**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(MarkOne)**

(Mark One)

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

**Forthe quarterly period ended SEPTEMBER 30, 2005**

**OR**

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

**Forthe transition period from               to                **

**CommissionFile Number: 000-28317**

**DIGIMARC CORPORATION**

(Exact name of registrantas specified in its charter)
| **Delaware**                                                     | **94-3342784**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **9405 SW Gemini Drive, Beaverton, Oregon**                      | **97008**                             |
| (Address of  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

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

As of October 31,2005, there were 20,772,820 shares of the registrant’s common stock, par value$0.001 per share, outstanding.

 

----

**Table of Contents**

| **PART I FINANCIAL  INFORMATION** |   |                                                                                                                                |
|----------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           |   | Financial Statements:                                                                                                               |   |   |
|                                   |   | Condensed  Consolidated Balance Sheets as of September 30, 2005 and  December 31, 2004 (Unaudited)                   |   | 3 |
|                                   |   | Condensed  Consolidated Statements of Operations for the three- and nine-months ended  September 30, 2005 and 2004 (Unaudited) |   | 4 |
|                                   |   | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2005 and 2004 (Unaudited)            |   | 5 |
|                                   |   | Notes  to Condensed Consolidated Financial Statements (Unaudited)                                                                   |   | 6 |
| Item 2.                                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                         |   | 15 |
| Item 3.                                |   | Quantitative  and Qualitative Disclosures About Market Risk                                                                         |   | 53 |
| Item 4.                                |   | Controls  and Procedures                                                                                                            |   | 53 |
| **PART II OTHER INFORMATION**     |   |                                                                                                                                |
| Item 1.                                |   | Legal  Proceedings                                                                                                                  |   | 57 |
| Item 6.                                |   | Exhibits                                                                                                                            |   | 58 |
| **SIGNATURES**                         |   | 59                                                                                                                                  |

 

2

----

**PART I. FINANCIAL INFORMATION**

**Item 1.**                        FinancialStatements.

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDBALANCE SHEETS(DOLLARS IN THOUSANDS)(UNAUDITED)**

| ** **                                                                                                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**               | ** ** | **2004(1)**           | ** ** |
| **ASSETS**                                                                                                                        |       |                   |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                   |       |                   |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                         |       |                   | $          | 19,842                |       |   |   | $ | 18,489 |   |   |
| Short-term investments                                                                                                            |       |                   | 6,305      |                  |       |   | 25,068 |   |   |
| Trade accounts receivable, net                                                                                                    |       |                   | 9,178      |                  |       |   | 9,666 |   |   |
| Unbilled trade receivables                                                                                                        |       |                   | 6,658      |                  |       |   | 5,008 |   |   |
| Inventory, net                                                                                                                    |       |                   | 8,539      |                  |       |   | 8,858 |   |   |
| Other current assets                                                                                                              |       |                   | 2,609      |                  |       |   | 1,779 |   |   |
| Total current assets                                                                                                              |       |                   | 53,131     |                  |       |   | 68,868 |   |   |
| Restricted cash                                                                                                                   |       |                   | 7,286      |                  |       |   | 8,279 |   |   |
| Property and  equipment, net                                                                                                      |       |                   | 66,068     |                  |       |   | 63,975 |   |   |
| Intangibles, net                                                                                                                  |       |                   | 17,939     |                  |       |   | 21,162 |   |   |
| Other assets, net                                                                                                                 |       |                   | 921        |                  |       |   | 1,003 |   |   |
| Total assets                                                                                                                      |       |                   | $          | 145,345               |       |   |   | $ | 163,287 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                     |       |                   |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                              |       |                   |       |                  |       |   |   |   |   |
| Accounts payable                                                                                                                  |       |                   | $          | 6,568                 |       |   |   | $ | 11,424 |   |   |
| Accrued payroll and related costs                                                                                                 |       |                   | 4,007      |                  |       |   | 2,161 |   |   |
| Deferred revenue                                                                                                                  |       |                   | 4,597      |                  |       |   | 4,854 |   |   |
| Other current liabilities                                                                                                         |       |                   | 1,878      |                  |       |   | 1,492 |   |   |
| Total current liabilities                                                                                                         |       |                   | 17,050     |                  |       |   | 19,931 |   |   |
| Other long-term  liabilities                                                                                                      |       |                   | 1,007      |                  |       |   | 1,112 |   |   |
| Total liabilities                                                                                                                 |       |                   | 18,057     |                  |       |   | 21,043 |   |   |
| Commitments and  contingencies (Note 5)                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Stockholders’ equity:                                                                                                        |       |                   |       |                  |       |   |   |   |   |
| Common stock  (20,772,820 and 20,453,429 shares outstanding at September 30, 2005 and  December 31, 2004, respectively) |       |                   | 21         |                  |       |   | 21 |   |   |
| Additional  paid-in capital                                                                                                       |       |                   | 209,215    |                  |       |   | 206,979 |   |   |
| Deferred stock  compensation                                                                                                      |       |                   | (1,670     | )                     |       |   | — |   |   |
| Accumulated other  comprehensive income                                                                                           |       |                   | 190        |                  |       |   | 147 |   |   |
| Accumulated  deficit                                                                                                              |       |                   | (80,468    | )                     |       |   | (64,903 | ) |   |
| Total stockholders’ equity                                                                                                   |       |                   | 127,288    |                  |       |   | 142,244 |   |   |
| Total liabilities  and stockholders’ equity                                                                                  |       |                   | $          | 145,345               |       |   |   | $ | 163,287 |   |   |

----

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

See Notes to Unaudited Condensed Consolidated Financial Statements.

3

----

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**

| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2005**                         | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                          |       |                             |       |                            |       |   |   |   |   |
| Service                                           |       | $                                | 22,372     |                            | $          | 20,001 |   | $ | 63,584 |   | $ | 55,530 |   |
| Product and subscription                          |       | 4,409                            |       | 3,519                           |       | 12,329 |   | 15,122 |   |
| Total revenue                                     |       | 26,781                           |       | 23,520                          |       | 75,913 |   | 70,652 |   |
| Cost of revenue:                                  |       |                             |       |                            |       |   |   |   |   |
| Service                                           |       | 14,704                           |       | 11,942                          |       | 42,722 |   | 33,197 |   |
| Product and subscription                          |       | 1,790                            |       | 1,788                           |       | 5,232 |   | 10,141 |   |
| Total cost of revenue                             |       | 16,494                           |       | 13,730                          |       | 47,954 |   | 43,338 |   |
| Gross profit                                      |       | 10,287                           |       | 9,790                           |       | 27,959 |   | 27,314 |   |
| Operating expenses:                               |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                               |       | 4,291                            |       | 3,090                           |       | 12,004 |   | 8,493 |   |
| Research, development and engineering             |       | 2,898                            |       | 1,931                           |       | 8,382 |   | 5,203 |   |
| General and administrative                        |       | 6,234                            |       | 6,748                           |       | 20,237 |   | 16,603 |   |
| Amortization of intangibles                       |       | 1,147                            |       | 688                             |       | 3,297 |   | 1,877 |   |
| Total operating expenses                          |       | 14,570                           |       | 12,457                          |       | 43,920 |   | 32,176 |   |
| Operating income (loss)                           |       | (4,283                           | )          | (2,667                          | )          | (15,961 | ) | (4,862 | ) |
| Other income (expense):                           |       |                             |       |                            |       |   |   |   |   |
| Interest income                                   |       | 262                              |       | 232                             |       | 799 |   | 659 |   |
| Interest expense                                  |       | (15                              | )          | (30                             | )          | (135 | ) | (81 | ) |
| Other                                             |       | (33                              | )          | (8                              | )          | 31 |   | (12 | ) |
| Total other income, net                           |       | 214                              |       | 194                             |       | 695 |   | 566 |   |
| Income (loss)  before provision for income taxes  |       | (4,069                           | )          | (2,473                          | )          | (15,266 | ) | (4,296 | ) |
| Provision for  income taxes                       |       | (159                             | )          | 6                               |       | (299 | ) | (228 | ) |
| Net income (loss)                                 |       | $                                | (4,228     | )                               | $          | (2,467 | ) | $ | (15,565 | ) | $ | (4,524 | ) |
| Net income (loss)  per share—basic           |       | $                                | (0.21      | )                               | $          | (0.12 | ) | $ | (0.76 | ) | $ | (0.22 | ) |
| Net income (loss)  per share—diluted         |       | $                                | (0.21      | )                               | $          | (0.12 | ) | $ | (0.76 | ) | $ | (0.22 | ) |
| Weighted average shares outstanding—basic    |       | 20,497                           |       | 20,371                          |       | 20,473 |   | 20,287 |   |
| Weighted average  shares outstanding—diluted |       | 20,497                           |       | 20,371                          |       | 20,473 |   | 20,287 |   |

``

See Notes to Unaudited Condensed Consolidated Financial Statements.

4

----

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS(IN THOUSANDS)(UNAUDITED)**

| ** **                                                                                 | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,  2005**    | ** ** | **September 30,  2004** | ** ** |
| Cash flows from operating activities:                                                      |       |                            |       |   |   |   |   |   |   |
| Net loss                                                                                   |       |                            | $          | (15,565 | ) |   |   | $ | (4,524 | ) |   |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                            |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                             |       |                            | 13,978     |   |   |   | 9,701 |   |   |
| Stock-based compensation  expense                                                          |       |                            | 355        |   |   |   | — |   |   |
| Impairment of  investments                                                                 |       |                            | —     |   |   |   | 300 |   |   |
| Issuance of common stock  for litigation settlement                                        |       |                            | —     |   |   |   | 348 |   |   |
| Increase (decrease) in  allowance for doubtful accounts                                    |       |                            | (10        | ) |   |   | — |   |   |
| Other non-cash charges                                                                     |       |                            | (11        | ) |   |   | 574 |   |   |
| Changes in operating assets and liabilities:                                               |       |                            |       |   |   |   |   |   |   |
| Restricted cash                                                                            |       |                            | 993        |   |   |   | 1,741 |   |   |
| Trade and unbilled  accounts receivable, net                                               |       |                            | (1,152     | ) |   |   | (2,342 | ) |   |
| Inventory, net                                                                             |       |                            | 319        |   |   |   | 451 |   |   |
| Other current assets                                                                       |       |                            | (830       | ) |   |   | 606 |   |   |
| Other assets, net                                                                          |       |                            | 82         |   |   |   | (257 | ) |   |
| Accounts payable                                                                           |       |                            | (4,856     | ) |   |   | 99 |   |   |
| Accrued payroll and  related costs                                                         |       |                            | 1,846      |   |   |   | 1,164 |   |   |
| Deferred revenue                                                                           |       |                            | (257       | ) |   |   | 414 |   |   |
| Other liabilities                                                                          |       |                            | 497        |   |   |   | 974 |   |   |
| Net cash provided by  (used in) operating activities                                       |       |                            | (4,611     | ) |   |   | 9,249 |   |   |
| Cash flows from investing activities:                                                      |       |                            |       |   |   |   |   |   |   |
| Purchase of property and  equipment                                                        |       |                            | (6,070     | ) |   |   | (22,309 | ) |   |
| Capitalization of labor  costs                                                             |       |                            | (6,589     | ) |   |   | (9,679 | ) |   |
| Sale or maturity of  short-term investments                                                |       |                            | 133,247    |   |   |   | 173,389 |   |   |
| Purchase of short-term  investments                                                        |       |                            | (114,484   | ) |   |   | (154,342 | ) |   |
| Net cash provided by  (used in) investing activities                                       |       |                            | 6,104      |   |   |   | (12,941 | ) |   |
| Cash flows from financing activities:                                                      |       |                            |       |   |   |   |   |   |   |
| Net proceeds from  issuance of common stock                                                |       |                            | 211        |   |   |   | 1,927 |   |   |
| Principal payments under  capital lease obligations                                        |       |                            | (351       | ) |   |   | (135 | ) |   |
| Net cash provided by  (used in) financing activities                                       |       |                            | (140       | ) |   |   | 1,792 |   |   |
| Net increase (decrease)  in cash and cash equivalents                                      |       |                            | 1,353      |   |   |   | (1,900 | ) |   |
| Cash and cash  equivalents at beginning of period                                          |       |                            | 18,489     |   |   |   | 33,626 |   |   |
| Cash and cash  equivalents at end of period                                                |       |                            | $          | 19,842 |   |   |   | $ | 31,726 |   |   |
| Supplemental disclosure of cash flow information:                                          |       |                            |       |   |   |   |   |   |   |
| Cash paid for interest                                                                     |       |                            | $          | 135 |   |   |   | $ | 81 |   |   |
| Cash paid for income  taxes                                                                |       |                            | $          | 139 |   |   |   | $ | — |   |   |
| Summary of non-cash investing and financing  activities:                                   |       |                            |       |   |   |   |   |   |   |
| Equipment acquired or  exchanged under capital lease obligations                           |       |                            | $          | 135 |   |   |   | $ | 77 |   |   |
| Grant of restricted stock                                                                  |       |                            | $          | 2,025 |   |   |   | $ | — |   |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

5

----

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

**1.   TheCompany, 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 October 2005, the Company holds 207 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. More than 150 million people around the world carry securecredentials from issuance systems produced by Digimarc. The substantial majorityof the Company’s revenues arise from provision of critical infrastructurepursuant to long-term contracts with government agencies—primarily U.S. stategovernment agencies engaged in the issuance of driver licenses, a consortium ofleading Central Banks, and national governments of certain foreign countries.The remainder of our revenues is generated primarily from patent and technologylicense fees paid by business partners, providing media and rights managementsolutions to major movie studios and music labels, television and radiobroadcasters, 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. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with U.S. generally accepted accounting principles havebeen condensed or omitted under the Securities and Exchange Commission’s rules andregulations.

6

----

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, whichwas filed 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 andincludes restated 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. The results of operations for the interim periods presented in thesecondensed consolidated financial statements are not necessarily indicative ofthe 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 for anyperiod presented. These reclassifications include the reclassification ofmarket auction preferred investments from cash equivalents to short-terminvestments and amortization of intangibles from general and administrative toa separate line item on the Statement of Operations.

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

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

Common stock equivalentsrelated to stock options of 6,371 and 6,277 were excluded from diluted net lossper share calculations for the three- and nine-month periods ended September 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 455 and 393 for the three- and nine-month periods ended September 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 6,556 and 5,866 outstanding stock options and warrants for the three-and nine-month periods ended September 30, 2004, respectively, areexcluded from the calculation of diluted net income per share because theirexercise price was higher than the average market price of the underlyingcommon stock for the period and therefore their inclusion would beanti-dilutive. In addition, common stock equivalents related to stock optionsof 227 and 320 for the three- and 

7

----

nine-monthperiods ended September 30, 2004, respectively, were excluded from dilutednet loss per share as the Company was in a loss position and their inclusionwould be anti-dilutive.

**3.  **Stock-Based Compensation

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.

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation for the three- and nine-month periodsended September 30, 2005 and 2004, respectively (in thousands, except per-shareamounts):

| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                        | ** ** | **2005**                         | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss, as  reported                                                                                            |       | $                                | (4,228     | )                               | $          | (2,467 | ) | $ | (15,565 | ) | $ | (4,524 | ) |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       | 153                              |       | —                          |       | 355 |   | — |   |
| Deduct: Total  stock-based employee  compensation expense determined under fair value based method for all awards |       | (1,280                           | )          | (3,246                          | )          | (4,790 | ) | (9,205 | ) |
| Pro forma net  loss                                                                                               |       | $                                | (5,355     | )                               | $          | (5,713 | ) | $ | (20,000 | ) | $ | (13,729 | ) |
| *Earnings per share:*                                                                                             |       |                             |       |                            |       |   |   |   |   |
| Basic—as reported                                                                                            |       | $                                | (0.21      | )                               | $          | (0.12 | ) | $ | (0.76 | ) | $ | (0.22 | ) |
| Diluted—as  reported                                                                                         |       | $                                | (0.21      | )                               | $          | (0.12 | ) | $ | (0.76 | ) | $ | (0.22 | ) |
| Basic—pro forma                                                                                              |       | $                                | (0.26      | )                               | $          | (0.28 | ) | $ | (0.98 | ) | $ | (0.68 | ) |
| Diluted—pro forma                                                                                            |       | $                                | (0.26      | )                               | $          | (0.28 | ) | $ | (0.98 | ) | $ | (0.68 | ) |

 

Stock-based compensation expense relates to restrictedstock granted in the current year, as described below, is based on the fairmarket value of the Company’s common stock on the date the restricted stock wasgranted (measurement date), and is being recognized over the four-year vestingperiod of the related restricted stock using the straight-line method.

On February 23, 2005,the Compensation Committee of the Board of Directors approved the form of therestricted stock agreement to be used in connection with restricted stockawards to be granted to officers of the Company under the terms of the Company’s1999 Stock Incentive Plan. The agreement provides, among other things, that theshares will vest in full upon the termination of the officer’s employmentwithout cause or the officer’s resignation for good reason following a changein control of the Company. Notwithstanding the foregoing, the planadministrator has discretionary authority, among other things, to determine theterms and conditions of any award granted under the Plan. A copy of theagreement was previously filed by the Company with the SEC as an exhibit to theCompany’s current 

8

----

reporton Form 8-K filed on March 1, 2005. The Compensation Committeeapproved grants of restricted stock awards to certain of its named executiveofficers, effective as of March 1, 2005, totaling 270 shares.One-quarter of the restricted shares granted to these executive officers willvest each December 31 beginning on December 31, 2005. The Companyrecorded $153 and $355 of stock-based compensation related to the issuance ofrestricted stock for the three- and nine-month periods ended September 30,2005. The Company did not incur any stock-based compensation expense for thethree- and nine-month periods ended September 30, 2004.

**4.   Segment Information**

The Company derives its revenue from a singlereporting segment, secure identity and media management. Revenue is generatedin this reporting segment through licensing and subscription of its variousproducts and the delivery of contracted and consulting services related tothese products. The Company markets its products in the United States and inother countries through its sales personnel and its subsidiaries.

There was no singlecustomer in the three- and nine-month periods ended September 30, 2005 or2004 that accounted for more than 10% of total revenue. There was no singlecustomer that accounted for more than 10% of trade and unbilled accountsreceivable, net at September 30, 2005 or 2004.

**5.  **Commitments and Contingencies

Beginning in September 2004, three purportedclass action lawsuits were commenced against the Company and certain of itscurrent and former directors and officers by or on behalf of persons claimingto have purchased or otherwise acquired Digimarc’s securities during the periodfrom April 17, 2002 to July 28, 2004. These lawsuits were filed inthe United States District Court for the District of Oregon and wereconsolidated into one action for all purposes on December 16, 2004. On May 16,2005, plaintiffs filed an amended complaint. The complaint asserts claims underthe federal securities laws, specifically Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934, relating to the Company’s announcementthat it had discovered errors in its accounting for software development costsand project capitalization and other project cost capitalization accountingpractices, and that it likely would be required to restate its previouslyreported financial statements for full fiscal year 2003 and the first twoquarters of 2004. Specifically, the action alleges that the Company issuedfalse and misleading financial statements and created a misperception regardingthe profitability of the Company in order to inflate the value of Digimarcstock, which resulted in insider sales of personal holdings at inflated values,and that the Company maintained insufficient accounting controls, which createdan environment where improper accounting could be used to manipulate financialresults. The complaint seeks unspecified damages. The Company believes that ithas substantial legal and factual defenses to the claims, which it intends topursue vigorously. On June 15, 2005, the Company filed a motion to dismissthe complaint. Plaintiffs filed a response on August 1, 2005. Due to theinherent uncertainties of litigation and because the lawsuits are still at apreliminary stage, the ultimate outcome of the 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.These lawsuits 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 August 25, 2005, the California plaintiffs filed two newderivative lawsuits in the United States District Court for the District ofOregon. On October 17, 2005, defendants filed a motion to dismiss thesecomplaints for lack of subject matter jurisdiction and failure to state a claim.This motion currently is pending. Separately, on November 8, 2004, aletter was mailed to the chairman of the Company’s Board of Directors by a lawfirm 

9

----

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. On August 25, 2005, the individual defendants filed amotion to stay this state court derivative lawsuit, and on September 26,2005, the Court entered a stipulated order granting the motion and staying thecase pending the outcome of an investigation by a committee appointed by theCompany’s Board of Directors of the claims asserted in the demand letter and inthe derivative 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 April 2002. The amended complaint alleges, among other things,that the underwriters of the Company’s initial public offering violatedsecurities laws by failing to disclose certain alleged compensationarrangements (such as undisclosed commissions or stock stabilization practices)in the Company’s initial public offering registration statement and by engagingin manipulative practices to artificially inflate the price of the Company’sstock in the after-market subsequent to the Company’s initial public offering.The Company and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. Theindividual officer and director defendants entered into tolling agreements and,pursuant to a court order dated October 9, 2002, were dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, acommittee of the Company’s Board of Directors conditionally approved a proposedpartial settlement with the plaintiffs in this matter. In June 2004, anagreement of settlement was submitted to the court for preliminary approval.The settlement would provide, among other things, a release of the Company andof the individual defendants for the conduct alleged in the amended complaintto be wrongful. The Company would agree to undertake other responsibilitiesunder the partial settlement, including agreeing to assign away, not assert, orrelease certain potential claims the Company may have against its underwriters.Any direct financial impact of the proposed settlement (other than defensecosts incurred and expensed prior to May 31, 2003) is expected to be borneby the Company’s insurers. The court granted the preliminary approval motion onFebruary 15, 2005, subject to certain modifications. On August 31,2005, the court issued a preliminary order further approving the modificationsto the settlement and certifying the settlement classes. The court alsoappointed the Notice Administrator for the settlement and ordered that noticeof the settlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearinghas been set for April 26, 2006. Following the hearing, if the courtdetermines that the settlement is fair to the class members, the settlementwill be approved. There can be no assurance that this proposed settlement wouldbe approved and implemented in its current form, or at all. Due to the 

10

----

inherent uncertainties oflitigation and because the settlement approval process is at a preliminarystage, we cannot accurately predict the ultimate outcome of the matter.

The Company, in its normal course of business, fromtime to time experiences delays in identification system implementation, timelyacceptance for identification systems programs, concerns regardingidentification system program performance, and other contractual disputes. Inaddition, from time to time, customers have given notice of their intention toassert claims for liquidated damages or other remedies. Management believesthat these assertions are part of the resolution process involving commercialdisagreements over the delivery terms of these contracts. Such disputes are notuncommon and tend to be resolved over time. However, such contingencies, if notsuccessfully resolved, could have a material effect on our results ofoperations from time to time.While there is always risk that damages could beassessed in the future, management cannot predict whether any material damageswill be imposed in the future or what the amount of any such damages would beif they were to be imposed.

Certain of the Company’s product license and servicesagreements include an indemnification provision for claims from third partiesrelating to the Company’s intellectual property. Such indemnificationprovisions are accounted for in accordance with SFAS No. 5, *Accounting for Contingencies*. To date,there have been no claims made under such indemnification provisions.

Digimarc is subject fromtime 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. No accrual has beenrecorded because the amounts are not probable or reasonably estimable inaccordance with SFAS No. 5, *Accountingfor Contingencies*.

**6.  **Comprehensive Loss

TheCompany has adopted SFAS No. 130, *ReportingComprehensive Income*, which establishes standards of reporting anddisplaying comprehensive income (loss) and its components of net income (loss)and other comprehensive income (loss). Other comprehensive income (loss) refersto revenues, expenses, gains and losses that are not included in net income(loss) but rather are recorded directly in stockholders’ equity. Comprehensiveincome (loss) is defined as changes in stockholders’ equity exclusive oftransactions with owners. To date, only foreign currency translationadjustments are required to be reported in comprehensive income (loss). Thefollowing table provides a summary of comprehensive loss for the three- andnine-month periods ended September 30, 2005 and 2004, respectively (inthousands):

| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                               | ** ** | **2005**                         | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income                               |       | $                                | (4,228     | )                               | $          | (2,467 | ) | $ | (15,565 | ) | $ | (4,524 | ) |
| Foreign currency  translation adjustment |       | (3                               | )          | (23                             | )          | 43 |   | (88 | ) |
| Comprehensive  income                    |       | $                                | (4,231     | )                               | $          | (2,490 | ) | $ | (15,522 | ) | $ | (4,612 | ) |

 

11

----

**7.  **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 forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage) in the determination of inventory carrying costs. Thestatement requires such costs be recognized as a current-period expense. FAS151 also requires 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.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections: a replacement of APB Opinion No. 20 andFASB Statement No. 3,” which requires companies to apply most voluntaryaccounting changes retrospectively to prior financial statements. SFAS No. 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. Any future voluntary accountingchanges made by us will be accounted for under SFAS No. 154.

On December 16, 2004,the FASB issued Statement No. 123(R) *Share-BasedPayment*, which is a revision of Statement No. 123 andsupersedes APB Opinion No. 25. Statement No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be valued at fair value on the date of grant, and to be expensed over theapplicable vesting period. Pro forma disclosure of the income statement effectsof share-based payments is no longer an alternative. Statement No. 123(R) iseffective for all stock-based awards granted on or after January 1, 2006.In addition, companies must also recognize compensation expense related to anyawards that are not fully vested as of the effective date. Compensation expensefor the unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123. The Company is currentlyassessing the impact of adopting Statement 123(R) to its consolidatedresults of operations.

**8.  **Revenue Recognition

Revenue from the Company’s long-term identificationand driver license issuance systems is generated from the production of cards.The Company recognizes revenue on these contracts based on the actual monthlyproduction of cards, if available, or, in limited situations, on the estimatedproduction of cards. When actual production information becomes available,typically within one month, the Company bills the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.Differences to date have not been significant. Revenue earned which has notbeen invoiced is classified as unbilled trade receivables in the condensedconsolidated balance sheets. Revenue related to an enhancement of or upgrade toan existing system is deferred and recognized over the remaining life of thecontract.

Revenue for sales of consumables and equipment notrelated to a long-term identification or driver license production contract isrecognized when the products have been shipped, ownership has been transferred,evidence of an arrangement exists, the sales price is fixed and determinable,and collectibility is reasonably assured.

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. Progress towards completion is measured using costs incurredcompared to the budgeted amounts contained in the contract. Losses oncontracts, if any, are provided for in the period in which the loss becomesdeterminable. Billing for services rendered generally occurs within one monthfollowing when the services are provided. Revenue earned which has not beeninvoiced is classified as unbilled trade receivables in the condensedconsolidated balance sheets.

12

----

Royalty revenue is recognized when the royalty amountsowed to the Company have been earned, are determinable, and collectibility isprobable. Subscriptions are paid in advance and revenue is recognized ratablyover the term of the subscription.

Maintenance revenue is recognized when the maintenanceamounts owed to the Company have been earned, are determinable, andcollectibility is probable. Maintenance contracts are, at times, paid inadvance and revenue is recognized ratably over the term of the service period.

Deferred revenue consists of payments received inadvance for professional services, subscriptions, and hardware for whichrevenue has not been earned.

The Company also generates revenue from the licensingof digital watermarking products and services for use in authenticatingdocuments, detecting fraudulent documents and deterring unauthorizedduplication or alteration of high-value documents, for use in communicatingcopyright, asset management and business-to-business image commerce solutions,and for use in connecting analog media to a digital environment. Software revenueis recognized in accordance with the American Institute of Certified PublicAccountant (“AICPA”) SOP No. 97-2, *SoftwareRevenue Recognition*, as amended by AICPA SOP No. 98-9, *Modification of SOP 97-2*, *With Respect to Certain Transactions*.Revenue for licenses of the Company’s software products is recognized upon theCompany meeting the following criteria: persuasive evidence of an arrangementexists; delivery has occurred; the vendor’s fee is fixed or determinable; andcollectibility is probable.

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

Certain customerarrangements encompass multiple deliverables, such as hardware sales,consumables sales, maintenance fees, and software development fees. The Companyaccounts for these arrangements in accordance with Emerging Issues Task Force (“EITF”)Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*. If the deliverables meetthe criteria in EITF Issue No. 00-21 for separation, thedeliverables are divided into separate units of accounting and revenue isallocated to the deliverables based on their relative fair values. The criteriaspecified in EITF Issue No. 00-21 are as follows: (i) thedelivered item has value to the customer on a stand-alone basis, (ii) thereis objective and reliable evidence of the fair value of the undelivered item,and (iii) if the arrangement includes a general right of return relativeto the delivered item, delivery or performance of the undelivered item isconsidered probable and substantially in the control of the vendor. For 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 allocationamong multiple deliverables, determination of whether undelivered elements areessential to the functionality of delivered elements and timing of revenuerecognition, among others.

13

----

**9.  **Inventory

Inventoryconsists primarily of the consumable materials used to manufactureidentification cards, such as inks, laminates, and adhesives (considered rawmaterial), equipment held for sale (considered finished goods) and deferredcontract costs (considered either finished goods or in-process). Inventoriesare valued on a first-in, first-out basis at the lower of cost or market value(net realizable value).

| ** **                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| Equipment and  deferred contract costs |       |                   | $          | 517                   |       |   |   | $ | 1,033 |   |   |
| Consumable  materials                  |       |                   | 8,022      |                  |       |   | 7,825 |   |   |
| Inventory, net                         |       |                   | $          | 8,539                 |       |   |   | $ | 8,858 |   |   |

 

The reserve for slowmoving and obsolete items was $459 and $271 at September 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 possible currentlyto predict if or when this will happen, or how much we may sell. Such saleshave not had a significant impact on gross profit margin, nor does the Companyexpect such sales to have a significant impact in future periods.

**10.  **Software Development Costs

Under SFAS No. 86, *Accounting for the Cost of Computer Software to Be Sold, Leased, orOtherwise Marketed*, software development costs are to be capitalizedbeginning when a product’s technological feasibility has been established andending when a product is made available for general release to customers. Todate, the establishment of technological feasibility of the Company’s productshas occurred shortly before general release and, therefore, softwaredevelopment 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.

**11.  **Related Party Transactions

During the three- and nine-month periods ended September 30,2005 the Company recognized revenue of $108 and $363, respectively, from aholder of common stock. In addition, the Company recognized revenue of $124 and$537 for the three- and nine-month periods ended September 30, 2004,respectively, from this holder. Net accounts receivable from this holder was $8at September 30, 2005 and $202 at December 31, 2004.

During the quarter ended September 30, 2005, theCompany entered into a relocation agreement with an executive officer. As partof the relocation package, the Company purchased the personal residence of thatofficer. The purchase price was based on independent appraisals and totaled$825. The Company has assumed all rights and obligations related to theresidence and is actively marketing it for sale. The carrying cost of thisasset is included on the balance sheet in the Other Current Assets line.

14

----

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

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

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes and otherfinancial information appearing elsewhere in this Form 10-Q. Readersare also urged to carefully review and consider the various disclosures made byus which attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made 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. Morethan 150 million people around the world carry secure credentials from issuancesystems produced by Digimarc.

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.We provide solutions based on this technology directly and through ourlicensees. As of October 2005, the Company holds 207 issued U.S. patentson this technology and related technologies, applications, systems, andprocesses and has more than 400 applications pending. Digimarc’s solutions andtechnologies are deployed by the Company and its business partners in mediaobjects and digital devices around the world.

The substantial majority of the Company’s revenuesarise from provision of critical infrastructure and services pursuant to long-termcontracts with government agencies—primarily U.S. state government agenciesresponsible for driver license issue (“State DL Issuers”), a consortium ofleading Central Banks, and national governments of a number of foreigncountries. In this area of our business, document issuers around the world takeadvantage of our systems design, integration and materials science expertise,as well as new security innovations, such as digital watermarking, to implementissuance systems and processes, and advanced technologies needed to improve thesecurity of identity documents and banknotes. The remainder of our revenues isgenerated primarily from patent and technology license fees paid by businesspartners providing media and rights management solutions to major movie studiosand music 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—either digitally or physically—and to enable newconsumer applications to access networks and information from PCs and mobiledevices.

15

----

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 createlong-term profitable relationships with our customers, and, through marketleadership and satisfied customers, make digital watermarking a standardfeature of all media content.

**Vision and History**

Digimarc’s vision is to improve the value of mediacontent through technology. The Company’s business was founded to commercializea signal processing innovation known as “digital watermarking.” Digitalwatermarking is a technology breakthrough that allows our customers to infusedigital data into all media content that is digitally-processed at some pointduring its lifecycle. The technology can be applied to printed materials,video, audio, and images. The inclusion of such digital data enables a widerange of improvements in security and media management, and enables newbusiness models. We use digital watermarking as a value driver anddifferentiator in nearly all of our product offerings.

Banknote counterfeit deterrence was the firstcommercially successful use of digital watermarking. Digimarc, in cooperationwith an international consortium of leading Central Banks, developed a systemto deter the use of digital technologies in the unauthorized reproduction of banknotes.Innovations based on the Company’s technology and experience have beenleveraged to create new products to deter counterfeiting and tampering ofdriver licenses and other government-issued secure credentials. Simultaneously,Digimarc’s business partners, under patent license from Digimarc, aredelivering solutions to track and monitor the distribution of music,television, movies and radio to consumers. The Company’s growing patentportfolio contains 207 issued U.S. patents, including more than 4,000 claims ondigital watermarking and related technologies, applications, systems andprocesses as of October 2005, as well as 54 patents in additionalcountries around the world.

The Company has made significant progress in its firstdecade. Its proprietary technologies are deployed in media objects and digitaldevices around the world, enhancing the security of banknotes,government-issued credentials, music, movies, images, and television and radiobroadcasts.

Digimarc’s secure identity and media managementsolutions are built upon an extensive portfolio of intellectual property, andcombine innovative software, hardware and materials that we deliver, togetherwith carefully selected and qualified best-of-breed third-party components, toour government and commercial customers. The roots of these technologies are inthe pioneering and commercialization of digital watermarking and in theacquisition of the Large Government Programs (“LGP”) business unit of PolaroidCorporation (“Polaroid”) in late 2001. The primary focus of this business isthe production of driver licenses and other identification documents (“IDs”) onbehalf of government agencies. The acquired assets included all relevantsoftware, hardware, services, materials science and distribution assets of thegovernment-issued photo identification business of Polaroid Corporation.

On the heels of9/11, we realized that our expertise in security printing and digital imagingtechnologies and systems placed us in a position to understand both the digitalthreats to identity management credentials and the issuer’s environment. In thestrategic acquisition of the LGP business unit of Polaroid, we saw a uniqueopportunity 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 

16

----

guidethem through numerous major upgrades and technology migrations in ID security.We are the leader in deploying new solutions to meet driver licensesecurity and service challenges. This includes 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,and secure 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 the Company’s current revenues arederived from government programs that involve long-term contracts withgovernment agencies in North America and around the world. Most of theremaining revenues are generated from patent and technology license fees paidby business partners providing media and rights management solutions to themedia and entertainment industry. Our licensing business is built upon our extensivepatent portfolio, which contains 207 issued U.S. patents. We expect patentlicensing to continue to contribute most of the revenues in the media andentertainment area of our business for the foreseeable future. We view ourpatent licensees and the government agencies with which we contract aslong-term business partners. The Company recognizes that customer satisfactionis the foundation of long-term customer relationships that will foster futuregrowth and improved financial performance.

Digital watermarking is a strategic component ofnearly all of our product offerings. Digital watermarking has already proven tobe a powerful differentiator in banknote security, giving rise to a long-termrelationship with leading Central Banks and many leading companies in the ITindustry. We are working to develop a similar success in secure identitymanagement systems. So far, the technology has been adopted by 12 stategovernment agencies that issue driver licenses, representing more than 20% of theannual U.S. driver license volume, and one foreign issuer. The United StatesDepartment of Transportation has provided a grant to Digimarc 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 improved media rights and asset management,reduced piracy and counterfeiting losses, improved marketing programs, and moreefficient and effective distribution of valuable media content.

17

----

**Markets andCompetition**

*Government Programs*

The Company believes thatthe global market for secure identity management solutions is in the earlyadoption stage, characterized by a fragmented supply chain with no dominantbrands, emerging standards, and increasing concerns about national and economicsecurity, entitlement programs, and requirements for controlling access toinformation and physical assets. Serving this identity management solutionsmarket involves successfully delivering a wide range of products ranging fromdata capture systems, applicant data and biometric verification systems, securecredentials incorporating a multitude of security features and ID validationsystems for authentication of IDs deployed at various points of inspection. Italso requires the expertise to integrate the various solution sets withexisting government agency databases and systems and the service, support andtraining to secure long-term customer relationships.

Digimarc estimates that thesize of the U.S. driver license issuance market is significantly in excess of $100 millionand believes the market size is likely to expand due to broadening use of thedriver license as a secure credential beyond its traditional role as evidenceof competence to drive a motor vehicle, technological innovation, desire amongissuers to improve security and efficiency, and new governmental regulations.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 intolaw by the President of the United States, mandating federal requirements fordriver licenses. On Oct. 18, 2005, the President signed into law $40million of funding for grants to States in fiscal year 2006 to make upgradesmandated by the REAL ID Act, of which $6 million is to be made available in thefourth quarter of 2005 to States for pilots, with the remaining funds beingsubject to review by Congress of the Department of Homeland Security’s REAL IDimplementation plan for 2006. The Company believes that these mandates andadditional funding may create significant growth in the size of this market.

*Media & Entertainment*

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 andmonitoring, authentication, anti-counterfeiting, or linking to networks andenhanced services. The Company believes these are only the early signs ofmarket penetration, representing a nominal portion of the potential market forDigimarc’s products, services, and technologies. The Company cannot providereliable estimates of the size of these markets as of the date of this report.Where reasonably reliable means to estimate application markets within theselarger markets become available to the Company, we will endeavor to share theseestimates with investors unless such disclosures create unreasonablecompetitive risks or would violate confidentiality of our business relationships.

*Competition*

Our competition tends tobe fragmented and application-specific. In secure identity management, ourprimary 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 

18

----

mediaobjects. Our competitive position within certain markets may also be affectedby factors such as inertia of the status quo and changes in governmentregulations.

**Government Programs**

More than 95% of ourcurrent revenues are derived from the sale of our products and services tovarious government programs. In this sector, document issuers around the worldtake advantage of our systems design, integration and materials scienceexpertise as well as new security innovations like digital watermarking toimplement 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 ofsecure ID solutions in North America, Digimarc systems produce more than 60million driver licenses and other secure personal identification documents peryear. Nearly two-thirds of the U.S. states and many foreign governments,including Russia, Latvia, Mexico, and Canada, utilize Digimarc secure IDsolutions. Many aspects of our advanced technology solutions anticipate boththe mandate of the recently-passed REAL ID Act and the emerging consensus onbest practices consistent 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 Data Capture*

·       Capturedigital images of identity source documents in a transferable format

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

·       Conduct mandatory facialimage capture

*Identity Verification*

·       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

·       Provide electronic accessto all other states to information contained in the motor vehicle database ofthe state

*Secure Credential 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

Digimarchas taken a leadership role in deploying systems that we believe represent bestpractices in secure ID issuance and card architecture, and has anticipated REALID Act requirements with product offerings like the newly announced DigimarcIdentity Validation Suite (IDVS). We currently provide solutions that:

·       Digitallycapture, authenticate and archive images of applicants’ identity documents

19

----

·       Verifyapplicant information by referencing various trusted third party data services,such as Social Security, immigration or commercial databases

·       Capturedigital facial images and fingerprints of individuals

·       Usefacial image and fingerprint biometrics to screen for identity theft and fraud

·       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

Digimarc has worked extensively with driver licenseissuers across the United States to strengthen their ID systems. As a result,we have identified and implemented numerous “best practices” throughout ourprocesses and developed modular, flexible solutions designed to improvesecurity within each component of the secure ID lifecycle—from the time anapplicant applies for or renews his or her driver license; to the secureproduction and issuance of the ID to the legitimate cardholder; to theauthentication of that document at a traffic stop, a bank, a border crossing, astore or the DMV. The chart below maps our solutions to an overview of thesecure ID lifecycle.

****

20

----

*Applicant DataCapture and Identity Verification*

Validation of documents and verification of applicantidentity is key to the secure intake and enrollment process, and a criticalstep toward ensuring that driver licenses are only issued to legitimateapplicants. In 2005, Digimarc introduced the Digimarc Identity Validation Suite,a new product in its solution set designed to validate identity documents andverify the data presented to establish an applicant’s identity.

IDVS implements multi-factor authentication,authenticating documents, verifying application data such as social securitynumber and address, and verifying identity using biometrics. IDVS scans,authenticates and archives images of applicant credentials, such asout-of-state driver licenses, passports, birth certificates and othergovernment-issued IDs. IDVS scans documents submitted by applicants andauthenticates key security features to determine whether the identity documentis genuine, altered or counterfeit. It examines such features as covert digitalwatermarks, barcodes, magnetic stripes and other machine-readable features.Documents are then archived digitally for use in appropriate subsequentinvestigations, and to meet the requirements of the new REAL ID Act.

Recently, the Company announced upgrades to IDVS tofacilitate customer compliance with new Homeland Security requirements forimproving the validation of identities of federal employees and contractors.Under Homeland Security Presidential Directive 12, federal agencies arerequired to acquire the operational capability to collect, verify and archivethe documents presented to establish the identity of all current and newfederal employees and contractors. We believe that IDVS could be a valuabletool for use by federal agencies in achieving compliance with theserequirements. The chart below outlines the document authentication andarchiving workflow of Digimarc’s IDVS solution.

****

21

----

*Applicant IdentityVerification*

The REAL ID Act requiresthat the source of each applicant identity document and key demographic data beverified. Digimarc was the first in the nation to deploy applicantverification, and its system has helped find hundreds of fraudulent attempts toobtain driver licenses. The Digimarc Identity Validation Suite aggregatesaccess to key third-party verification services, such as Social Securityverification and national driver registers. The verification step is integratedinto Digimarc’s secure end-to-end workflow, allowing efficient identificationand processing of exceptions and potential fraud cases, while ensuring timelyprocessing of valid applications.

*Image Capture*

The Digimarc Image CaptureStation enables secure ID and driver license issuers to capturehigh-quality portraits, signatures and fingerprints needed to complete theintake and enrollment process. This step is essential to customer satisfactionthrough high-quality photos, reliable biometric verification, and crucial toproducing a portrait that serves the security function and provides ahigh-quality image of the 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 biometrics component of theDigimarc Identity Validation Suite is a modular, scalable component of oursecure ID solution that incorporates both fingerprint and facial recognitioncapabilities. Digimarc was the first to employ facial recognition as averification step for driver license issuance. We apply our years of solutiondesign and delivery experience to select top-rated, best-of-breed algorithmsand integrate them into IDVS to help our customers identify applicants who arealready in the system—by aiding their screening process with automaticcomparison of facial features or fingerprints to the issuer’s biometricdatabases and, for commercial drivers of Hazardous Materials, against FBIdatabases. Digimarc’s solution offers a proven, effective means of reducingapplicant fraud that has been successfully deployed—catching hundreds offraudulent 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 issueoptions. In both the central issue and over-the-counter workflows, Digimarcprovides secure materials management, complete field service, and integratedoperation with the issuers’ data center applications. Digimarc is positioned tosatisfy a State’s choice of production workflow, based on what the State feels bestfits its population distribution, customer service requirements, and securitypolicies.

*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 incorporatednew and 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.

22

----

*Point of InspectionValidation*

Once a State or national issuer has used bestpractices to process an applicant and issue a highly secure and durableidentity document, the Secure ID lifecycle is not complete unless that document’sroutinely validated at the point of use. With the introduction of securityfeatures such as digital watermarks, today’s secure IDs carry machine-readablefeatures that allow for low-cost and effective cross-jurisdictionalauthentication of identity documents, taking the guesswork out of determiningif a presented ID matches one of the more than 240 valid driver licensedesigns. Digimarc is pioneering the use of point of inspection validation inits work with the U.S. Department of Transportation, which provided the Companywith a grant of approximately $1 million to study the use of digitalwatermarking in driver license authentication in the State of Nebraska.

We believe that our proprietarycard materials and security features, verification and validation solutions,and expertise in issuance system design and production, allow our customers toproduce the most secure, counterfeit and tamper resistant driver licensesavailable. We also believe that, because of our customer focus, expertise,proprietary technologies, and investments in research and development, we arewell positioned to compete effectively within the markets for these productsand services.

*Financial DocumentSecurity*

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 andentertainment sector, customers use secure media solutions from Digimarc andits business partners 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.Many major movie studios, record labels, broadcasters, corporations andcreative professionals rely on digital watermarking as a cost-effective meansto:

·  Deter piracy and illegal use of movies, musicand images

·  Protect entertainment content from copyrightinfringement

·  Track and monitor entertainment content forrights usage and licensing compliance

·  Monitor advertisements to verify ad placementand measure return on investment, and

·  Enable fair and legitimate use of content byconsumers

During the third quarter of 2005, we signed amulti-year patent licensing agreement with Dolby Laboratories, including itswholly owned Cinea, Inc. subsidiary. The agreement facilitates theexpansion of Cinea’s current digital watermarking business to offer a morecomplete range of solutions for protecting the management and distribution ofdigital movie content. Our business partners in this area now include ActivatedContent,  Dolby Laboratories (includingits wholly owned subsidiary Cinea), MediaGrid, Nielsen Media Research (whichrecently acquired AudioAudit), Royal Philips Electronics, Signum, Teletrax(under sublicense from Philips), Technicolor (under sublicense from Philips),Verance and Verimatrix. While each partner addresses particular customer needs,as a whole they are propagating digital watermarking in music, movies, images,and television and radio as a means to improve media rights and assetmanagement, reduce piracy losses, improve marketing programs, and provide moreefficient and effective distribution of valuable media content.

23

----

Digital watermarking solutions in this sector from ourbusiness partners include the following:

*ForensicTracking:**  *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.

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 digital 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.

*BroadcastMonitoring:**  *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.

*CopyPrevention:*   Digital watermarks allow companiesto control the use of copyrighted image, audio and video content. A watermarktravels with the content, persisting through the changes in file format, andthrough transformation between digital and analog form. This allows the contentowner to specify whether 

24

----

or how often the work canbe legally copied or shared without visually or audibly impairing the work. Italso allows greater and safer dissemination of copyrighted works while at thesame time ensuring appropriate compensation to the owners. Digital watermarkingfrom Verance, a Digimarc business partner, has been deployed in conjunctionwith licensed DVD-audio implementations to prevent playback of unauthorized copies.Digital watermarking is currently under consideration as an important securitylayer for additional audiovisual media content and in October of 2005, DVD CopyControl Association (DVD-CCA) issued a Request for Expressions of Interest toevaluate technologies for the purpose of selecting a technology for use inmarking audio-visual content to convey certain content control information (“CCI”). Theselected technology will be used to enhance the Content Scramble System (“CSS”)copy protection system for audio-visual content that is used to protect DVDmovies. The DVD-CCA’s earlier watermarking evaluation efforts concluded in July of2002 without selection of a watermarking technology. According to the DVD-CCARequest, it appears that they anticipate that the optimal solution foraddressing their needs is likely to be audio watermarking. More information canbe found at *www.dvdcca.org.*

*DigitalImage Management:**  *Our owndigital watermarking product portfolio includes our Digimarc ImageBridge andDigimarc MyPictureMarc products, focused on digital image management, Digimarcannounced earlier this year upgrades to its image protection products targetedto creative professionals, and published a beta version of an enhanced desktopimage search made possible by digital watermarking

MyPictureMarc 2005, an update to oursubscription-based offering available at *www.digimarc.com/mypicturemarc,*was released earlier this year to give photographers and other creativeprofessionals new and enhanced layers of security for protecting their digitalimage collections—including digital watermarking for copyright communication,enhanced digital rights management tracking, online image backup and thecapability to add visual watermarking 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 licensing opportunities.

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

*RightsManagement:**  *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:**  *The popularity of Napster, a free peer-to-peer (P2P)music swapping service, brought the issue of content and rights management to acrisis point. Because P2P systems have difficulty determining which audio filesare copyrighted and which are not, it is relatively easy for content to beillegally distributed across these networks. Digital watermarks could allow P2Psystems to easily identify and distinguish copyrighted from non-copyrightedaudio or video files and thereby facilitate legal file sharing. Digitalwatermarks could also enhance P2P systems by enabling them to collaborate withrecord labels and other audio retailers to link to and market legitimatecopyrighted songs. A June 2005 U.S. Supreme Court ruling(Metro-Goldwyn-Mayer Studios vs. Grokster) identified digital watermarking as one of the solutions that could helpcurb copyright infringement and illegal distribution of music or movies sharedacross P2P networks. The ruling recognizes the possibility that digitalwatermarks could be used to 

25

----

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.

*RemoteTriggering:**  *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, digital watermarking has the potential to give consumers morechoices, better access and faster delivery of the products and entertainmentthey want.

**Customers**

The bulk ofDigimarc’s revenues arise from supplying infrastructure pursuant to long-termcontracts with government agencies, primarily U.S. state Departments of MotorVehicles, a consortium of leading Central Banks, and national governments ofvarious foreign countries. Our contract with the Central Banks is in its eighthyear. Last year we 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:

·  State and national government agencies thatissue driver licenses, national IDs and voter credentials, including 32 U.S.states, the District of Columbia, two Canadian provinces, Latvia, Mexico andRussia

·  An international consortium of the world’sleading Central Banks

·  ActivatedContent, Dolby Laboratories (including its wholly owned subsidiary Cinea),MediaGrid, Nielsen Media Research (which recently acquired AudioAudit), RoyalPhilips Electronics, Signum, 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 servicerevenue growth in the fourth quarter of 2005 as compared to 2004 as a result ofour marketing successes in 2003 and 2004, (including new programs for digital driver license systems inFlorida, Alabama and Ohio that are expected to reach full production levelsduring 2005). Consistent with the historical seasonality of our revenues, weexpect revenues in the fourth quarter of 2005 to be lower than revenues in thethird quarter of 2005.

26

----

We also expect tobid on some new contract opportunities during the upcoming months. We areencouraged by the interest of the federal government in promoting more securedriver licenses and the possibility of federal funding to support systemsupgrades by our state customers.

The Company alsoanticipates continued interest in media content and digital rights management,Homeland Security and anti-theft/anti-fraud solutions. While there can be noassurance that this interest will result in more widespread adoption ofsolutions from Digimarc and its business partners, we believe that our patentedtechnologies and solutions and established expertise in large-scale secure IDsystems will enable us to compete effectively for business opportunities thatarise in these areas.

**Subsequent Events**

Subsequent to the end of the quarter, the TexasDepartment of Public Safety selected Digimarc in a competitive bid to provideimage capture systems, design and produce a new highly secure driver license,and improve issuance security with facial recognition and fingerprintbiometrics, under a new five-year contract valued at nearly $30 million.

The new Texas driver license is built upon Digimarc’sinnovative, highly secure and durable ExianEvidentTM card architecture, arevolutionary advance in counterfeit- and tamper-proof card construction. Thedriver license will be produced in Digimarc’s Texas central issue factory, usingbest practices for secure issuance. The system also includes implementation offacial recognition and fingerprint matching, via the Digimarc IdentityValidation Suite (IDVS), to screen for fraud in both new issuance andrenewals.

In the media and entertainment market, according torecent statements by studio executives, such as published in the October 27edition of Warren’s Consumer Electronics Daily, audio watermarking technologymay also be under consideration as a security element for protection of newhigh definition media formats such as HD-DVD and Blu-ray.

Subsequent to the end ofthe quarter, the DVD Copy Control Association (DVD-CCA) issued a Request forExpressions of Interest to evaluate technologies for the purpose of selecting atechnology for use in marking audio-visual content to convey certain contentcontrol information (“CCI”).  The selected technology will be used toenhance the Content Scramble System (“CCS”) copy protection system foraudio-visual content that is used to protect DVD movies. The DVD-CCA’s earlierwatermarking evaluation efforts concluded in July of 2002 withoutselection of a watermarking technology. According to the DVD-CCA Request, itappears that they anticipate that the optimal solution for addressing theirneeds is likely to be audio watermarking. More information can be found at *www.dvdcca.org.*

**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 our estimates,including those related to bad debts, inventories, intangible assets, incometaxes, restructuring, long-term service contracts, warranties, investments, andcontingencies and litigation. We base our estimates on historical experienceand on various other assumptions we believe to be reasonable under thecircumstances. Actual results may differ from these estimates under differentassumptions 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 

27

----

significant judgments andestimates used in the preparation of our condensed consolidated financialstatements:

**Revenuerecognition on long-term service contracts:****  **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.These amounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting 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 is generallydetermined based on time and material or a cost plus a profit margin measure.Revenue for professional services is recognized as the services are performed.Losses on contracts, if any, are provided for in the period in which the lossbecomes determinable. Billing for services rendered generally occurs within onemonth following when the services are provided. Revenue earned which has notbeen invoiced is classified as unbilled trade receivables in the consolidatedbalance sheets.

**Impairmentsand estimation of useful lives of long-lived assets:****  **We periodically assess long-livedassets for impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable in accordance with theprovisions of SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets.*This statementrequires that long-lived assets and certain identifiable intangibles bereviewed 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.

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

**Reservesfor uncollectible accounts receivable:****  **We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments. We determine the allowance based on historicalwrite-off experience and current information. We review, and adjust 

28

----

when appropriate, ourallowance for doubtful accounts on at least a quarterly basis. If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required. If ourestimate of uncollectible accounts were too low by 10%, there would be nomaterial impact on the reported value of accounts receivable on our condensedconsolidated balance sheets.

**Contingencies andLitigation:****  **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.

**Results of Operations**

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

| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                       | ** ** | **2005**                         | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                             | 84         | %                               |       |   | 85 | % |   |   | 84 | % |   |   | 79 | % |   |
| Product and subscription                         |       |                             | 16         |                            |       |   | 15 |   |   |   | 16 |   |   |   | 21 |   |   |
| Total revenue                                    |       |                             | 100        |                            |       |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                 |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Service                                          |       |                             | 55         |                            |       |   | 51 |   |   |   | 56 |   |   |   | 47 |   |   |
| Product and subscription                         |       |                             | 7          |                            |       |   | 7 |   |   |   | 7 |   |   |   | 14 |   |   |
| Total cost of revenue                            |       |                             | 62         |                            |       |   | 58 |   |   |   | 63 |   |   |   | 61 |   |   |
| Gross profit                                     |       |                             | 38         |                            |       |   | 42 |   |   |   | 37 |   |   |   | 39 |   |   |
| Operating  expenses:                             |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                              |       |                             | 16         |                            |       |   | 13 |   |   |   | 16 |   |   |   | 12 |   |   |
| Research, development and engineering            |       |                             | 11         |                            |       |   | 8 |   |   |   | 11 |   |   |   | 7 |   |   |
| General and administrative                       |       |                             | 23         |                            |       |   | 29 |   |   |   | 27 |   |   |   | 24 |   |   |
| Amortization of intangibles                      |       |                             | 4          |                            |       |   | 3 |   |   |   | 4 |   |   |   | 3 |   |   |
| Total operating expenses                         |       |                             | 54         |                            |       |   | 53 |   |   |   | 58 |   |   |   | 46 |   |   |
| Operating income (loss)                          |       |                             | (16        | )                               |       |   | (11 | ) |   |   | (21 | ) |   |   | (7 | ) |   |
| Other income  (expense):                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                  |       |                             | 1          |                            |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Interest expense                                 |       |                             | 0          |                            |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Other                                            |       |                             | 0          |                            |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Total other income, net                          |       |                             | 1          |                            |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Income (loss)  before provision for income taxes |       |                             | (15        | )                               |       |   | (10 | ) |   |   | (20 | ) |   |   | (6 | ) |   |
| Provision for  income taxes                      |       |                             | (1         | )                               |       |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Net income (loss)                                |       |                             | (16        | )%                              |       |   | (10 | )% |   |   | (20 | )% |   |   | (6 | )% |   |

 

29

----

*Revenue*

Total revenue was $26.8 million and $75.9 millionfor the three- and nine-month periods ended September 30, 2005,respectively, compared to total revenue of $23.5 million and $70.7 million forthe three- and nine-month periods ended September 30, 2004, respectively,and represented a 14% and 7% increase over the three- and nine-month periodsended September 30, 2005 and 2004 respectively. The changes in totalrevenue between the comparable three- and nine-month periods of 2005 and 2004resulted primarily from additional programs added in late 2004 and early 2005,such as Florida, Alabama, Mexico, Latvia and Ohio that are either at fullproduction or expected to reach full production by the end of the year. Thisincrease in revenue was partially offset by a small number of contracts ending.

In addition, we have observed seasonality in ourrevenues, with larger revenues in the second and third quarter of the year, andgenerally lower revenues in the first and fourth quarters. We expect ourresults in the fourth quarter of 2005 to be consistent with this pattern ofseasonality.

Based on projected driver license production volumesand other commitments we have for the periods under contract with ourrespective customers, we anticipate our current contracts as of September 30,2005 will generate more than $210 million in revenue during thecontractual terms of such contracts, currently up to seven years. We expectapproximately $20 million of this amount to be recognized as revenue during theremainder of 2005. This amount includes production volumes reasonably expectedto be achieved under currently effective contracts, government orders that arefirm but not yet funded, and government contracts awarded but not yet signed.

Some factors thatlead to increased backlog are:

·  Competitive bid wins,

·  Renewals with current customers,

·  Add-on sales to current customers, and

·  Contracts with longer contractual periodsreplacing contracts with shorter contractual periods.

Some factors thatlead to decreased backlog are:

·  Recognition of revenue associated with backlogcurrently in place,

·  Periods following low bid activity,

·  Contracts with shorter contractual periodsreplacing contracts with longer contractual periods, and

·  The revenue model utilized for a particularcustomer (e.g., a “price-per-card” model with a large associated backlog vs. a “hardwareand consumables” model with a small associated backlog).

The mix of these factors, among others, dictateswhether our backlog increases or decreases for any given period. For example,the three-month period ended September 30, 2005 followed a period of lowbid activity, and as a result we have consumed backlog during the quarterwithout large replenishments from competitive bid wins. However, during thesame three-month period we had higher bid activity, and as a result we haveannounced and expect to announce new contracts that have been awarded. As aresult, we expect backlog at the end of the year to increase from the September 30,2005 level. In addition, over the next year or so, we anticipate several statesto request bids on their driver license issuance system programs. This periodof expected high bid activity could lead to additional backlog if we aresuccessful with our bids. Another 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.

30

----

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.

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 to the prime contractor; and, asa prime contractor, we are responsible for integrating the components of thesystem to the customer’s specifications. Revenue from international customerswas $5.5 million and $14.6 million for the three- and nine-month periodsended September 30, 2005, respectively, compared to $4.6 million and $15.7million for the three- and nine-month periods ended September 30, 2004,respectively. International sales represented 21% and 19% of our total revenueduring the three-month periods ended September 30, 2005 and 2004,respectively, and 20% and 22% of our total revenue during the nine-monthperiods ended September 30, 2005 and 2004, respectively. Internationalsales for us have typically taken the form of an outright sale of equipmentand/or consumables to non-U.S. government agencies or their prime contractors.These sales often can be large, carry relatively low margins and may causenoticeable spikes in quarterly revenue and variations in gross profit trends.We enter into such contracts from time to time to maintain market presence andcustomer and partner relationships, as such programs often transition to moreprofitable digital technologies over time. Due to the nature of suchinternational programs and customers, the timing of these sales is somewhatless predictable than are service revenues provided by domestic customers and,consequently, international sales can occur unevenly during the course of ayear. We believe that international growth opportunities exist for us and weexpect to continue to invest in personnel and resources to support ourpotential revenue growth outside of the U.S.

*Service.**  *Service revenue consists primarilyof card production on a price-per-card basis, software development services,and hardware and software maintenance. The majority of service revenuearrangements are typically structured as price-per-card product agreements,time and materials consulting agreements, or fixed price consulting agreements.Service revenue is an umbrella category consisting of both service revenue andcontract-based service revenue. The distinction between these two subcategoriesis that service revenue is generated from long-term identification and driverlicense production contracts, while contract-based service revenue is generatedfrom other long-term, time-and-materials service contracts.

Service revenue was $22.4 million and $63.6 millionfor the three- and nine-month periods ended September 30, 2005,respectively, compared to $20.0 million and $55.5 million for the three- andnine-month periods ended September 30, 2004, respectively. The $2.4million or 12% increase for the three-month period and the $8.1 million or 15%increase for the nine-month period ended September 30, 2005, respectively,as compared to the corresponding three- and nine-month periods of 2004, wereprimarily due to issuance revenue from new programs for Mexico and Latvia,which started generating revenue in the second quarter of 2004, Florida, whichstarted in the third quarter of 2004, Ohio, which started in the first quarterof 2005, and Alabama, which started in the second quarter of 2005, offsetpartially by contracts that ended and contracts that converted to consumablesales.

*Productand 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 $4.4 million and $12.3 million for the three- and nine-monthperiods ended September 30, 2005, respectively, compared to $3.5 millionand $15.1 million for the three- 

31

----

andnine-month periods ended September 30, 2004, respectively. The $0.9 millionor 25% increase for the three-month period ended September 30, 2005 ascompared to the corresponding three-month period from the prior year wasprimarily due to the timing of a non-recurring sale to a foreign customer thatoccurred in the three-month period ended September 30, 2005 without acorresponding sale in the same period last year. The $2.8 million or 18%decrease for the nine-month period ended September 30, 2005 as compared tothe corresponding nine-month period from the prior year was primarily due tothe timing of larger non-recurring sales to domestic and foreign customers thatoccurred in 2004, partially offset by smaller non-recurring sales to domesticand foreign customers that occurred in 2005.

*Cost of Revenue*

*Service.**  *Cost of service revenue primarilyincludes costs of consumables used in delivering a service, compensation forsoftware developers, quality assurance personnel, product managers, fieldoperations personnel, business development personnel and outside contractors,depreciation charges for machinery, equipment and capitalized software,deployment costs used specifically for service delivery, provisions forobsolete and excess inventories, and travel costs directly attributable toservice and development contracts.

Cost of service revenue was $14.7 million and $42.7million for the three- and nine-month periods ended September 30, 2005,respectively, compared to $11.9 million and $33.2 million for the three- andnine-month periods ended September 30, 2004, respectively. The $2.8million or 23% increase for the three-month period and $9.5 million or 29%increase for the nine-month period ended September 30, 2005, respectively,as compared to the corresponding three- and nine-month periods of 2004 wereprimarily the result of higher consumables and general support costs related tothe higher revenue identified above, higher depreciation on revenue-generatingassets, increased costs to deliver support and maintenance for new and existingprograms, and increased freight costs related to higher shipping activity,partially offset by lower inventory reserves.

*Productand 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 $1.8 million and $5.2 million for the three- and nine-monthperiods ended September 30, 2005, respectively, compared to $1.8 millionand $10.1 million for the three- and nine-month periods ended September 30,2004, respectively. The absence of change for the three-month period and$4.9 million or 48% decrease for the nine-month period ended September 30,2005, respectively, as compared to the corresponding three- and nine-monthperiods of 2004 were the result of higher margin sales in the first threequarters of 2005 as compared to the prior year and lower overall product and subscriptionsales for the nine-month period, yielding a decrease in product andsubscription cost of revenue.

*Gross Profit*

Overall gross profit as a percentage of revenue forthe three- and nine-month periods ended September 30, 2005 and was 38% and 37%,respectively, compared to the 42% and 39% for the three-and nine-month periodsended September 30, 2004, respectively, largely for the reasons stated aboveunder the “Cost of Revenue” section.

In addition, we have observed that our variable coststo deliver incremental revenue have remained relatively consistent from periodto period when based on a percentage of revenue (such costs include the priceof materials and labor to produce an identification card); however, our fixedcosts as a percentage of revenue are larger. These fixed costs includeamortization and depreciation of costs incurred during the delivery process(such costs are capitalized and then amortized or depreciated over the life ofthe contract) 

32

----

and include field servicepersonnel costs (such personnel are used to perform maintenance on our deployedsystems). The current higher fixed costs as a percentage of revenue are aresult of a several factors. The primary factor relates to some new programsinvolving competitive wins, where we have provided a complete systemreplacement using advanced technologies. These programs have recently beencompleted and transitioned from deployment to revenue production, and thus arenow affecting margins. These installations were particularly challenging forus, representing a stretch in terms of scope from our historical systemdeliveries. We were successful in delivering these programs, but at higher coststhan have been customary. In one other case, we bid the program at relativelylow margin as part of a market development strategy that we believe will yieldgood long-term performance. The fixed costs for these systems, which includeamortization and depreciation of costs capitalized during the delivery processas well as field service and operational costs to manage and maintain them, arehigher than average and, thus, reduce reported margins. We anticipate that wewill be able to improve margins in these accounts over time and earn a goodreturn on investment over the life of the account relationship.

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.We use 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 percentage of revenue inthe second and third quarter of the year and decreasing margins as a percentageof revenue 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*

*Salesand 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 $4.3 million and $12.0 million forthe three- and nine-month periods ended September 30, 2005, respectively,compared to $3.1 million and $8.5 million for the three- and nine-month periodsended September 30, 2004, respectively.

The $1.2 million or39% increase for the three-month period resulted primarily from the following:

·  employee compensation-related expenses forsalaries, benefits, recruiting costs, and incentive plans increased $0.6million due to personnel mix for higher level focus on marketing andgovernmental activities, and higher benefit program costs;

·  increased bids and proposal work of $0.5million;

·  increased presence at tradeshows, advertising,consulting fees and event sponsorship of approximately $0.2 million;

·  increase in other sales and marketingexpenditures of $0.2 million;

·  partially offset by a one time impairmentcharge of $0.3 million taken in the three-month period ended September 30,2004 related to an investment in a company licensed to market our watermarkingtechnology.

33

----

The $3.5 million or41% increase for the nine-month period resulted primarily from the following:

·  employee compensation-related expenses forsalaries, benefits, recruiting costs, and incentive plans increased $1.8million due to personnel mix for higher level focus on marketing andgovernmental activities, and increased benefits;

·  increased bids and proposals work of $0.7million;

·  increased presence at tradeshows, advertising,consulting fees and event sponsorship of approximately $0.5 million;

·  increase in other general and administrativesales and marketing expenditures of $0.5 million;

·  partially offset by a one time impairmentcharge of $0.3 million taken in the three-month period ended September 30,2004 related to an investment in a company licensed to market our watermarkingtechnology.

We anticipate that we will continue to invest at orabove the current run rate in sales and marketing in the near term whilemoderating spending in the longer term.

*Research,development and engineering.**  *Research, development and engineering expensesconsist primarily of compensation, benefits and related costs of softwaredevelopers and quality assurance personnel and payments to outside contractors.Research, development and engineering expenses were $2.9 million and $8.4million for the three- and nine-month periods ended September 30, 2005,respectively, compared to $1.9 million and $5.2 million for the three- andnine-month periods ended September 30, 2004, respectively.

The $1.0 million or50% increase for the three-month period resulted primarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $0.6 million; and

·       applicationof resources from capital projects of $0.3 million to research activities toenhance existing products, develop new products, and focus on requirements ofthe recently passed REAL ID Act.

The $3.2 million or61% increase for the nine-month period resulted primarily from the following:

·       employeecompensation-related expenses for salaries, benefits, recruiting costs, andincentive plans increased $2.2 million; and

·       applicationof resources from capital projects of $0.8 million to research activities toenhance existing products, develop new products, and focus on requirements ofthe recently passed REAL ID Act.

We anticipate that we will continue to invest at orabove the current run rate in research and development in the near term whilemoderating spending in the longer term.

*Generaland 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 $6.2 millionand $20.2 million for the three- and nine-month periods ended September 30,2005, respectively, compared to $6.7 million and $16.6 million for the three-and nine-month periods ended September 30, 2004, respectively.

34

----

The $0.5 million or8% decrease for the three-month period resulted primarily from the following:

·  decreased bad debt expense charges of $0.4million;

·  rent expense decreased $0.3 million related toaccelerated charges in 2004 to move the corporate office;

·  partially offset by increased audit andconsulting fees of $0.1 million primarily related to our Sarbanes-Oxley audit,compliance activities, remediation efforts, and finance staff expansion.

The $3.6 million or22% increase for the nine-month period resulted primarily from the following:

·  increased headcount and skills mix to addressenhanced governance and internal controls drove up employee-related expensessuch as salaries, benefits, recruiting costs, and incentive plans by$1.8 million;

·  audit and consulting fees increased $1.8million primarily related to our year-end audit, restatement work,Sarbanes-Oxley audit, and finance staff expansion;

·  increased software expense of $0.3 millionrelated to continued licensing costs and software upgrades;

·  increased other administrative costs of $0.3million related to support for our growing infrastructure;

·  partially offset by decreased bad debt expensecharges of $0.2 million; and

·  rent expense decreased $0.4 million related toaccelerated charges in 2004 to move the corporate office.

We anticipate that we will continue to invest infinance and IT and the operational infrastructure at our identification systemsbusiness to more effectively manage growth in the context of increasedregulatory requirements. We also anticipate that we will invest above ourcurrent run rate in general and administrative in the near term whilemoderating spending in the longer term.

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

Amortization expense was $1.1 million and $3.3 millionfor the three- and nine-month periods ended September 30, 2005,respectively, compared to $0.7 million and $1.9 million for the three- andnine-month periods ended September 30, 2004, respectively. The$0.4 million or 67% increase for the three-month period and $1.4 millionor 76% increase for the nine-month period ended September 30, 2005,respectively, as compared to the corresponding three- and nine-month periods of2004 resulted primarily from the accelerated amortization of intangible balancesbased on current estimates of useful lives.

35

----

*Totalother income, net.**  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.2 million and $0.7 million for the three- and nine-monthperiods ended September 30, 2005, respectively, compared to $0.2 millionand $0.6 million for the three- and nine-month periods ended September 30,2004. The slight increase resulted from higher interest earned on lowercash and investment balances partially offset by higher interest expenserelated to capitalized leases.

*Provision for Income Taxes*.   Theprovision for income taxes reflects expected tax expense from profitability inforeign jurisdictions. Due to the uncertainty of realization of deferred taxassets, including those generated in the current period, we have recorded afull valuation allowance against our net deferred tax assets atSeptember 30, 2005. We will continue to evaluate the realizability of ournet deferred tax assets in future periods and may recognize income tax benefitsin future earnings if we determine that the realization of these assets is morelikely than not.

**Liquidity andCapital Resources**

As of September 30, 2005, we had cash and cashequivalents, restricted cash, and short-term investments of $33.4 million,representing a decrease of approximately $18.4 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 September 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 September 30, 2005 was $36.1 million,compared to working capital of $48.9 million at December 31, 2004. The decreasein working capital resulted primarily from investments made in the new Floridaand Alabama programs.

The $4.6 million of cash used in operations for thenine months ended September 30, 2005 resulted from a net loss of $15.6million, partially offset by non cash items related to depreciation andamortization of $14.0 million and an increase in accrued payroll and relatedcosts of $1.8 million. Items negatively affecting cash used in operations werea decrease in accounts payable of $4.9 million and an increase in trade andunbilled accounts receivable of $1.2 million. The $9.2 million of cash providedby operations for the nine months ended September 30, 2004 was positivelyimpacted by an increase in accrued payroll and related costs of $1.2 million, adecrease in restricted cash of $1.7 million and depreciation and amortizationof $9.7 million, partially offset by $4.5 million of net loss for the periodand an increase in trade and unbilled accounts receivable, net of $2.3 million.

The $6.1 million of cash provided by investingactivities for the nine-month period ended September 30, 2005 primarilyrelated to $18.8 million in net sale or maturity of short-term investmentspartially offset by $12.7 million for the purchase of property and equipment,including capitalization of labor costs. The $12.9 million of cash used ininvesting activities for the nine months ended September 30, 2004 wasrelated primarily to $32.0 million for the purchase of property and equipment,including capitalization of labor costs, partially offset by $19.0 million innet sale or maturity of short-term investments.

The $0.1 million of cash used in financing activitiesfor the nine-month period ended September 30, 2005 resulted primarily fromthe principal payments on capital leases, partially offset by the proceeds fromthe issuance of stock. The $1.8 million of cash provided by financingactivities for the nine months ended September 30, 2004 primarily relatedto the issuance of stock. On January 7, 2004, five holders of warrants topurchase shares of common stock exercised their warrants for an aggregate of74,506 shares of common stock, which resulted in approximately$1.0 million of gross proceeds to us. The remaining proceeds 

36

----

resulted from the issuanceof stock related to our stock incentive plans, which were partially offset byprincipal payments on capital leases of $0.1 million.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $9.2 million as of September 30,2005, and are payable in monthly installments through August 2011. Ourobligations under non-cancelable capital leases, which totaled $1.1 million asof September 30, 2005, are payable in monthly installments through March 2009.

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.

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 $2.3 million of expenditures. The estimates are derived frominformation known to the Company at the time the estimates were prepared. Suchestimates were prepared as of quarter end. Actual expenditures may vary fromour estimates. We anticipate that these expenditures will be recouped throughreceipts from the related 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 orproduct lines.

We believe that our current cash, cash equivalents,and short-term investment balances will satisfy our projected working capitaland capital expenditure requirements for at least the next 12 months.Thereafter, we anticipate continuing to use cash, cash equivalents, and short-terminvestment balances to satisfy our projected working capital and capitalexpenditure requirements. However, in the event that we were to win contractsrequiring 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 our business..

**Recent Accounting 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 forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage) in the determination of inventory carrying costs. Thestatement requires such costs be recognized as a current-period expense. FAS151 also requires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. This 

37

----

statement is effective forfiscal years beginning after July 15, 2005. The Company does not expectthat the adoption of this standard will have a material impact on its financialcondition or results of operations.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections: a replacement of APB Opinion No. 20 andFASB Statement No. 3,” which requires companies to apply most voluntaryaccounting changes retrospectively to prior financial statements. SFAS No. 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. Any future voluntary accountingchanges made by us will be accounted for under SFAS No. 154.

On December 16, 2004,the FASB issued Statement No. 123(R) *Share-BasedPayment*, which is a revision of Statement No. 123 andsupersedes APB Opinion No. 25. Statement No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be valued at fair value on the date of grant, and to be expensed over theapplicable vesting period. Pro forma disclosure of the income statement effectsof share-based payments is no longer an alternative. Statement No. 123(R) iseffective for all stock-based awards granted on or after January 1, 2006.In addition, companies must also recognize compensation expense related to anyawards that are not fully vested as of the effective date. Compensation expensefor the unvested awards will be measured based on the fair value of the awardspreviously calculated in developing the pro forma disclosures in accordancewith the provisions of Statement No. 123. The Company is currentlyassessing the impact of adopting Statement 123(R) to its consolidatedresults of operations.

**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 and withregard to opportunities to facilitate efforts of State government agencies tocomply with REAL ID, statements regarding the expected deployment of programsin 2005, statements regarding anticipated expenses, costs, margins andinvestment activities in the foreseeable future, statements regardinganticipated revenue to be generated from current contracts and as a result ofnew programs, statements regarding the investments required to complete certaindriver license programs and the Company’s ability to recoup those expensesunder the relevant contract, statements regarding our profitability in futureperiods, statements regarding our the development and growth of the market fordigital watermarking technology, statements regarding business opportunitiesthat could require that we seek additional financing, statements regarding theexistence of international growth opportunities and our future investment insuch opportunities, statements regarding the continuance of operationalpressures on our identification systems business in future quarters, statementsregarding the source of a majority of our future revenue, statements regardingthe contribution of new sales channels in domestic and foreign markets to ourfuture results, statements regarding future effects on our business inconnection with the continuing implementation of our new accounting andmaterial requirements planning systems and modifications to our inventorymanagement and controls systems and procedures or other review processes,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 our expectedshort-term and long-term liquidity positions, statements regarding ouruse of cash in upcoming quarters, statements regarding anticipated levels ofbacklog in future periods, statements regarding anticipated extensions of 

38

----

the termof our contract with the Central Banks, and other statements containing wordssuch as “anticipate,” “estimate,” “expect,” “management believes,” “we believe,”“we intend” and similar words or phrases, which are intended to identifyforward-looking statements. Actual results may vary materially due to, amongother things, the failure of the potential markets for the Company’s digitalwatermarking technology to develop as anticipated, the adoption of alternativetechnologies within these markets, the inability of the Company to becomeprofitable, inherent limitations in all control systems and related procedures,risks as to litigation and related matters in connection with our restatementof financial results, the actual timing and impact of our compliance with Section 404of the Sarbanes-Oxley Act of 2002, changes resulting from any key personneladditions or changes, as well as changes in economic, business, competitive,technology and/or regulatory factors and trends, and the other factorsdescribed in this Form 10-Q or in our other documents filed with theSEC, including our Form 10-K for the year ended December 31,2004. All forward-looking statements are necessarily only estimates of futureresults and there can be no assurance that actual results will not differmaterially from expectations, and, therefore, investors are cautioned not toplace undue reliance on such statements. Investors should understand that it isnot possible to predict or identify all risk factors and that the risksdiscussed above should not be considered a complete statement of all potentialrisks and uncertainties. We do not intend to update any forward-lookingstatements as a result of future events or developments.

**Risk Factors**

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

*Given our history of losses, we cannot guarantee sustainedprofitability, particularly if we were to lose large contracts.*

We incurred significantnet losses from inception through the fiscal year ended December 31, 2002,during 2004, and the first three quarters of 2005. Our accumulated deficit asof September 30, 2005 was $80.5 million. In order to attain sustainedprofitability, we will need to generate higher revenue than we have in prioryears while controlling expenditures. Even though we have achievedprofitability in the past, we were not profitable in 2004 or the first part of2005. 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.

*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 the

39

----

loss ofrevenue and margin on a prospective basis, we could also incur acceleratedamortization expense or impairment of intangible assets related to thecustomer.

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

The markets inwhich we compete for business are intensely competitive and rapidly evolving.We expect competition to continue from both existing competitors and new marketentrants. We face competition from other companies and from alternativetechnologies. The potential for an influx of federal funds into our core U.S.driver license market is likely to draw new competition. As we expand theapplications for our technologies, we will experience more competition fromproducts and services that are substitutes for our applications. Because ourdigital watermarking business is new and emerging, we also may face competitionfrom unexpected sources. Alternative technologies that may directly orindirectly compete with particular applications of our watermarkingtechnologies include:

·       Encryption—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 severe pricecuts or take other measures in an effort to gain market 

40

----

share or otherwise impedeour progress. We cannot assure you that digital watermarking technologies, andour products and services using these technologies, will gain widespread marketacceptance.

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.

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

Products and systems ascomplex as those we offer or develop may contain undetected defects or errors.Furthermore, we often provide complex implementation, integration,customization, consulting and other technical services in connection with theimplementation and ongoing maintenance of our products. Despite testing,defects or errors in our products and services may occur, which could result indelays in the development and implementation of products and systems, inabilityto meet customer requirements or expectations in a timely manner, loss ofrevenue or market share, failure to achieve market acceptance, diversion ofdevelopment resources, injury to our reputation, increased insurance costs,increased service and warranty costs and warranty or breach of contract claims.Although we attempt to reduce the risk of losses resulting from warranty orbreach of contract claims through warranty disclaimers and liability limitationclauses in our sales agreements when we can, these contractual provisions aresometimes not included and may not be enforceable in every instance.Furthermore, although we maintain errors and omissions insurance, thisinsurance coverage may not adequately cover these claims. If a court refuses toenforce the liability-limiting provisions of our contracts for any reason, orif liabilities arose that were not contractually limited or adequately coveredby insurance, the expense associated with defending such actions or paying theresultant claims could be significant and decrease our profits.

41

----

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

Many of our 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 watermarking technologyor any of our other technologies. Such a negative position by these companies,bodies or institutions, if taken, may result in obstacles for us that we wouldbe incapable of overcoming and may make achieving our business objectivesdifficult or impossible, potentially diminishing our anticipated revenue growthas a result.

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

Our future success will depend in part on 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.

*We expect oursecure identity systems business to experience variability in gross margins.*

We are likely toexperience variability in gross margins on our government contracts due tonumerous 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;

42

----

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

·       Seasonalityof issuance volumes;

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

·       Salesmix related to domestic sales compared to international sales;

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

·       Strategicdecisions on new business; 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 secure identitysystems business.

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

We derive substantialportions of our revenue from government contracts which are subject to periodicopen, competitive bids. The timing of such bids is solely within the discretionof the governmental authority. Consequently, large components of new 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.

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

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

·       Wemay be unable to develop sources of new revenue or sustainable growth 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 in the development stage. Consequently, products incorporatingthese key technologies are undergoing technological change and are in the earlystage of introduction in the marketplace. Delays in the adoption of theseproducts or adverse competitive developments may result in delays in thedevelopment of new revenue sources or the growth in our revenue. In addition,we may be required to incur unanticipated capital expenditures in the eventproduct changes or improvements are 

43

----

required.Additionally, new industry standards might redefine the products that we areable to sell, especially if these products are only in the prototype stage ofdevelopment. If product changes or improvements are required, success inmarketing these products and achieving profitability from these products couldbe delayed or halted. We also may be required to fund such changes or improvementsout of operating income, which could reduce or eliminate our profitability.

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

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, integrateor bundle such technologies, or these partners are unsuccessful in theirefforts, our efforts to bring our technologies to market would be adverselyaffected and, consequently, we would not generate revenue as anticipated. Inaddition, if our technologies do not perform according to market expectations,our future sales would suffer as customers seek other providers and,consequently, our anticipated future revenues would decrease.

For example, our businessand our strategy rely, in part, on deployment of our watermark readertechnology by third parties. One form of our watermark reader is commonlydeployed in image editing applications (offered by vendors including Adobe,Corel and Ulead) to permit users of these products to read watermarks embeddedin imagery, and thereby discern the identities of image owners. Another form ofour watermark reader is used in our anti-counterfeiting product offerings. Ifthird parties who include such technology in their products, and other partieswhom we expect to include such technology in their products, decline to do so,then we would lose a portion of our currently anticipated revenue and we maysuffer other adverse affects to our business model. Although such anticipatedrevenue amounts are not currently significant, they may be in the future.

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

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

44

----

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

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.

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

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 the LGP business unit ofPolaroid in 2001, we have limited experience in integrating an acquiredbusiness into our existing business. The process of integration may produceoperating difficulties (like those experienced with the LGP acquisition) andmay require significant attention of our management that otherwise would beavailable for the ongoing development of our business. In the end, we may beunsuccessful in integrating an acquired business, technology or other assetwith our existing business. Moreover, if we make acquisitions, we may issueshares of our stock that would dilute the equity holdings of our existingstockholders, incur debt, assume contingent liabilities or create additionalexpenses related to amortizing intangible and other acquired assets. Any ofthese may result in reduced earnings and cause our stock price to decline. Ourdue diligence of acquired companies may fail to reveal material risks orliabilities. Additionally, in order to take advantage of opportunities, we mayfind it necessary to obtain additional equity financing, debt financing, or creditfacilities, and we may not be successful in doing so on satisfactory terms. Anyfinancing that we might need for future acquisitions may also placerestrictions on our business. Furthermore, we may never achieve any of thebenefits that we might anticipate from a future acquisition.

*As international customers have accounted forapproximately 19% of our total revenue during the nine months ended September 30,2005, the loss of these customers or the failure to find new customers mayresult in a decline in our international revenue, which could lower ourprofitability and slow our growth.*

We expect 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;

45

----

·       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 we are affected by these risks, our sales ofproducts and services to customers outside the U.S. could be reducedsignificantly, as such customers may decide to terminate or delay theimplementation of our products and services. Any such actions by foreigncustomers, in particular foreign government authorities, could potentiallydelay or reduce our anticipated revenue under our contracts with suchcustomers, and we may have limited recourse against them to recover anypotential 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.

*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 otherprovisions that may cause our quarterly results to fluctuate and ouranticipated revenue to potentially decrease significantly.*

Our contracts for driver license and otheridentification issuance systems and their related products typically includeterms relating to supplier dependencies, time-based performance, developmentand delivery schedules and milestones, and other contract terms that may createsituations where a customer may assert that we are late in meeting our deliveryobligations and that we owe them late penalties, charges or other damages. 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 agreements to sell entire systems orportions of a system for an agreed upon price. These contracts normally do nothave clauses that allow for recovery of cost overruns. Under these contracts,we provide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on 

46

----

some of these 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 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 procurementprocedures, strict legal requirements, budget changes and cutbacks duringeconomic downturns, variations in appropriations cycles, and protests ofcontract awards. Additionally, some governmental authorities requireperformance bonds that we are obligated to maintain during the life of thecontract. Often, the terms of these bonds require that we maintain large restrictedcash reserves as a guarantee, reducing our ability to use these funds for ourother business purposes. Even with the availability of such cash reserveguarantees, we may not be able to obtain such performance bond underwriting ata favorable rate or at all. Our failure to be able to provide such performancebonds may preclude our ability to bid on new government contracts or maintainour existing contracts for the entirety of their full terms. The size, natureand purpose of, and the risks and uncertainties associated with, public sectorcontracts can potentially cause our quarterly results to fluctuate andanticipated revenue to decrease significantly.

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

Government 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 maythen argue that it falls within the class of works for which it owns thecopyright, enabling the state to turn the Digimarc-authored software over toone of our competitors, dedicate it to the public domain, or otherwise use thesoftware in a manner detrimental to our business. Objectionable contract termsmay lead us to decline to bid on identification issuance systems to newcustomers, or to decline to retain business with customers we have historicallyserved, which could reduce our market share and lower our revenues or profits.In addition, if we decline to retain business with customers we havehistorically served, it could result in the accelerated depreciation ofintangible assets. Alternatively, we may decide to accept at least some level ofobjectionable terms rather than cede an important contract to a competitor,which could also lower our revenues or profits.

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

We are materiallydependent on a limited number of third parties to produce systems or assembliesnecessary for us to produce some of our products. 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, under some of our contracts.

47

----

*We may not be able to protect adequately ourintellectual property, and we may be subject to infringement claims and otherlitigation, which could adversely affect our business, reduce the perceivedvaluation of the company and result in a lower stock price.*

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

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

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

Effective protection of intellectual property rightsmay be unavailable or limited, both in the United States and in othercountries. Patent protection throughout the world is generally established on acountry-by-country basis. We have applied for patent protection both inthe United 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, some mayseek contractual assurances that we will pursue—by litigation if necessary—theircompetitors who use our patented technology but are not licensed to do so.Compliance with any such contract provisions may require that we pursuelitigation where our costs exceed our likely damages award.

48

----

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 in othercountries, impairing our ability to enter and compete in these markets. In theUnited States, the trademark “Digimark” and the domain names “Digimark.com” and“Mediabridge.com” have been registered by unrelated companies. While we haveput in place formal arrangements for co-existence with one of these unrelatedcompanies, and while we have co-existed successfully to date with the other, ifwe were forced to change our name or were prevented from using our other brandnames, we would lose 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.

*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 programsoperations, and our President and Chief Operating Officer resigned. While weanticipate that these changes in leadership and staffing will improveoperations, there is a risk that these changes may disrupt the operations ofour business and, consequently, may result in some short-term inefficiencies aspersonnel complete their transitions and new leaders implement their new plansand procedures. We also expect that these changes may require furthermodifications of our finance and business processes and will likely causeadditional costs to our business in the short term before any benefits fromsuch changes, if any, may be realized.

49

----

*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 agreements. The loss of the services of any of our seniormanagement or any of our other key employees could delay projects or underminecustomer relationships.

*If we are not ableto retain, hire or integrate qualified personnel, we may not be able to meetour commitments.*

Our ability tosuccessfully develop, market, sell, license and support our products, services,and intellectual property depends to a significant degree upon the continuedcontributions of our key personnel in engineering, sales, marketing,operations, legal and licensing, many of whom would be difficult to replace.Similarly, without the continued contributions of our key finance personnel, webelieve that our ability to meet our reporting obligations and operatesuccessfully as a public company may be limited. We believe our future successwill depend in large part upon our ability to retain our current key employeesand our ability to attract, integrate and retain such personnel in the future.It may not be practical for us to match the compensation certain of ouremployees could garner at other employment. In addition, we may encounterdifficulties in hiring and retaining employees because of concerns related toour restatement, late SEC filings, shareholder litigation and financialperformance. In addition, these events may have a negative impact on the marketprice of our common stock, and employees and prospective employees may factorin the uncertainties relating to our stability and the value of any equity-basedincentives in their decisions regarding employment opportunities and decide toleave our employ. In addition, our business is based in part on patentedtechnology, which is unique and not generally known. New employees requiresubstantial training, involving significant resources and management attention.Competition for experienced personnel in our business can be intense. If we donot succeed in attracting new, qualified personnel or in integrating, retainingand motivating our current personnel, our growth and ability to deliverproducts and services that our customers require may be hampered. Although ouremployees generally have executed agreements containing non-competitionclauses, there is no assurance that a court would enforce all of the terms ofthese clauses or the clauses generally. If these clauses were not fullyenforced, our employees could be able to freely join our competitors. Althoughwe generally attempt to control access to and distribution of our proprietaryinformation by our employees, there can be no assurances that the confidentialnature of our proprietary information will be maintained in the course of suchfuture employment. Any of these events could have a material adverse effect onour financial and business prospects.

*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 against usin 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.

50

----

*If ajudgment were to be entered against the company and our director and officerliability insurance was inadequate or unavailable, the obligation to pay thejudgment may materially 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 certainfuture liabilities ordinarily mitigated by director and officer liabilityinsurance.

*Wehave identified certain issues relating to our controls and procedures, which,if not remedied effectively, could impede our ability to run and monitor ourbusiness.*

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. 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. We have acted promptlyto address these issues and are engaged in an ongoing design and implementationprocess of new and enhanced controls and procedures. If we are unable toidentify and remedy all such issues promptly and effectively, it could have amaterial adverse effect on our business, as well as impair our ability to meetour quarterly and annual reporting requirements in a timely manner. While weare completing the design, implementation and testing of our enhanced controlsenvironment, the controls and procedures on which we currently rely may fail tobe sufficiently effective, and such controls and procedures may not be adequateto prevent or detect errors or ensure the accuracy of our financial statementsor reports filed with the SEC. Further, any system of control, however welldesigned and operated, is based in part on certain assumptions and can provideonly reasonable, and not absolute, assurance that the objectives of the systemare met. The failure or circumvention of our controls, policies and procedurescould have a material adverse effect on our compliance with disclosure andlisting requirements, and if they were to lead to a financial loss, couldnegatively affect the results of our operations and financial condition. Formore information about the material weaknesses in our internal control over financialreporting, see Item 4 of Part I of this Form 10-Q.

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

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.

51

----

*Ourcommon stock may be delisted from the Nasdaq National Market, which may, amongother things, reduce the price and the liquidity of our common stock.*

As a result of the Company’sfailure to timely file its Form 10-Q for the quarters ended September 30,2004 and March 31, 2005 and the Company’s failure to timely file its Form 10-Kfor the fiscal year ended December 31, 2004, the Nasdaq ListingQualifications Panel (the “Nasdaq Panel”) notified the Company that its commonstock was subject to delisting from The Nasdaq National Market. Subsequently,the Company filed the delinquent reports and there are no pending delistingproceedings with respect to the Company’s common stock. The Company has filedall periodic reports required to be filed with the SEC and is in compliancewith all requirements for continued listing on the Nasdaq National Market.However, if the Company fails to timely file periodic reports that are requiredto be filed with the SEC in the future, our common stock may be delisted fromthe Nasdaq National Market. If our common stock is delisted, it would be listedon some other quotation medium, such as the “pink sheets,” depending upon ourability to meet the specific listing requirements of those quotation systems.In the event our common stock is delisted from the Nasdaq National Market, thevisibility, liquidity and price of our common stock may be reduced, ourstockholders may find it more difficult to dispose of, or to obtain accurateprice quotations for, our shares. In addition, if our common stock is delistedfrom the Nasdaq National Market, it may also result in other negativeimplications, including the potential loss of confidence by suppliers,customers and employees, the loss of institutional investor interest, theinability of the Company to raise additional equity capital, and fewer businessdevelopment opportunities.

*Wecould face adverse consequences as a result of our late SEC filings and therestatement of our historical financial statements.*

We failed to timely fileour Form 10-Q for the quarterly periods ended September 30,2004 and March 31, 2005 and our Form 10-K for the year ended December 31,2004. As a result of these late filings, we will not be eligible to use a “shortform” registration statement on Form S-2 or S-3 until June 1,2006. Our inability to use a short form registration statement may impair ourability, or increase the costs and complexity of our efforts, to raise funds inthe public markets should we desire to do so during this one year period. Inaddition, if we are unable to remain current in our financial filings, we mayface additional adverse consequences, including (1) an inability to have aregistration statement under the Securities Act of 1933 covering a publicoffering of securities declared effective by the SEC, (2) an inability tomake offerings pursuant to existing registration statements (includingregistration statements on Form S-8 covering employee stock plans)or pursuant to certain “private placement” rules of the SEC underRegulation D to any purchasers not qualifying as “accredited investors,” (3) thepossible delisting of our common stock from the Nasdaq National Market, and (4) limitationson the ability of our affiliates to sell our securities pursuant to Rule 144under the Securities Act. These restrictions may adversely affect our abilityto attract and retain key employees and may further impair our ability to raisefunds in the public markets should we desire to do so.

In addition, our futuresuccess depends largely upon the support of our customers, suppliers andinvestors. The effects of the restatement and late SEC filings could cause someof our customers or potential customers to refrain from purchasing or deferdecisions to purchase our products and services. Additionally, current orpotential suppliers may re-examine their willingness to do business with us, todevelop critical interfaces to our products or to supply products and servicesif they lose confidence in our ability to fulfill our commitments. Any of theselosses could have a material adverse effect on our financial and businessprospects.

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

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 

52

----

Statestargets, rumors or threats of war, actual conflicts involving the United Statesor its allies, or military or trade disruptions, may impact our operations byleading to deferred or cancelled projects, which may reduce our revenue andprofits. While any of these terrorist-related events could result in anincreased need for new security features that may, as a result, favorablyimpact our revenues from our government programs operations and our sales ofproduct and subscription and service in connection with our digitalwatermarking technology, any of these events could also, or alternatively,result in increased volatility in the United States and worldwide financial marketsand economies, or drive up our research, development and engineering costsassociated with attempting to achieve heightened effectiveness in new products.Also, any of these terrorist-related events could result in economic recessionin the United States or abroad. If such negative consequences were to occur,they could reduce our revenue and profits without the effect of reducing costsin the short-term and might result in the volatility of the future market priceof our common stock.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market 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.**                        Controlsand 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 constitute “material weaknesses” as defined under standards establishedby the Public Company Accounting Oversight Board or “PCAOB”.

·       *Inadequate supervision and technical accountingexpertise within the accounting and finance department.  *Therewas not adequate supervision and technical accounting expertise within ouraccounting and finance department. The personnel resources and technicalaccounting expertise in the accounting and finance department were notsufficient to adequately resolve non-routine matters or complex accountingprocesses, such as those matters and processes relating to the 

53

----

recording of softwarecapitalization, standard costing, and revenue recognition in accordance withU.S. generally accepted accounting principles (“U.S. GAAP”).

·       *Inadequate design and implementation of newaccounting system.  *The new accounting system we began toimplement in the second quarter of 2002, and which was placed in service duringthe fourth quarter of 2003, was not designed or implemented properly. There wasa lack of accounting expertise within our accounting and finance department; asa result our internally developed guidelines were not properly implementedduring the setup and configuration of the new accounting system. Implementationof the new accounting system also was flawed because some of our accounting andfinance employees were not properly trained in the use of the new accountingsystem. In addition, the new and old accounting systems were not operated inparallel prior to the Company’s reliance on the new system. Running new and oldaccounting systems in parallel helps validate that the new system is correctlyrecording accounting entries. These implementation issues resulted in errorswith respect to fixed assets and inventory, including the duplicate recordingof purchases, the capitalization of assets that should have been expensed andthe expensing of assets that should have been capitalized.

·       *Inadequate quarterly and year-end financial statementclose and review process.  *For each quarterly and fiscalyear-end period, a financial statement close and review process occurs. Ourstaffing for the quarterly and year-end financial statement close process wasnot sufficient, and in some instances, we failed to have adequate managementreview and supervision over the financial statement close and review process,including timely reconciliation of inventory, tax and accounts payable accountsto ensure our financial statements were prepared in accordance with U.S. GAAP.Where there was a review process, documentation of approvals was not alwaysevident.

·       *Insufficient controls both for determining the natureand types of costs that should be capitalized and for ensuring allocation ofcosts to particular projects are appropriate.*   Controls fordetermining 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 to ensure that variousinternational, state, and local tax exposures were quantified and properlyaccrued 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 with U.S. GAAP. This affected our income tax payable and income taxexpense accounts, as well as sales, use, and property tax expense and accrualaccounts.

·       *Insufficient training and inadequate reconciliationprocesses for complex revenue recognition requirements primarily related tointernational transactions.*   Training and reconciliationprocesses related to complex revenue recognition requirements regardingdistributor discounts, partial deliveries of goods and the acceptance criteriafor shipped goods were insufficient to ensure these transactions were recordedin accordance with U.S. GAAP. This affected our revenue and our deferredrevenue accounts.

54

----

·       *Insufficient controls related to system access andsegregation of duties.*   Insufficient internal controls resultedin a lack of segregation of duties among employees. Users of our new accountingsystem had access to multiple accounting processes within the system, includingvendor set-up and account maintenance, instead of only those processes thatwere the responsibility of such user. In the absence of such controls,inappropriate or unauthorized transactions could be entered into the systemwhich increases the susceptibility to the misappropriation of assets.

·       *Inadequacies related to entity-level controls.*   Managementhas concluded that there are deficiencies in the design and execution of ourentity-level controls relating to training, job descriptions, managing ofemployee turnover, application of U.S. GAAP, documentation of expenditureapprovals and communication between departments that constitute “materialweaknesses” in our internal control over financial reporting. Thesedeficiencies contributed to the restatement of our previously issued financialstatements and delays in compliance efforts with Section 404 of theSarbanes-Oxley Act of 2002 and the 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 and previouslyreported in our Form 10-Q for the quarter ended June 30, 2005,filed on August 9, 2005, the following changes have been made during thequarter ended September 30, 2005 to improve our internal controls.

1.     We havehired several new employees into the finance and accounting organization toimprove the overall quality and level of experience in the organization. We arecontinuing to actively recruit and hire new employees to add further depth tothe finance and accounting organization.

2.     We havemade, and will continue to make, changes in our finance and accountingprocesses to provide clearer segregation of responsibilities and supervision. Ofparticular significance is our monthly and quarterly close process which hasbeen enhanced to include additional analysis and support for the financialaccounts as well as improved documentation supporting controls over compilationand preparation of our quarterly financial statements.

4.     We havecontinued to deploy significant internal and external resources directed atdocumenting and testing our internal control over financial reporting ascontemplated by Section 404 of Sarbanes-Oxley, and such efforts have beenhelpful in improving our overall process 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, which include sales, manufacturing, customer support, engineering,accounting, and legal, during the contract negotiation, implementation and fulfillmentphases.

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.

7.     We haveimplemented formal procedures to estimate and document international taxexpense and established a procedure to true up prior filings. In addition, wehave established procedures to estimate and record our state and local taxexpense and exposure.

55

----

We continue to take remedial steps to strengthen ourinternal control over financial reporting and enhance our reporting processes.Moreover, our on-going control assessment and improvement activities haveresulted in some, and may result in further, remediation efforts with respectto some of our accounting processes, in particular with regard to costcapitalization and project accounting. Given the time requirements andresources necessary to test our processes, there can be no assurance as to whenwe will be fully compliant with the requirements relating to internal controlover 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 September 30, 2005that have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

As described above, wehave designed and implemented new controls to address the weaknesses identifiedin our internal control over financial reporting and we will continue to do so.Notwithstanding these improvements, our internal control over financialreporting may not be capable of preventing all instances of error or fraud. Anycontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the design of a control system must reflect the fact thatthere are knowledge and resource constraints in any such system, and a largenumber of complex permutations of facts, circumstances, accounting policies,procedural implications and business practices that must be considered. Becauseof the inherent limitations in all control systems, no evaluation of controlscan provide absolute assurance that all control issues and instances of fraud,if any, have been detected. These inherent limitations include the realitiesthat judgments in decision-making can be faulty, and breakdowns can occurbecause of simple error or mistake. Additionally, controls can be circumventedby the individual acts of some persons, by collusion of two or more people, orby management override of the controls. The design of any system of controlsalso is based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Over time, the controlsystems we develop may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate. Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error 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 September 30,2005, which included an evaluation of disclosure controls and proceduresapplicable to the period covered by the filing of this periodic report. Basedon the evaluation of the effectiveness of our disclosure controls andprocedures by our management as of September 30, 2005, and subject to theinformation set forth in this Item 4, our principal executive officer andprincipal financial officer have concluded that our disclosure controls andprocedures were not effective.

56

----

**PART II. OTHER INFORMATION.**

**Item 1.**                        LegalProceedings.

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 have purchasedor otherwise acquired our securities during the period from April 17, 2002to July 28, 2004. These lawsuits were filed in the United States DistrictCourt for the District of Oregon and were consolidated into one action for allpurposes on December 16, 2004. On May 16, 2005, plaintiffs filed anamended complaint. The complaint asserts claims under the federal securitieslaws, specifically Sections 10(b) and 20(a) of the SecuritiesExchange Act of 1934, relating to our announcement that we had discoverederrors 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.These lawsuits 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 August 25, 2005, the California plaintiffs filed two newderivative lawsuits in the United States District Court for the District ofOregon. On October 17, 2005, defendants filed a motion to dismiss thesecomplaints for lack of subject matter jurisdiction and failure to state a claim.This motion currently is pending.

Separately, on November 8, 2004, a letter wasmailed to the chairman of the Company’s Board of Directors by a law firmpurporting to represent a shareholder of the Company, demanding that the boardcommence a civil action against each of the directors and officers on behalf ofthe Company to recover for damages alleged to have been incurred as a result ofalleged breaches of fiduciary duties. On or about April 6, 2005, thisshareholder filed a purported shareholder derivative suit against certain ofthe Company’s officers and directors, naming the Company as a nominaldefendant, in the Circuit Court of the State of Oregon for the County ofWashington. 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 to investigate the claimsasserted in the demand letter and in the derivative lawsuits. On August 25,2005, the individual defendants filed a motion to stay this state courtderivative lawsuit, and on September 26, 2005, the Court entered astipulated order granting the motion and staying the case pending the outcomeof an investigation by a committee appointed by the Company’s Board ofDirectors of the claims asserted in the demand letter and in the derivativelawsuits.

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 

57

----

directors, and certain underwritersof the Company’s initial public offering as defendants. The complaints havesince been consolidated into a single action, and a consolidated amendedcomplaint was filed in April 2002. The amended complaint alleges, amongother things, that the underwriters of the Company’s initial public offeringviolated securities laws by failing to disclose certain alleged compensationarrangements (such as undisclosed commissions or stock stabilization practices)in the Company’s initial public offering registration statement and by engagingin manipulative practices to artificially inflate the price of the Company’sstock in the after-market subsequent to the Company’s initial public offering.The Company and certain of its officers and directors are named in the amendedcomplaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) andRule 10b-5 of the Securities Exchange Act of 1934 on the basis of analleged failure to disclose the underwriters’ alleged compensation arrangementsand manipulative practices. The complaint seeks unspecified damages. Theindividual officer and director defendants entered into tolling agreements and,pursuant to a court order dated October 9, 2002, were dismissed from thelitigation without prejudice. Furthermore, in July 2002, the Company andthe other defendants in the consolidated cases filed motions to dismiss theamended complaint for failure to state a claim. The motion to dismiss claimsunder Section 11 was denied as to virtually all the defendants in theconsolidated actions, including the Company. The claims against the Companyunder Section 10(b), however, were dismissed. In June 2003, acommittee of the Company’s board of directors conditionally approved a proposedpartial settlement with the plaintiffs in this matter. In June 2004, anagreement of settlement was submitted to the court for preliminary approval.The settlement would provide, among other things, a release of the Company andof the individual defendants for the conduct alleged in the amended complaintto be wrongful. The Company would agree to undertake other responsibilitiesunder the partial settlement, including agreeing to assign away, not assert, orrelease certain potential claims the Company may have against its underwriters.Any direct financial impact of the proposed settlement (other than defensecosts incurred and expensed prior to May 31, 2003) is expected to be borneby the Company’s insurers. The court granted the preliminary approval motion onFebruary 15, 2005, subject to certain modifications. On August 31,2005, the court issued a preliminary order further approving the modificationsto the settlement and certifying the settlement classes. The court alsoappointed the Notice Administrator for the settlement and ordered that noticeof the settlement be distributed to all settlement class members beginning on November 15,2005 and completed by January 15, 2006. The settlement fairness hearinghas been set for April 26, 2006. Following the hearing, if the courtdetermines that the settlement is fair to the class members, the settlementwill be approved. There can be no assurance that this proposed settlement wouldbe approved and implemented in its current form, or at all. Due to the inherentuncertainties of litigation and because the settlement approval process is at apreliminary stage, we cannot accurately predict the ultimate outcome of thematter.

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.

**Item 6.**                        Exhibits.

See attached exhibit index.

58

----

**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: November 7,  2005 | By:                  | /s/  MICHAEL MCCONNELL |
|                         |                 | Michael McConnell |
|                         | * *             | *Chief Financial  Officer and Treasurer  (Duly Authorized Officer  and Principal Financial Officer)* |

 

59

----

**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 (incorporated by reference to  Exhibit 3.3 of Exhibits to Registrant’s Quarterly Report on Form 10-Q,  as filed with the Securities and Exchange Commission on August 9, 2005)                                                                  |
| 31.1            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                       |
| 31.2            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                       |
| 32.1            |       | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                                        |
| 32.2            |       | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                        |

 

60

----