, compared to $3.4 million and$8.4 million for the three- and six-month periods ended June 30,2004, respectively. The $2.4 million or 69% decrease for the three-monthperiod and $4.9 or 59% decrease for the six-month period ended June 30,2005, respectively, as compared to the corresponding three- and six-monthperiods of 2004 were the result of lower product sales in our ID systemsbusiness in the current year as compared to the prior year. Sales in the firsttwo quarters of 2005 had higher margins compared to the non-recurring sale in 2004of voter identification supplies and hardware to a domestic and a foreigncustomer during the first two quarters of 2004, yielding the decreased cost ofproduct and subscription revenue.

*Gross Profit*

Overall gross profit as a percentage of revenue remainedcomparable for the three- and six-month periods ended June 30, 2005 and was35% and 36%, respectively, compared to the 37% for both the three- andsix-month periods ended June 30, 2004, for the reasons stated above.

We have observedseasonality in the production of driver license issuances and correspondingrevenue in the United States, with larger volumes in the second and thirdquarter of the year, and generally lower volumes in the first and fourthquarters. The fourth quarter is usually the seasonally low quarter each year. Weuse the straight line method of depreciation and amortization forprogram-related assets. The combination of seasonality and straight linedepreciation and amortization can cause significant variations in quarterlygross margin trends, generally increasing margins as a percent of revenue inthe second and third quarter of the year and decreasing margins as a percent ofrevenue in the first and fourth quarters of the year, while having a neutraleffect on a yearly basis. We continue to study the predictability of seasonaltrends and are evaluating potential changes in our depreciation andamortization methods to more closely match the production seasonality in ourbusiness.

*Operating Expenses*

*Sales and marketing.  *Salesand marketing expenses consist primarily of compensation, benefits and relatedcosts of sales and marketing employees, product managers and sales engineers,as well as recruiting, travel, market research, and costs associated withmarketing programs, such as trade shows, public relations and new productlaunches. Sales and marketing expenses were $3.9 million and $7.7 

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million for the three- andsix-month periods ended June 30, 2005, respectively, compared to $2.8million and $5.4 million for the three- and six-month periods ended June 30,2004, respectively.

The $1.1 million or37% increase for the three-month period resulted primarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $0.5 million, despite lower headcount, due topersonnel mix for higher level focus on marketing and governmental activities,and higher benefit program costs;

·  Increasedpresence at tradeshows, advertising, consulting fees and event sponsorship ofapproximately $0.1 million;

·  Increaseduse of other departments in support of sales and marketing activities of$0.3 million, and;

·  Othersmaller sales and marketing expenditures making up the difference.

The $2.3 million or 43% increase for the six-monthperiod resulted primarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $1.0 million, despite lower headcount, due topersonnel mix for higher level focus on marketing and governmental activities,and increased benefits;

·  increasedpresence at tradeshows, advertising, consulting fees and event sponsorship ofapproximately $0.3 million; and

·  Increaseduse of other departments in support of sales and marketing activities of$0.4 million, and;

·  Othersmaller sales and marketing expenditures making up the difference.

Sales and marketing employees totaled 54 and 58 as of June 30,2005 and 2004, respectively. We anticipate that we will continue to invest ator above the current run rate in sales and marketing for the foreseeablefuture.

*Research, development andengineering.  *Research, development and engineeringexpenses consist primarily of compensation, benefits and related costs ofsoftware developers and quality assurance personnel and payments to outsidecontractors. Research, development and engineering expenses were $3.0 millionand $5.5 million for the three- and six-month periods ended June 30, 2005,respectively, compared to $1.6 million and $3.3 million for the three- andsix-month periods ended June 30, 2004, respectively.

The $1.5 million or 94% increase for the three-monthperiod resulted primarily from employee and consulting costs that were eitheradded (approximately $0.7 million) or reallocated from capital projects(approximately $0.8 million) to research activities to enhance existingproducts, develop new products, and focus on requirements of the recentlypassed REAL ID Act. Some areas of focus have been research of card materialsfor enhanced security, new software security features, and new equipment for ourdriver license production. In addition, travel costs increased by $0.3 million.The overall increase was partially offset by decreased contract-labor costs of$0.5 million.

The $2.2 million or 68% increase for the six-monthperiod resulted primarily from the same reasons stated above (added costs ofapproximately $0.9 million and reallocated costs of approximately$0.7 million), in addition to increased travel-related costs of $0.7million partially offset by decreased contract-labor costs of $0.3 million.

We anticipate that we will continue to invest at orabove the current run rate in research and development for the foreseeablefuture. Research, development and engineering personnel totaled 162 and 120 asof June 30, 2005 and 2004, respectively.

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*General and administrative.  *Generaland administrative expenses consist primarily of compensation, benefits andrelated costs of executive, finance and administrative personnel, informationtechnology personnel, facilities costs, legal, human resources and otherprofessional fees, and depreciation and amortization expense not directlyassociated with programs. General and administrative expenses were $7.0 millionand $14.0 million for the three- and six-month periods ended June 30,2005, respectively, compared to $5.0 million and $9.9 million for the three-and six-month periods ended June 30, 2004, respectively.

The $2.0 million or39% increase for the three-month period resulted primarily from the following:

·       increasedheadcount and skills mix to address enhanced governance and internal controlsdrove up employee-related expenses such as salaries, benefits, recruitingcosts, and incentive plans by $0.8 million;

·       auditand consulting fees increased $0.6 million primarily related to ourSarbanes-Oxley audit, compliance, remediation efforts, and finance staffenhancement;

·  increasedother administrative costs of $0.5 million related to and support for ourgrowing infrastructure.

The $4.1 million or42% increase for the six-month period resulted primarily from the following:

·       increasedheadcount and skills mix to address enhanced governance and internal controlsdrove up employee-related expenses such as salaries, benefits, recruiting costs,and incentive plans by $1.3 million;

·       auditand consulting fees increased $1.3 million primarily related to our year-endaudit, restatement work, Sarbanes-Oxley audit, and finance staff enhancement;

·  legalfees increased $0.3 million various corporate matters, including ourrestatement and derivative lawsuits;

·       increasedsoftware expense of $0.2 million related to continued licensing costs andsoftware upgrades; and

·       increasedother administrative costs of $0.5 million related to and support for ourgrowing infrastructure.

General and administrative employees totaled 77 and 62as of June 30, 2005 and 2004, respectively. We expect general andadministrative expenses to decrease somewhat in future periods as we havecompleted the restatement work, but still expect significant legal and otherprofessional fees related to the shareholder derivative lawsuits and increasedaccounting, audit and legal fees related to our compliance with Section 404of the Sarbanes-Oxley Act of 2002. We anticipate that we will continue toinvest in finance and IT and the operational infrastructure at ouridentification systems business to more effectively manage growth in thecontext of increased regulatory requirements.

*Amortization of intangible assets*.   Weaccount for intangible assets resulting from acquisitions in accordance withFASB Statement Nos. 141, *BusinessCombinations*and 142, *Goodwilland Other Intangible Assets*. These statements require the recordingof intangible assets under purchase accounting rules, and require theamortization of such intangible assets over their expected useful life. As aresult, in December 2001 we recorded $29.5 million of intangible assetsrelated to the acquisition of certain assets and certain liabilities fromPolaroid and affiliates. These intangible assets were set up to amortize over a12-year period, representing the expected useful life. Changes incontract status and customer relationships may lengthen or shorten the expecteduseful life of such intangible assets, or cause an impairment charge related tothe intangible asset, so some variability is expected to exist related tointangibles depending on internal and external factors.

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Amortization expense was $1.3 million and $2.2 millionfor the three- and six-month periods ended June 30, 2005, respectively,compared to $0.6 million and $1.2 million for the three- and six-month periodsended June 30, 2004, respectively. The $0.8 million or 143% increasefor the three-month period and $1.0 million or 81% increase for the six-monthperiod ended June 30, 2005, respectively, as compared to the correspondingthree- and six-month periods of 2004 resulted primarily from the acceleratedamortization of intangible balances based on current estimates of useful lives.

*Total other income, net.  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.3 million and $0.5 million for the three- and six-monthperiods ended June 30, 2005, respectively, compared to $0.2 million and$0.4 million for the three- and six-month periods ended June 30, 2004.This increase resulted from higher interest earned on lower balancespartially offset by higher interest expense related to capitalized leases.

*Provisionfor 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 netoperating loss carryforwards and, as such, have included no provision for U.S.federal and state income tax reporting purposes.

**Liquidity and Capital Resources**

As of June 30, 2005, we had cash and cashequivalents, restricted cash, and short-term investments of $36.9 million,representing a decrease of approximately $14.9 million from $51.8 million at December 31,2004. The decrease primarily resulted from investments in significant newprogram implementations, in particular in Florida and Alabama, and cash used tofund operations during the first half of 2005. As of June 30, 2005, $7.3million of cash and cash equivalents is restricted as a result of therequirements of performance bonds that we are obligated to maintain inconnection with some of our long-term contracts in our personal identificationsystems business. Due to the losses incurred during 2004 the terms ofrestriction changed and we were required to classify the restricted cash aslong-term. Working capital at June 30, 2005 was $38.6 million, compared toworking capital of $48.9 million at December 31, 2004. The decrease inworking capital resulted primarily from investments made in the new Florida andAlabama programs that we anticipate will contribute to revenue growth in 2005and due to the net loss incurred during the first half of the year.

The $4.9 million of cash used in operations for thesix months ended June 30, 2005 resulted from a net loss of $11.3 million,offset by non cash items related to depreciation and amortization of $8.6million and an increase in accrued payroll and related costs of $1.3 million.Items negatively affecting cash used in operations were a decrease in accountspayable of $4.0 million and an increase in other current assets of $1.2million. The $6.3 million of cash provided by operations for the six monthsended June 30, 2004 was positively impacted by an increase in accountspayable of $3.5 million, an increase in deferred revenue of $1.1 million anddepreciation and amortization of $5.8 million, partially offset by $2.1 millionof net loss for the period and a decrease in trade and unbilled accountsreceivable, net of $2.9 million.

The $7.7 million of cash provided by investingactivities for the six-month period ended June 30, 2005 primarily relatedto $16.7 million in net sale or maturity of short-term investments partiallyoffset by $9.0 million for the purchase of property and equipment, includingcapitalization of labor costs. The $11.9 million of cash used in investingactivities for the six months ended June 30, 2004 was related primarily to$22.2 million for the purchase of property and equipment, includingcapitalization of labor costs, partially offset by $10.3 million in net sale ormaturity of short-term investments. We also acquired approximately $0.1 offixed assets during 2005 and 2004 through capital lease arrangements.

The $0.1 million of cash used in financing activitiesfor the six-month period ended June 30, 2005 resulted primarily from theprincipal payments on capital leases, partially offset by the proceeds from theissuance of stock. The $1.8 million of cash provided by financing activitiesfor the six months ended 

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June 30, 2004primarily related to the issuance of stock. On January 7, 2004, fiveholders of warrants to purchase shares of common stock exercised their warrantsfor an aggregate of 74,506 shares of common stock, which resulted inapproximately $1.0 million of gross proceeds to us. The remaining proceedsresulted from the issuance of stock related to our stock incentive plans, whichwere partially offset by principal payments on capital leases of $0.1 million.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $9.6 million as of June 30,2005, and are payable in monthly installments through August 2011. Ourobligations under non-cancelable capital leases, which totaled $1.1 million asof June 30, 2005, are payable in monthly installments through March 2009.

We have driver license contracts with various statesthat are not yet fully deployed for which we have estimated the amounts tocomplete. In order to complete these contracts, we estimate we will incurapproximately $4 million of expenditures. The estimates are derived frominformation known to the Company at the time the estimates were prepared.Actual expenditures may vary from our estimates. These expenditures arerecouped through receipts from the long-term price-per-card agreements.

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

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

In order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities although we do not believe atthis time that our long-term working capital and capital expenditures will beof such a nature that we would be required to take steps presently to remedyany such potential deficiency. If it were necessary to obtain additionalfinancings or credit facilities, we may not be able to do so, or if these fundsare available, they may not be available on satisfactory terms.

**Off-Balance Sheet Arrangements**

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

**RecentAccounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards No. 151,*Inventory Costs—an amendment of ARB 43,chapter 4*(FAS 151). FAS 151 clarifies the accounting for abnormalamounts of idle facility expense, freight, handling costs, and wasted material(spoilage) in the determination of inventory carrying costs. The statementrequires such costs be recognized as a current-period expense. FAS 151 alsorequires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. Thisstatement is effective for fiscal years beginning after July 15, 2005. TheCompany does not expect that the adoption of this standard will have a materialimpact on its financial condition or results of operations.

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In May 2005, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections: areplacement of APB Opinion No. 20 and FASB Statement No. 3,” whichrequires companies to apply most voluntary accounting changes retrospectivelyto prior financial statements. SFAS No. 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005. Any future voluntary accounting changes made by us will be accounted forunder SFAS No. 154.

On December 16, 2004, the FASB issued Statement No. 123(R) *Share-Based Payment*, which is arevision 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. Pro formadisclosure of the income statement effects of share-based payments is no longeran alternative. Statement No. 123(R) is effective for all stock-basedawards granted on or after January 1, 2006. In addition, companiesmust also recognize compensation expense related to any awards that are notfully vested as of the effective date. Compensation expense for the unvestedawards will be measured based on the fair value of the awards previouslycalculated in developing the pro forma disclosures in accordance with theprovisions of Statement No. 123. The Company is currently assessing theimpact of adopting Statement 123(R) to its consolidated results ofoperations.

**Risk Factors**

Our business, financialcondition, results of operation and cash flows may be impacted by a number offactors, including the factors set forth below. The order in which these riskfactors are presented does not necessarily reflect their relative significance.

**Risks Related to Our Business**

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

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

·       Wemay be unable to develop sources of new revenue or sustainable growth inrevenue because our current and anticipated technologies, products and servicesmay be inadequate or may be unable to attract or retain customers;

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

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

Some of our keytechnologies are 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 in theevent product changes or improvements are required. Additionally, new industrystandards might redefine the products that we are able to sell, especially ifthese products are only in the prototype stage of development. If productchanges or improvements are required, success in marketing these products andachieving profitability from these products could be delayed or halted. We alsomay be required to fund such changes or improvements out of operating 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 substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new revenueare tied to procurement schedules, which could shift as the needs of therelated government procurement agencies change. Many of these governmentalcustomers are facing continued budget pressures introducing added uncertainty.Any shift in the government procurement process, which is outside our controland may not be predictable, could result in delays in bookings forecasted forany particular financial period, could impact the predictability of ourquarterly results, and might limit our actual revenue in any given quarter,resulting in reduced and less 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 businessinvolves embedding digital watermarks in traditional and digital media,including identification documents, secure documents, audio, video and imagery,and licensing our intellectual property. Through 2001, our revenue stream wasbased primarily on a combination of development, consulting, subscription andlicense fees from copyright protection and counterfeit deterrence applications.Beginning in 2002 and for the foreseeable future, we have seen, and weanticipate, that the majority of our revenue will be from government andprivate-sector customers for providing security-related applications relating tosecure personal identification, copyright protection, and counterfeitdeterrence to such customers. We have not fully developed revenue models forcertain of our future digital watermarking applications and licensingendeavors. In addition, because some of our products and services are not yetwell-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure and marketing for them will be effective. We cannotassure you that our anticipated digital watermarking products and services andlicensable intellectual property will be able to compete effectively againstother alternative technologies or that we will be able to compete effectivelyagainst current or future digital watermarking suppliers in terms of price,performance, applications or other features of their technologies. In addition,as we develop models for generating 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 betweengovernment agencies and Digimarc have varying duration, averaging three to fiveyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. If we were to lose a contract dueto cancellation 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 loselarge contracts.*

We incurred significantnet losses from inception through the fiscal year ended December 31, 2002,during 2004, and the first quarter of 2005. Our accumulated deficit as of June 30,2005 was $76.2 million. In 

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order toattain sustained profitability, we will need to generate higher revenue than wehave in prior years while controlling expenditures. Even though we haveachieved profitability in the past, we were not profitable in 2004 or the firsthalf of 2005. A return to profitability will depend upon a variety of factors,including the impact of new regulatory mandates requiring us to expense stockoptions, the amount of costs we incur in connection with our compliance withSarbanes-Oxley, and the extent of any ongoing expenses that we incur inconnection with our restatement and related matters, such as our continuingremediation efforts with respect to financial controls as well as expensesrelated to litigation and other proceedings that have arisen as a result of therestatement. In addition, we evaluate our strategy and market opportunities onan ongoing basis and will adjust our approach to market conditions that prevailfrom time to time. Accordingly, in the short term we may focus more on growingour revenue and taking advantage of market opportunities than an immediatereturn to profitability. Finally, various adverse developments including theloss of large contracts or cost overruns on our existing contracts could have anegative impact on our revenue or our margins. 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 common stock may be delisted from the NasdaqNational Market, which may, among other things, reduce the price and theliquidity of our common stock.*

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 our Form 10-Q for the quarterended September 30, 2004. On April 6, 2005, we were advised by Nasdaqthat, due to our failure to timely file our Form 10-K for the yearended December 31, 2004, our common stock was subject to delisting fromThe Nasdaq Stock Market. On April 29, 2005, we were advised by Nasdaq thatthe Nasdaq Listing Qualifications Panel (the “Nasdaq Panel”) had determined tocontinue the listing of our common stock on the Nasdaq National Market providedthat we amend our Form 10-K for the year ended December 31,2004 on or before May 16, 2005 to include our internal control reportsrequired by Section 404 of the Sarbanes-Oxley Act, and provided that wetimely file all periodic reports with the SEC and Nasdaq for all reportingperiods ending on or before December 31, 2005. We filed our Form 10-Qfor the quarterly period ended March 31, 2005 on May 16, 2005, fivebusiness days after the prescribed due date, in reliance on Rule 12b-25.We filed our amended Form 10-K for the year ended December 31,2004 on June 1, 2005, which included the report on management’s assessmentof the effectiveness of internal control over financial reporting and therelated attestation report of our independent registered public accounting firmas required by Section 404 of the Sarbanes-Oxley Act and the Nasdaq Panel’sApril 29, 2005 decision.

Separately, on May 4, 2005, we were notified byNasdaq that the Nasdaq Listing and Hearing Review Council (the “Listing Council”)has called for review the March 22, 2005 decision by the Nasdaq Panelregarding Digimarc. In the March 22, 2005 decision, the Nasdaq Panelgranted our request to extend the deadline to March 31, 2005 to file our Form 10-Qfor the quarterly period ended September 30, 2004 and our Form 10-Kfor the year ended December 31, 2004, including all required restatementsof prior periods. The March 22, 2005 decision was called for review toconsider whether the Nasdaq Panel’s decision to grant such extension wasappropriate. The Listing Council has the authority to review on its own motionall decisions of the Nasdaq Listing Qualifications Panels and may affirm,modify, reverse, dismiss, or remand the March 22, 2005 decision to theNasdaq Panel. On July 5, 2005, the Company received a letter from Nasdaqinforming the Company that the Nasdaq Listing and hearing Review Council (the “NasdaqCouncil”) had withdrawn its call for review of the March 22, 2005 decisionof the Nasdaq Panel granting the Company’s request to extend to March 31,2005 the deadline for filing the Company’s Form 10-Q for the quarterended September 30, 2004 and the Company’s Form 10-K for theyear ended December 31, 2004.

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As a result of thewithdrawal of the Nasdaq Council’s call for review of the March 22, 2005Nasdaq Panel decision, there are no pending delisting proceedings with respectto the Company’s common stock. The Company has filed all periodic reportsrequired to be filed with the SEC and is in compliance with all requirementsfor continued listing on the Nasdaq National Market. However, if the Companyfails to timely file such periodic reports that are required in the future, ourcommon stock may be delisted from the Nasdaq National Market. If our commonstock is delisted, it would be listed on some other quotation medium, such asthe “pink sheets,” depending upon our ability to meet the specific listingrequirements of those quotation systems. In the event our common stock isdelisted from the Nasdaq National Market, the visibility, liquidity and priceof our common stock may be reduced, our stockholders may find it more difficultto dispose of, or to obtain accurate price quotations for, our shares. Inaddition, if our common stock is delisted from the Nasdaq National Market, itmay also result in other negative implications, including the potential loss ofconfidence by suppliers, customers and employees, the loss of institutionalinvestor interest, the inability of the Company to raise additional equitycapital, and fewer business development opportunities.

*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, ondeployment of our watermark reader technology by third parties. For example,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. Although such anticipated revenue amounts arenot currently significant, they may be in the 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 such 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 asanticipated. In addition, if our technologies do not perform according tomarket expectations, our future sales would suffer as customers seek otherproviders and, consequently, our anticipated future revenues would decrease.

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. While we strive to havealternative suppliers provide us with many of our products, a loss of one ormore of such suppliers could have a material adverse effect on our ability toperform effectively, if at all, for some 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 

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or other damages. Suchprovisions are common in large scale government contracts at the state andfederal levels. These contracts include installation, customer acceptance andtesting, and other delivery and related procedures. 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 meetsuch requirements or milestones, customers may assert against us compensatoryor liquidated damages, breach of contract, or other claims. Consequently, ourfailure to meet contractual milestones or other performance requirements aspromised could result in our having to incur increased costs, lower margins, orcompensatory obligations, in addition to other losses, such as harm to ourreputation. Such unexpected increases in costs to meet our contractualobligations or any other requirements necessary to address claims and damageswith regard to our customer contracts could have a material adverse effect onour business and financial results. We anticipate that future contracts willcontinue to have such provisions unless and until industry practices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on such contracts inthe recent past. Such contracts involve greater financial risks because we bearthe risk 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 ofour business depends on a limited number of large, public-sector contracts,which are generally subject to termination for convenience, as determined bythe subject agency, or for lack of budgetary appropriation provided for thesubject agency. Some government contracts also may be one-time events, such asin the case of some personal identification systems in non-U.S. marketsinvolving voter registration programs. In such cases, we may generatesubstantial revenue that may not be subject to future renewal. Moreover,government contracts result from purchasing decisions made by public sectoragencies that may be subject to political influence, unusual procurement procedures,strict legal requirements, budget changes and cutbacks during economicdownturns, variations in appropriations cycles, and protests of contractawards. Additionally, some governmental authorities require performance bondsthat we are obligated to maintain during the life of the contract. Often, theterms of these bonds require that we maintain large restricted cash reserves asa guarantee, reducing our ability to use these funds for our other businesspurposes. Even with the availability of such cash reserve guarantees, we maynot be able to obtain such performance bond underwriting at a favorable rate orat 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 purposeof, and the risks and uncertainties associated with, public sector contractscan potentially cause our quarterly results to fluctuate and anticipatedrevenue 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 agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure identification issuance systems. For example, it is customary for stateagencies to require that a vendor fund the capital-intensive initial deploymentof a driver license issuance system (the costs of which the vendor normallyrecoups over the life of the contract in per-card fees), while reserving theright to terminate the contract for convenience. Similarly, in connection withintellectual property rights, a contract may require that our pre-existingissuance system software be written in a different language and a state 

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may thenargue that it falls within the class of works for which it owns the copyright,enabling the state to turn the Digimarc-authored software over to one of ourcompetitors, dedicate it to the public domain, or otherwise use the software ina manner detrimental to our business. Objectionable contract terms may lead usto decline to bid on identification issuance systems to new customers, or todecline to retain business with customers we have historically served, whichcould reduce our market share and lower our revenues or profits. In addition,if we decline to retain business with customers we have historically served, itcould result in the accelerated depreciation of intangible assets.Alternatively, we may decide to accept at least some level of objectionableterms rather than cede an important contract to a competitor, which could alsolower 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 not experience a timely, positive reaction from issuingauthorities to our new offerings, our projected revenues, margins and earningsmay be negatively impacted and, consequently, the future market price of ourcommon stock might experience significant volatility.

In addition, we aredeveloping new sales channels in domestic and foreign markets for certaincomponents and subsystems of our domestic driver license solutions. 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 secure identitysystems business expects to experience variability in gross margins.*

We are likely to experiencevariability in gross margins on its contracts due to numerous factors,including, among other things, the following:

·       Governmentalregulation of credentials and issuance policies;

·       Privatesector usage trends for driver licenses and other credentials;

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

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

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

·       Variationsin costs of materials and manufacturing;

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

·       Seasonalityof issuance volumes;

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

·       Salesmix related to domestic sales compared to international sales;

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

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·       Strategicdecisions on new business; and

·       Depreciationand amortization of capitalized project costs related to new or upgradedprograms.

The numerous factorsaffecting gross margins make such margins complex and difficult to predict. Weare continually refining our predictive tools and increasing our understandingof what drives these various factors. For reasons such as those listed above,we expect that there will be fluctuations in our future operating results as aresult of the variability in margins from period to period in the secureidentity systems business.

*Recent and ongoing leadership and staffing changes mayresult 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 quarterof 2004, we made significant changes in our management and staff as a result ofa detailed review of our business processes. Many of these changes wereinitiated following the hiring of our new Chief Financial Officer in June 2004and other senior managers, and in conjunction with the continuingimplementation of our new accounting and material requirements planning systemsand work on Sarbanes-Oxley compliance. In addition, in the second quarter of2005, we appointed a new President of ID systems and government programs operations,and our President and Chief Operating Officer resigned. While we anticipatethat these changes in leadership and staffing will improve operations, there isa risk that these changes may disrupt the operations of our business and,consequently, may result in some short-term inefficiencies as personnelcomplete their transitions and new leaders implement their new plans andprocedures. We also expect that these changes may require further modificationsof our finance and business processes and will likely cause additional costs toour business in the short term before any benefits from such changes, if any,may be realized.

*We may encounter significant employee turnover, anddifficulties in hiring new employees, that could reduce our ability to sell,deliver, and support future commitments.*

Due to concerns related toour restatement, late SEC filings, possible delisting from the Nasdaq NationalMarket and shareholder litigation, we could encounter significant departures ofkey employees from the Company and difficulties in hiring new employees. Whilewe are taking steps to support employee retention, there can be no assurancesthat key employees will not leave the Company for other jobs, thus impairingour ability to meet commitments and sustain revenue. In addition, these eventsmay have a negative impact on the market price of our common stock, andemployees and prospective employees may factor in the uncertainties relating toour stability and the value of any equity-based incentives in their decisionsregarding employment opportunities and decide to leave our employ. Theseuncertainties also could result in an erosion of morale, and affect the focusand productivity of our remaining employees, including those directlyresponsible for revenue generation, which in turn may affect our revenue in thefuture. Additionally, current employees may seek future employment with ourbusiness partners, customers or competitors. Although we generally attempt tocontrol access to and distribution of our proprietary information by ouremployees, 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 could have a material adverse effect on ourfinancial and business prospects. For more information about the shareholderlitigation, 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 asignificant extent on the performance and continued service of our seniormanagement. Except for our Chief Executive Officer, our senior management doesnot have employment 

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agreements.The loss of the services of any of our senior management or any of our otherkey employees could delay projects or undermine customer relationships.

*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 license successfully our products, services, and intellectual propertydepends to a significant degree upon the continued contributions of our keypersonnel in engineering, sales, marketing, operations, legal and licensing,many of whom would be difficult to replace. Similarly, without the continuedcontributions of our key finance personnel, we believe that our ability to meetour reporting obligations and operate successfully as a public company may belimited. We believe our future success will depend in large part upon ourability to retain our current key employees and our ability to attract,integrate and retain such personnel in the future. It may not be practical forus to match the compensation certain of our employees could garner at otheremployment. Our business is also based in part on patented technology, which isunique and not generally known. New employees require substantial training,involving significant resources and management attention. Competition forexperienced personnel in our business can be intense. If we do not succeed inattracting new, qualified personnel or in integrating, retaining and motivatingour current personnel, our growth and ability to deliver products and servicesthat our customers require may be hampered. Although our employees generallyhave executed agreements containing non-competition clauses, there is noassurance that a court would enforce all of the terms of these clauses or theclauses generally. If these clauses were not fully enforced, our employeescould be able to freely join our competitors.

*We are engaged inlitigation from time to time which is unpredictable and can lead to unplannedexpenses.*

From time to time we areengaged in litigation with third parties. For example, we currently are engagedin litigation relating to the initial public offering of our securities andvarious other routine actions, in addition to the class actions filed againstus in connection with our previously announced accounting errors. Litigationtypically is an expensive process and, due to its inherent uncertainties andbecause the settlement and trial preparation processes are lengthy andpotentially inconclusive, the ultimate cost and outcome of such matters cannotbe predicted. As a result, while we believe that litigation often is necessaryto preserve the interests of our company, it also can lead to additionalexpense and thus lower profits to our business without generating offsettingand 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.

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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, litigationagainst known infringers of our patent rights, or may cause us not to file for,or pursue, patent protection for all of our inventive technologies injurisdictions where they may have value. Some governmental entities that mightinfringe our intellectual property rights may enjoy sovereign immunity fromsuch claims. Failure to reliably enforce our patent rights against infringersmay make licensing more difficult. If we fail to protect our intellectualproperty rights and proprietary technologies adequately, if there are changesin applicable laws that are adverse to our interests, or if we become involvedin litigation relating to our intellectual property rights and proprietarytechnologies or relating to the intellectual property rights of others, ourbusiness could be seriously harmed because the value ascribed to ourintellectual 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 incursignificant litigation, settlement, or judgment expenses. Similarly, as we seekto broaden the number of companies licensed under our patent portfolio, somemay seek contractual assurances that we will pursue—by litigation ifnecessary—their competitors who use our patented technology but are notlicensed to do so. Compliance with any such contract provisions may requirethat we pursue litigation where our costs exceed 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 as other countries. We are pursuing theregistration of “DIGIMARC” in additional countries, and we are pursuing theregistration of certain other trademarks including “IDMARC”, “EXIAN” and “CENTRIAN”.However, our trade names or trademarks may be registered by third parties inother 

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countries, impairing ourability to enter and compete in these markets. In the United States, thetrademark “Digimark” and the domain names “Digimark.com” and “Mediabridge.com”have been registered by unrelated companies. While we have put in place formalarrangements for co-existence with one of these unrelated companies, and whilewe have co-existed successfully to date with the other, if we were forced tochange our name or were prevented from using our other brand names, we wouldlose a significant amount of our brand equity.

As more companies engagein business activities relating to personal identification technologies anddigital watermarking, and develop corresponding intellectual property rights,it is increasingly likely that claims may arise which assert that some of ourproducts or services infringe upon other parties’ intellectual property rights.These claims could subject us to costly litigation, divert management resourcesand result in the invalidation of our intellectual property rights. Theseclaims may require us to pay significant damages, cease production ofinfringing products, terminate our use of infringing technologies or developnon-infringing technologies. In these circumstances, continued use of ourtechnologies may require that we acquire licenses to the intellectual propertythat is the subject of the alleged infringement, and we might not be able toobtain these licenses on commercially reasonable terms or at all. Our use ofprotected technologies may result in liability that threatens our continuingoperation. In addition, we offer indemnification against intellectual propertyinfringement for some contracts to which we are a party. As deployment of ourtechnology increases, and more companies enter our markets, the likelihood of athird party lawsuit resulting from such indemnification increases. If a claimwere made under such an indemnity provision, we could incur significantexpense.

*The securitysystems used in our product and service offerings may be circumvented orsabotaged by third parties, which could result in the disclosure of sensitivegovernment information or private personal information or cause other businessinterruptions that could damage our reputation and disrupt our business.*

Our business relies on computers and other informationtechnologies, both in-house and at customer and vendor locations. In addition,many of the systems we sell manage private personal information and protectinformation involved in sensitive government functions. The protective measuresthat we use in these systems may not prevent security breaches, and failure toprevent security breaches may disrupt our business, damage our reputation, andexpose us to litigation and liability. A party who is able to circumventsecurity measures used in these systems could misappropriate sensitive orproprietary information or materials or cause interruptions or otherwise damageour products, services and reputation, and the property of our customers. Ifunintended parties obtain sensitive data and information, or create bugs orviruses or otherwise sabotage the functionality of our systems, we may receivenegative publicity, incur liability to our customers or lose the confidence ofour customers, any of which may cause the termination or modification of ourcontracts. Further, our insurance coverage may be insufficient to cover lossesand liabilities that may result from such events.

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

*Our products couldhave unknown defects or errors, which may give rise to claims against us ordivert application of our resources from other purposes.*

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 indelays in the development and implementation of products and systems, loss ofrevenue or market share, failure to achieve market acceptance, diversion of developmentresources, injury to our reputation, increased insurance costs and increasedservice and warranty costs. Furthermore, we often provide 

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implementation,integration, customization, consulting and other technical services inconnection with the implementation and ongoing maintenance of our products. Theperformance of these products typically involves working with sophisticatedsoftware, computing and communications systems. Our inability to meet customerexpectations or project milestones in a timely manner could also result in aloss of, or delay in, revenue, loss of market share, failure to achieve marketacceptance, injury to our reputation, increased costs and potential claims ofbreach of contract and compensatory 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. Thesedefects or errors could also result in product liability or warranty claims.Although we attempt to reduce the risk of losses resulting from these claimsthrough warranty disclaimers and liability limitation clauses in our salesagreements when we can, these contractual provisions are sometimes not includedand may not be enforceable in every instance. Furthermore, although we maintainerrors and omissions insurance, this insurance coverage may not adequatelycover these claims. If a court refuses to enforce the liability-limitingprovisions of our contracts for any reason, or if liabilities arose that werenot contractually limited or adequately covered by insurance, the expenseassociated with defending such actions or paying the resultant claims could besignificant and decrease our profits.

As our digital watermarkingsolutions are more broadly deployed by our customers, our potential exposure tolitigation may increase. For example, as we provide technology solutions tocustomers, our offerings may face product liability or intellectual propertyinfringement claims (as is the possibility with any technology), either aloneor in conjunction with our customers.

*We may acquireother businesses or technologies and, if we do, we may be unable to integratethem with our own business, or we may have reduced earnings from doing so andwe may never achieve any of the benefits that we might anticipate from suchacquisitions.*

From time to time we mayacquire other businesses, assets and technologies. Such acquisitions involvecertain risks. We may not be able to identify, negotiate or finance any futureacquisition successfully. We may incur additional or one-time charges relatedto the pursuit of acquisitions or restructurings or other matters in connectionwith acquisitions. Other than the acquisition of LGP in 2001, we have limitedexperience in integrating an acquired business into our existing business. Theprocess of integration may produce operating difficulties (like thoseexperienced with the LGP acquisition) and may require significant attention ofour management that otherwise would be available for the ongoing development ofour business. In the end, we may be unsuccessful in integrating an acquiredbusiness, technology or other asset with our existing business. Moreover, if wemake acquisitions, we may issue shares of our stock that would dilute theequity holdings of our existing stockholders, incur debt, assume contingentliabilities or create additional expenses related to amortizing intangible andother acquired assets. Any of these may result in reduced earnings and causeour stock price to decline. Our due diligence of acquired companies may fail toreveal material risks or liabilities. Additionally, in order to take advantageof opportunities, we may find it necessary to obtain additional equityfinancing, debt financing, or credit facilities, and we may not be successfulin doing so on satisfactory terms. Any financing that we might need for futureacquisitions may also place restrictions on our business. Furthermore, we maynever achieve any of the benefits that we might anticipate from a futureacquisition.

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*As internationalcustomers have accounted for approximately 18% of our total revenue during thesix months ended June 30, 2005, the loss of these customers or the failureto find new customers may result in a decline in our international revenue,which could lower our profitability and slow our growth.*

We expect revenuefrom sales of products and services to governments and other customers outsidethe U.S. to represent a growing percentage of our total revenue in the future.International sales and services are subject to a number of risks, includingthe following:

·       changesin foreign government regulations and security requirements;

·       exportlicense requirements, tariffs and taxes;

·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       longerpayment cycles than those for customers in the United States;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

If our customers are affected by these risks, theirability to purchase our products and services could be reduced significantly.And, as a result, they may decide to terminate or delay the implementation ofour products and services. Any such actions by foreign customers, in particularforeign government authorities, could potentially delay or reduce ouranticipated revenue under our contracts with such customers, and we may havelimited recourse against them to recover any potential losses.

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

**RisksRelated to the Restatement of Our Prior Financial Results and Internal Controls**

*We have identifiedcertain issues relating to our controls and procedures, which, if not remediedeffectively, could impede our ability to run and monitor our business.*

Management concluded thatcertain problems in our internal controls and procedures resulted in therestatement of our financial statements and the inability to timely filereports with the SEC and constituted material weaknesses as of December 31,2004. We made this determination in consultation with the audit committee ofthe Company’s board of directors. We have acted promptly to address theseissues and are engaged in an ongoing design and implementation process of newand enhanced controls and procedures. If we are unable to identify and remedyall such issues promptly and effectively, it could have a material adverseeffect on our business, as well as impair our ability to meet our quarterly andannual reporting requirements in a timely manner. While we are completing thedesign, implementation and testing of our enhanced controls environment, thecontrols and procedures on which we currently rely may fail to be sufficientlyeffective, and such controls and procedures may not be adequate to prevent ordetect errors or ensure the accuracy of our financial statements or reportsfiled with the SEC. Further, any system of control, however well designed andoperated, is based in part on certain assumptions and can provide onlyreasonable, and not absolute, assurance that the objectives of the system aremet. The failure or circumvention of our controls, policies and procedurescould have a material adverse effect on our 

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compliancewith disclosure and listing requirements, and if they were to lead to afinancial loss, could negatively affect the results of our operations andfinancial condition. For more information about the material weaknesses in ourinternal control over financial reporting, see Item 4 of Part I ofthis Form 10-Q.

*We were notsuccessful in meeting the requirements under Section 404 of theSarbanes-Oxley Act of 2002 in a timely basis and the market price of ourcommon stock and our regulatory compliance may be adversely affected as aresult. Moreover, our assessment of the effectiveness of our internal controlover financial reporting as required by Section 404 has identifiedadditional issues relating to our internal controls and has resulted 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 were not able tocomplete the evaluation and testing of our internal control over financialreporting as required by Section 404 of the Sarbanes-Oxley Act of 2002within the time prescribed by SEC rules. The focused application of criticalresources to our accounting review in connection with the restatement of ourfinancial statements and the preparation of filings with the SEC reflecting therestatement had a significant impact on our Section 404 compliance efforts. Following completion of our evaluationand testing of such internal controls, we filed a Form 10-K/A withthe SEC, which included our report on internal control over financial reportingand the related attestation report of the Company’s independent registeredpublic accounting firm. Our internal control assessment confirmed materialweaknesses in our internal control over financial reporting that we previouslydisclosed in our Form 10-K and Form 10-K/A for the yearended December 31, 2004. Consequently, our assessment resulted in anattestation report with an opinion from our independent registered publicaccounting firm that the Company had not maintained effective internal controlover financial reporting as of December 31, 2004. This opinion and our Section 404assessment could have an adverse effect on investor perceptions of the Companyand cause a decline in the market price of our common stock.

*We are investingsignificant 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.*

Changes in the laws andregulations that have recently been enacted, including provisions of theSarbanes-Oxley Act of 2002, are likely to continue to increase our expenses aswe devote resources in response to them. For example, we already have deployedsignificant resources to document, implement and test our financial processesas part of our implementation of the requirements under Section 404 of theSarbanes-Oxley Act of 2002, including the requirements under Section 404for our management to report on, and our independent registered publicaccounting 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 risksrelated to securities litigation and investigations that could have a materialadverse 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 statements.Following this announcement, three class action lawsuits were commenced againstus and certain of our current and former officers by persons claiming to havepurchased or otherwise acquired our securities at specified dates. In addition,three purported shareholder derivative lawsuits were filed against the Companyand certain of our officers and directors, claiming that certain of ourofficers and directors breached their fiduciary duties to the Company’sstockholders and to the 

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Company. Additionallawsuits may be filed against us. Defending against existing and potentiallitigation relating to the restatement of our consolidated financialstatements, or responding to other regulatory inquiries or investigations, willlikely require significant time, attention and resources of management, whichmay adversely affect our business, results of operations and financialcondition.

Our response to theforegoing legal matters will likely result in significant future legalexpenses, some of which will not be covered by insurance. Predicting theresolution of legal claims is inherently uncertain. Accordingly, it is notpossible to state with certainty the remedies that may be sought or obtained inthe foregoing legal proceedings. There is a risk that these proceedings couldhave a material impact on the Company’s financial performance or its businessin the future.

*If a judgment wereto be entered against the company and our director and officer liabilityinsurance was inadequate or unavailable, the obligation to pay the judgment maymaterially harm our business and financial condition.*

Our director and officerliability insurance policies provide liability protection relating to thesecurities class action and derivative lawsuits against us and certain of ourofficers and directors up to prescribed policy limits. If these policies do notadequately cover expenses and certain liabilities relating to these lawsuits,our financial condition could be materially harmed. In addition, if thisinsurance coverage becomes unavailable to us or premiums increase significantlyin the future, it could make it more difficult for us to retain and attractofficers and directors and could expose us to potentially self-funding certain futureliabilities ordinarily mitigated by director and officer liability insurance.

*We could faceadverse consequences as a result of our late SEC filings and the restatement ofour historical financial statements.*

We failed to timely file our Form 10-Q forthe quarterly period ended September 30, 2004 and our Form 10-Kfor the year ended December 31, 2004. As a result of these late filings,we will not be eligible to use a “short form” registration statement on Form S-2or S-3 for a period of 12 months after we become current in ourfilings. Our inability to use a short form registration statement for a periodof 12 months after becoming current in our SEC reporting obligations mayimpair our ability, or increase the costs and complexity of our efforts, toraise funds in the public markets should we desire to do so during this oneyear period. In addition, if we are unable to remain current in our financialfilings, we may face additional adverse consequences, including (1) aninability to have a registration statement under the Securities Act of 1933covering a public offering of securities declared effective by the SEC, (2) aninability to make offerings pursuant to existing registration statements(including registration statements on Form S-8 covering employeestock plans) or pursuant to certain “private placement” rules of the SECunder 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. Theserestrictions may adversely affect our ability to attract and retain keyemployees and may further impair our ability to raise funds in the publicmarkets should we desire to do so.

In addition, our futuresuccess depends largely upon the support of our customers, suppliers andinvestors. The restatement and late SEC filings have resulted in negativepublicity, 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 or potentialsuppliers may re-examine their willingness to do business with us, to developcritical interfaces to our products or to supply products and services if theylose confidence in our ability to fulfill our commitments. Any of these lossescould have a material adverse effect on our financial and business prospects.

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**Risks Related to Our Industry**

*If we are unable torespond to regulatory or industry standards effectively, or if we are unable todevelop and integrate new technologies effectively, our growth and thedevelopment of our products and services could be delayed.*

Our future success will depend in part on our abilityto enhance and improve the responsiveness, functionality and features of ourproducts and services in accordance with regulatory or industry standards. Ourability to remain competitive will depend in part on our ability to influenceand respond to emerging industry and governmental standards, in a timely andcost-effective manner. If we are unable to influence these or other standardsor respond to such standards effectively, our growth and the development ofcertain products and services could be delayed.

Our market ischaracterized by new and evolving technologies. The success of our businesswill depend on our ability to develop and integrate new technologieseffectively and address the increasingly sophisticated technological needs ofour customers in a timely and cost-effective manner. Our ability to remaincompetitive will depend in part on our ability to:

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

·       Continueto develop our technical expertise; and

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

We cannot assure you thatwe will be successful in responding to these technological and industrychallenges in a timely and cost-effective manner. If we are unable to developor integrate new technologies effectively or respond to these changing needs,our margins could decrease and our release of new products and services couldbe slowed.

*If leadingcompanies in our industry or standard-setting bodies or institutions downplay,minimize, or reject the use of digital watermarking, its deployment may beslowed and our revenue growth may be diminished.*

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

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*The market for ourproducts is highly competitive, and as a result, alternative technologies orlarger 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. The potential for aninflux of federal funds into our core U.S. driver license market is likely todraw new competition. As we expand the applications for our technologies, wewill experience more competition from products and services that aresubstitutes for our applications. Because our digital watermarking business isnew and emerging, we also may face competition from unexpected sources.Alternative technologies that may directly or indirectly compete withparticular applications of our watermarking technologies include:

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

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

·       DataGlyphs®—aslightly visible modification of the characteristics of an image or documentthat is machine-readable;

·       ScrambledIndicia®—an optical refraction-based data-hiding technique that is insertedinto an image and can be read with a lens;

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

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

·       Internettechnologies—numerous existing and potential Internet access and search methodsare competitive with the Digimarc MediaBridge system and the searchingcapabilities of Digimarc ImageBridge;

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

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

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

In addition, as we more broadly apply our digitalwatermarking technologies to the Internet through new commercial solutionsapplications, we may begin to compete with a wide range of other types ofcompanies beyond those companies using digital watermarking technologies andalternative technologies. 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.

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New developments areexpected to continue, and we cannot assure you that discoveries by others,including current and potential competitors, will not render our services andproducts noncompetitive. Moreover, because of rapid technological changes, wemay be required to expend greater amounts of time and money than currentlyanticipated to develop new products and services, which in turn may necessitateus to require greater revenue streams on such products and services to coverdevelopmental costs. We cannot assure you that we will be able to competesuccessfully against current or future participants in our market or againstalternative technologies, nor can we assure you that the competitive pressureswe face will not decrease our revenue and profits in the future.

*Terrorist attacksand threats of, or actual, war may negatively impact all aspects of ouroperations, revenue, costs and stock price.*

Threats of terroristattacks in the United States, as well as future events occurring in response toor in connection with them, including, without limitation, future terroristattacks or threats against United States targets, rumors or threats of war,actual conflicts involving the United States or its allies, or military ortrade disruptions, may impact our operations by leading to deferred orcancelled projects, which may reduce our revenue and profits. While any ofthese terrorist-related events could result in an increased need for newsecurity features that may, as a result, favorably impact our revenues from ourgovernment programs operations and our sales of product and subscription andservice in connection with our digital watermarking technology, any of theseevents could also, or alternatively, result in increased volatility in theUnited States and worldwide financial markets and economies, or drive up ourresearch, development and engineering costs associated with attempting toachieve heightened effectiveness in new products. Also, any of theseterrorist-related events could result in economic recession in the UnitedStates or abroad. If such negative consequences were to occur, they couldreduce our revenue and profits without the effect of reducing costs in theshort-term and might result in the volatility of the future market price of ourcommon stock.

**SafeHarbor Statement under the Private Securities Litigation Reform Act of 1995**

Because this Report on Form 10-Qcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995, any of the risk factors set forthabove or elsewhere in this Report on Form 10-Q or incorporatedherein by reference could cause our actual results to differ materially fromthose results projected or suggested in such forward-looking statements.Statements that are not historical facts are hereby identified as “forward-lookingstatements” for the purposes of the safe harbor provided by Section 21E ofthe Securities Exchange Act of 1934 and Section 27A of the Securities Actof 1933. Such forward-looking statements include but are not limited tostatements relating to trends and expectations in revenue growth, includingwith regard to programs in Florida, Ohio, Alabama, Latvia and Mexico,statements regarding the expected deployment of programs in 2005, 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 in domestic andforeign markets to our future results, statements regarding future effects onour business in connection with the continuing implementation of our newaccounting and material requirements planning systems and modifications to ourinventory 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 the 

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Companyof our recent restatement, late SEC filings, possible delisting from Nasdaq andshareholder litigation, statements regarding our expected short-term andlong-term liquidity positions, statements regarding our use of cash in upcomingquarters, statements relating to the Company’s compliance with Nasdaq’sconditions for continued listing on the Nasdaq National Market, and otherstatements containing words such as “anticipate,” “estimate,” “expect,” “managementbelieves,” “we believe,” “we intend” and similar words or phrases, which areintended to identify forward-looking statements. Actual results may varymaterially due to, among other things, the failure of the potential markets forthe Company’s digital watermarking technology to develop as anticipated, theadoption of alternative technologies within these markets, the inability of theCompany to become profitable, inherent limitations in all control systems andrelated procedures, risks as to litigation and related matters in connectionwith our restatement of financial results, the actual timing and impact of ourcompliance with Section 404 of the Sarbanes-Oxley Act of 2002, changesresulting from any key personnel additions or changes, as well as changes ineconomic, business, competitive, technology and/or regulatory factors andtrends, and the other factors described in this Form 10-Q or in ourother documents filed with the SEC, including our Form 10-K for theyear ended December 31, 2004. 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.Investors should understand that it is not possible to predict or identify allrisk factors and that the risks discussed above should not be considered acomplete statement of all potential risks and uncertainties. We do not intendto update any forward-looking statements as a result of future events ordevelopments.

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk.**

The Company’s market riskdisclosures as set forth in Item 7A of its Annual Report on Form 10-Kfor the year ended December 31, 2004 have not changed materially.

**Item 4. Controls and Procedures.**

**Changes in Internal Controls**

As previously disclosed, we identified during thethird quarter of 2004 certain errors in the accounting for software developmentcosts and project capitalization and we postponed the release of our financialresults for the quarter ended September 30, 2004 pending the completion ofour review of these accounting errors. We identified these errors as a resultof our review of our accounting and our review of our internal control overfinancial reporting in preparation for compliance with Section 404 of theSarbanes-Oxley Act of 2002 and its implementing regulations. This reviewinvolved 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 financial statements.During the course of our review, we determined that certain prior periodfinancial statements required restatement. As a result, we restated ourconsolidated financial statements as of and for (1) the year ended December 31,2003, including each of the quarterly periods in the year ended December 31,2003, and (2) the quarterly periods ended March 31, 2004 and June 30,2004. Our restated quarterly information and our restated financial statementsare included in the Form 10-K for the year ended December 31,2004, which was filed on April 7, 2005.

As previouslydisclosed in our Form 10-K/A filed on June 1, 2005, ourmanagement concluded, based on an evaluation of the effectiveness of ourinternal control over financial reporting under Section 404 of theSarbanes-Oxley Act of 2002, that our internal control over financial reportingwas not effective as of December 31, 2004. In connection with ourassessment, we identified and reported to our audit committee the followingareas for improvement in our internal control over financial reporting. Thesematters 

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constitute“material weaknesses” as defined under standards established by the PublicCompany Accounting Oversight Board or “PCAOB”.

·  *Inadequatesupervision and technical accounting expertise within the accounting andfinance department.  *There was not adequate supervision andtechnical accounting expertise within our accounting and finance department.The personnel resources and technical accounting expertise in the accountingand finance department were not sufficient to adequately resolve non-routinematters or complex accounting processes, such as those matters and processesrelating to the recording of software capitalization, standard costing, andrevenue recognition in accordance with U.S. generally accepted accountingprinciples (“U.S. GAAP”).

·  *Inadequatedesign and implementation of new accounting system.  *The newaccounting system we began to implement in the second quarter of 2002, andwhich was placed in service during the fourth quarter of 2003, was not designedor implemented properly. There was a lack of accounting expertise within ouraccounting and finance department; as a result our internally developedguidelines were not properly implemented during the setup and configuration ofthe new accounting system. Implementation of the new accounting system also wasflawed because some of our accounting and finance employees were not properlytrained in the use of the new accounting system. In addition, the new and oldaccounting systems were not operated in parallel prior to the Company’sreliance on the new system. Running new and old accounting systems in parallelhelps validate that the new system is correctly recording accounting entries.These implementation issues resulted in errors with respect to fixed assets andinventory, including the duplicate recording of purchases, the capitalizationof assets that should have been expensed and the expensing of assets thatshould have been capitalized.

·  *Inadequatequarterly and year-end financial statement close and review process.  *Foreach quarterly and fiscal year-end period, a financial statement close andreview process occurs. Our staffing for the quarterly and year-end financialstatement close process was not sufficient, and in some instances, we failed tohave adequate management review and supervision over the financial statementclose and review process, including timely reconciliation of inventory, tax andaccounts payable accounts to ensure our financial statements were prepared inaccordance with U.S. GAAP. Where there was a review process, documentation ofapprovals was not always evident.

·  *Insufficient controls bothfor determining the nature and types of costs that should be capitalized andfor ensuring allocation of costs to particular projects are appropriate.*   Controlsfor determining the nature and types of costs that should be capitalized inaccordance with U.S. GAAP, and for ensuring that costs were allocated toappropriate projects, were inadequate, which affected our fixed asset andresearch and development accounts. We lacked enough personnel with sufficientexpertise in complex software capitalization and project accounting rules underU.S. GAAP and there was not a clear understanding regarding the application ofour internal policies in these areas. Some of our employees who performedaccounting functions were not adequately trained and supervised, and there weredeficiencies in communication between functional departments within theCompany. Such controls also were insufficient because the documentary supportfor the historical 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, state, and local tax exposures werequantified and properly accrued on a timely basis.*   Internalcontrols related to the quantification and accrual of international, state, andlocal taxes incurred by the Company were insufficient. There was not sufficientstaff to properly quantify, accrue, and record such taxes on a timely basis inaccordance 

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with U.S. GAAP. Thisaffected our income tax payable and income tax expense accounts, as well assales, use, and property tax expense and accrual accounts.

·  *Insufficient training andinadequate reconciliation processes for complex revenue recognition requirementsprimarily related to international transactions.*   Training andreconciliation processes related to complex revenue recognition requirementsregarding distributor discounts, partial deliveries of goods and the acceptancecriteria for shipped goods were insufficient to ensure these transactions wererecorded in accordance with U.S. GAAP. This affected our revenue and ourdeferred revenue accounts.

·       *Insufficient controls related to system access andsegregation of duties.  *Insufficientinternal controls resulted in a lack of segregation of duties among employees.Users of our new accounting system had access to multiple accounting processeswithin the system, including vendor set-up and account maintenance, instead ofonly those processes that were the responsibility of such user. In the absenceof such controls, inappropriate or unauthorized transactions could be enteredinto the system which increases the susceptibility to the misappropriation ofassets.

·       *Inadequacies related to entity-level controls.  *Management has concluded that thereare deficiencies in the design and execution of our entity-level controlsrelating to training, job descriptions, managing of employee turnover,application of U.S. GAAP, documentation of expenditure approvals andcommunication between departments that constitute “material weaknesses” in ourinternal control over financial reporting. These deficiencies contributed tothe restatement of our previously issued financial statements and delays incompliance efforts with Section 404 of the Sarbanes-Oxley Act of 2002 andthe rules issued thereunder.

**Remediation Activities**

Digimarc places thehighest priority on addressing these matters. Under the direction of our seniormanagement and the participation and oversight of our audit committee, we haveimplemented significant changes to our infrastructure and related processesover the past several quarters, and continue to address these matters and willmake changes as appropriate. In addition to changes already implemented andpreviously reported in our Form 10-Q for the quarter ended March 31,2005, filed on May 16, 2005, the following changes have been made duringthe quarter ended June 30, 2005 to improve our internal controls.

1.     We hired aDirector of Tax in May and a Director of Internal Controls and Compliancein June. We continue to actively recruit and hire other members of the financeand accounting organization to improve the overall quality and level ofexperience in the organization.

2.     We havemade, and will continue to make, changes in our finance and accounting organizationto provide clearer segregation of responsibilities and supervision with regardto, among others, documentation supporting our quarterly and annual financialstatements.

3.     We haveimplemented an enhanced monthly and quarterly financial review and closeprocess to include additional analysis and support for the financial accounts. Weare continuing to make enhancements to further improve and streamline theseprocesses.

4.    We have continued to deploy significantinternal and external resources directed at documenting and testing ourinternal control over financial reporting as contemplated by Section 404of Sarbanes-Oxley, and such efforts have been helpful in improving our overallprocess and control environment.

5.     We havecontinued to implement steps, including changes to our processes and systems,to improve the information flow among the various personnel that have a role inthe determination of proper cost capitalization as well as to improve thereview and approval process relating to such determination, and we areimplementing processes to improve communication among our various functionalgroups, 

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which include sales,manufacturing, customer support, engineering, accounting, and legal, during thecontract negotiation, implementation and fulfillment phases.

6.     We havecontinued to implement preventive control procedures related to system accessand to monitor and control access to system modules in accordance withappropriate guidelines in order to ensure safeguarding of assets. In addition,we have implemented detective controls such as the enhanced review ofaccounting transactions and financial statements.

We continue to take remedial steps to strengthen ourinternal control over financial reporting and enhance our reporting processes. Moreover,our on-going accounting review has resulted in some, and may result in further,remediation efforts with respect to some of our accounting processes, in particularwith regard to cost capitalization and project accounting. Given the timerequirements and resources necessary to test our processes, there can be noassurance as to when we will be fully compliant with the requirements relatingto internal control over financial reporting and other aspects of Section 404.

Other than as described above, management does notbelieve there have been any changes in the Company’s internal control overfinancial reporting during the fiscal quarter ending June 30, 2005 thathave materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

As described above, wecurrently are designing and implementing new controls to address the weaknessesidentified in our internal control over financial reporting. Notwithstandingthese improvements, our internal control over financial reporting may not becapable of preventing all instances of error or fraud. Any control system, nomatter 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 must reflect the fact that there are knowledgeand resource constraints in any such system, and a large number of complex permutationsof facts, circumstances, accounting policies, procedural implications andbusiness practices that must be considered. Because of the inherent limitationsin all control systems, no evaluation of controls can provide absoluteassurance that all control issues and instances of fraud, if any, have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty, and breakdowns can occur because of simple erroror mistake. Additionally, controls can be circumvented by the individual actsof some persons, by collusion of two or more people, or by management overrideof the controls. The design of any system of controls also is based in partupon certain assumptions about the likelihood of future events, and there canbe no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions. Over time, the control systems wedevelop may become inadequate because of changes in conditions, or the degreeof compliance with the policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and not be detected.

**Evaluationof Disclosure Controls and Procedures**

The SEC defines the term “disclosurecontrols and procedures” to mean a company’s controls and other procedures thatare designed to ensure that information required to be disclosed in the reportsthat it files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported, within the time periods specified in theCommissions’ rules and forms. While our disclosure controls and proceduresare designed to provide reasonable assurance of achieving their objectives, thedesign of any system of controls is based in part upon certain assumptionsabout the likelihood of future events, and there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions, regardless of how remote. Our current management, with theparticipation of our principal executive officer and principal financialofficer, carried out a separate evaluation of the effectiveness of ourdisclosure controls and procedures (as defined in Rules 240.13a-15(e) and240.15d-15(e) of the Securities Exchange Act of 1934) as of June 30,2005, which included an evaluation of 

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disclosurecontrols and procedures applicable to the period covered by the filing of thisperiodic report. Based on the evaluation of the effectiveness of our disclosurecontrols and procedures by our management as of June 30, 2005, and subjectto the information set forth in this Item 4, our principal executive officerand principal financial officer have concluded that our disclosure controls andprocedures were not effective.

**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. These lawsuits were filed in the United StatesDistrict Court for the District of Oregon and were consolidated into one actionfor all purposes on December 16, 2004. On May 16, 2005, plaintiffsfiled an amended complaint. The complaint asserts claims under the federalsecurities laws, specifically Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, relating to our announcement that we haddiscovered errors in our accounting for software development costs and projectcapitalization and other project cost capitalization accounting practices, andthat we likely would be required to restate our previously reported financialstatements for full fiscal year 2003 and the first two quarters of 2004.Specifically, the action alleges that we issued false and misleading financialstatements and created a misperception regarding the profitability of thecompany in order to inflate the value of Digimarc stock, which resulted ininsider sales of personal holdings at inflated values, and that we maintainedinsufficient accounting controls, which created an environment where improperaccounting could be used to manipulate financial results. The complaint seeksunspecified damages. We believe that we have substantial legal and factualdefenses to the claims, which we intend to pursue vigorously. On June 15,2005, we filed a motion to dismiss the complaint. Plaintiffs filed a responseon August 1, 2005. Due to the inherent uncertainties of litigation andbecause the lawsuits are still at a preliminary stage, the ultimate outcome ofthe matter cannot be predicted.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of the Company’sofficers and directors, naming the Company as a nominal defendant, in theSuperior Court of the State of California for the County of San Luis Obispo. Theselawsuits were consolidated into one action for all purposes on March 14,2005. On July 19, 2005, the court granted the Company’s motion to staythese consolidated actions in favor of a shareholder derivative action to befiled by plaintiffs in the Circuit Court of the State of Oregon for the Countyof Washington. On November 8, 2004, a letter was mailed to the chairman ofthe Company’s Board of Directors by a law firm purporting to represent ashareholder 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. On or about April 6, 2005, this shareholder filed apurported shareholder derivative suit against certain of the Company’s officersand directors, naming the Company as a nominal defendant, in the Circuit Courtof the State of Oregon for the County of Washington. These suits claim thatcertain of these officers and directors breached their fiduciary duties to theCompany’s shareholders and to the Company. The complaints are derivative innature and do not seek relief from the Company. The Company has appointed acommittee to investigate the claims asserted in the demand letter and in thederivative lawsuits.

Beginning in May 2001, a number of substantiallyidentical class action complaints alleging violations of the federal securitieslaws were filed in the United States District Court for the Southern Districtof New York naming approximately 300 companies, including the Company, certainof its officers and directors, and certain underwriters of the Company’sinitial public offering as defendants. The complaints have since beenconsolidated into a single action, and a consolidated amended complaint wasfiled in 

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April 2002. Theamended complaint alleges, among other things, that the underwriters of theCompany’s initial public offering violated securities laws by failing todisclose certain alleged compensation arrangements (such as undisclosedcommissions or stock stabilization practices) in the Company’s initial publicoffering registration statement and by engaging in manipulative practices toartificially inflate the price of the Company’s stock in the after-market subsequentto the Company’s initial public offering. The Company and certain of itsofficers and directors are named in the amended complaint pursuant to Section 11of the Securities Act of 1933, and Section 10(b) and Rule 10b-5of the Securities Exchange Act of 1934 on the basis of an alleged failure todisclose the underwriters’ alleged compensation arrangements and manipulativepractices. The complaint seeks unspecified damages. The individual officer anddirector defendants entered into tolling agreements and, pursuant to a courtorder dated October 9, 2002, were dismissed from the litigation withoutprejudice. Furthermore, in July 2002, the Company and the other defendantsin the consolidated cases filed motions to dismiss the amended complaint forfailure to state a claim. The motion to dismiss claims under Section 11was denied as to virtually all the defendants in the consolidated actions,including the Company. The claims against the Company under Section 10(b),however, were dismissed. In June 2003, a committee of the Company’s boardof directors conditionally approved a proposed partial settlement with theplaintiffs in this matter. In June 2004, an agreement of settlement wassubmitted to the court for preliminary approval. The settlement would provide,among other things, a release of the Company and of the individual defendantsfor the conduct alleged in the amended complaint to be wrongful. The Companywould agree 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. If such modifications are acceptable tothe 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 assurancethat this proposed settlement would be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation, the ultimateoutcome of the matter cannot be predicted.

The Company is subjectfrom time to time to other legal proceedings and claims arising in the ordinarycourse of business. Although the ultimate outcome of these matters cannot bedetermined, management believes that the final disposition of these proceedingswill not have a material adverse effect on the consolidated financial position,results of operations, or liquidity of the Company.

**Item4. Submission of Matters to a Vote of Security Holders.**

We held our annualmeeting of stockholders on May 12, 2005. Two proposals were voted on byour stockholders.

**Proposal1:**   Election of Three Class III Directors

BruceDavis, Brian J. Grossi and James T. Richardson were elected as Class IIIdirectors for a term of 3 years. The voting for each director was as follows:
| ** **          | ** ** | **For**    | ** ** | ** ** | **Withheld** | ** ** |
|---------------------|------------|------------|------------|------------|--------------|------------|
| Bruce Davis         |       | 15,291,332 |       |       | 1,040,090    |       |
| Brian J. Grossi     |       | 13,257,463 |       |       | 3,073,959    |       |
| James T. Richardson |       | 16,092,499 |       |       | 238,923      |       |

 

The Company’s Class I and Class II directorsdid not stand for reelection at the annual meeting. The terms of the Company’s Class Idirectors, Alty van Luijt, Jim Roth, Lloyd G. (Buzz) Waterhouse and William J.Miller, will continue until the 2006 annual meeting of stockholders. The termsof the Company’s 

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Class II directors,Philip J. Monego, Sr., Peter W. Smith and Bernard Whitney, will continueuntil the 2007 annual meeting of stockholders.

**Proposal 2:**   Ratificationof the Appointment of KPMG LLP as the Company’s Independent Certified PublicAccountants

KPMG LLP was ratified asour independent certified public accountants for the fiscal year ending December 31,2005 with 16,099,712 votes in favor, 213,704 votes against and 18,006abstentions.

**Item 6. Exhibits.**

See attached exhibit index.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                            | DIGIMARC CORPORATION |
|----------------------------|----------------------|
| Date: August 9,  2005 | By:                  | /s/  MICHAEL MCCONNELL |
|                       |                 | Michael McConnell |
|                       |                 | *Chief  Financial Officer and Treasurer  (Duly Authorized Officer  and Principal Financial Officer)* |

 

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**EXHIBIT INDEX**
| Exhibit  Number | ** ** | **Document**                                                                                                                                                                                                                                                                                                       |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Second Amended and Restated Certificate of  Incorporation of the Registrant (incorporated by reference to  Exhibit 3.1 of Exhibits to 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                                                                                                                                                                                                                                                         |
| 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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