**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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FORM 10-Q

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(Mark One)

**x**                                 QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended MARCH 31, 2005   **

**OR**

**o**                                   TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                                 to                                **

**CommissionFile Number: 000-28317**

| **DIGIMARC CORPORATION**                                         |
|------------------------------------------------------------------|
| (Exact name of  registrant as 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  telephone number, 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 o  No x

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

Asof April 30, 2005, there were 20,723,429 shares of the registrant’s commonstock, par value $0.001 per share, outstanding.

 

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**Table of Contents**
| **PART I FINANCIAL  INFORMATION** | ** **                                                                                                                                       |
|----------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                | Financial Statements:                                                                                                                            |   |
|                                   | Condensed Consolidated  Balance Sheets as of March 31, 2005 and December 31, 2004. (Unaudited)                                    | 3 |
|                                   | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2005 and  March 31, 2004 (restated). (Unaudited) | 4 |
|                                   | Condensed Consolidated  Statements of Cash Flows for the three months ended March 31, 2005 and  March 31, 2004 (restated). (Unaudited) | 5 |
|                                   | Notes to Condensed Consolidated  Financial Statements. (Unaudited)                                                                               | 6 |
| Item 2.                                | Management’s Discussion and  Analysis of Financial Condition and  Results of Operations                                                     | 17 |
| Item 3.                                | Quantitative and Qualitative  Disclosures About Market Risk                                                                                      | 45 |
| Item 4.                                | Controls and Procedures                                                                                                                          | 46 |
| **PART II  OTHER INFORMATION**    | ** **                                                                                                                                       |
| Item 1.                                | Legal Proceedings                                                                                                                                | 51 |
| Item  6.                               | Exhibits                                                                                                                                         | 52 |
| **SIGNATURES**                         | 53                                                                                                                                               |

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**DIGIMARC CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS(IN THOUSANDS)(UNAUDITED)**
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**           | ** ** | **2004 (1)**     | ** ** |
| **ASSETS**                                       |       |               |       |                  |       |   |   |
| Current assets:                                  |       |               |       |                  |       |   |   |
| Cash and cash equivalents                        |       | $                  | 19,133     |                  |       | $ | 18,489 |   |   |
| Restricted cash                                  |       | 1,084              |       |                  | —     |   |   |
| Short-term investments                           |       | 14,791             |       |                  | 25,068     |   |   |
| Trade accounts receivable, net                   |       | 11,051             |       |                  | 9,666      |   |   |
| Unbilled trade receivables                       |       | 5,201              |       |                  | 5,008      |   |   |
| Inventory                                        |       | 9,005              |       |                  | 8,858      |   |   |
| Other current assets                             |       | 1,557              |       |                  | 1,779      |   |   |
| Total current assets                             |       | 61,822             |       |                  | 68,868     |   |   |
| Restricted cash                                  |       | 7,287              |       |                  | 8,279      |   |   |
| Property and  equipment, net                     |       | 66,602             |       |                  | 63,975     |   |   |
| Intangibles, net                                 |       | 20,371             |       |                  | 21,162     |   |   |
| Other assets, net                                |       | 901                |       |                  | 1,003      |   |   |
| Total assets                                     |       | $                  | 156,983    |                  |       | $ | 163,287 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |               |       |                  |       |   |   |
| Current liabilities:                             |       |               |       |                  |       |   |   |
| Accounts payable                                 |       | $                  | 9,205      |                  |       | $ | 11,424 |   |   |
| Accrued payroll and related costs                |       | 3,426              |       |                  | 2,161      |   |   |
| Deferred revenue                                 |       | 4,621              |       |                  | 4,854      |   |   |
| Other current liabilities                        |       | 1,375              |       |                  | 1,492      |   |   |
| Total current liabilities                        |       | 18,557             |       |                  | 19,931     |   |   |
| Other long-term  liabilities                     |       | 1,164              |       |                  | 1,112      |   |   |
| Total liabilities                                |       | 19,741             |       |                  | 21,043     |   |   |
| Commitments and  contingencies (Note 6)          |       |               |       |                  |       |   |   |
| Stockholders’ equity:                       |       |               |       |                  |       |   |   |
| Common stock                                     |       | 21                 |       |                  | 21         |   |   |
| Additional paid-in capital                       |       | 209,004            |       |                  | 206,979    |   |   |
| Deferred stock compensation, net                 |       | (1,974             | )          |                  | —     |   |   |
| Accumulated other comprehensive income           |       | 164                |       |                  | 147        |   |   |
| Accumulated deficit                              |       | (70,023            | )          |                  | (64,903    | ) |   |
| Total stockholders’ equity                  |       | 137,192            |       |                  | 142,244    |   |   |
| Total liabilities  and stockholders’ equity |       | $                  | 156,983    |                  |       | $ | 163,287 |   |   |

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

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARCCORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**
| ** **                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | ** **                                       | ** ** | **(Restated)** | ** ** |
| Revenue:                                          |       |                                             |       |   |   |
| Service                                           |       | $                                                | 19,596     |   | $ | 17,067 |   |
| Product and subscription                          |       | 4,783                                            |       | 6,591 |   |
| Total revenue                                     |       | 24,379                                           |       | 23,658 |   |
| Cost of revenue:                                  |       |                                             |       |   |   |
| Service                                           |       | 13,140                                           |       | 9,963 |   |
| Product and subscription                          |       | 2,353                                            |       | 4,881 |   |
| Total cost of revenue                             |       | 15,493                                           |       | 14,844 |   |
| Gross profit                                      |       | 8,886                                            |       | 8,814 |   |
| Operating expenses:                               |       |                                             |       |   |   |
| Sales and marketing                               |       | 3,815                                            |       | 2,563 |   |
| Research, development and engineering             |       | 2,483                                            |       | 1,722 |   |
| General and administrative                        |       | 7,004                                            |       | 4,823 |   |
| Amortization of Intangibles                       |       | 811                                              |       | 642 |   |
| Total operating expenses                          |       | 14,113                                           |       | 9,750 |   |
| Operating loss                                    |       | (5,227                                           | )          | (936 | ) |
| Other income (expense):                           |       |                                             |       |   |   |
| Interest income                                   |       | 264                                              |       | 219 |   |
| Interest expense                                  |       | (62                                              | )          | (21 | ) |
| Other                                             |       | (18                                              | )          | 2 |   |
| Total other income, net                           |       | 184                                              |       | 200 |   |
| Loss before  provision for income taxes           |       | (5,043                                           | )          | (736 | ) |
| Provision for  income taxes                       |       | (77                                              | )          | (50 | ) |
| Net loss                                          |       | $                                                | (5,120     | ) | $ | (786 | ) |
| Net loss per  share—basic                    |       | $                                                | (0.25      | ) | $ | (0.04 | ) |
| Net loss per  share—diluted                  |       | $                                                | (0.25      | ) | $ | (0.04 | ) |
| Weighted average shares outstanding—basic    |       | 20,453                                           |       | 20,212 |   |
| Weighted average  shares outstanding—diluted |       | 20,453                                           |       | 20,212 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARCCORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(IN THOUSANDS)(UNAUDITED)**
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **March 31,  2005**         | ** ** | **March 31,  2004** | ** ** |
| ** **                                                                                 | ** ** | ** **                       | ** ** | **(Restated)** | ** ** |
| Cash flows from operating activities:                                                      |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (5,120     | ) | $ | (786 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                             |       |   |   |
| Depreciation and  amortization                                                             |       | 3,430                            |       | 2,792 |   |
| Stock-based compensation  expense                                                          |       | 51                               |       | — |   |
| Increase (deccrease) in  allowance for doubtful accounts                                   |       | (33                              | )          | 10 |   |
| Other non-cash charges                                                                     |       | 17                               |       | (28 | ) |
| Changes in operating assets and liabilities:                                               |       |                             |       |   |   |
| Restricted cash                                                                            |       | (92                              | )          | (4 | ) |
| Trade and unbilled  accounts receivable                                                    |       | (1,545                           | )          | (3,430 | ) |
| Inventory                                                                                  |       | (147                             | )          | (195 | ) |
| Other current assets                                                                       |       | 222                              |       | (409 | ) |
| Other assets, net                                                                          |       | 102                              |       | 69 |   |
| Accounts payable                                                                           |       | (2,219                           | )          | 4,446 |   |
| Accrued payroll and  related costs                                                         |       | 1,265                            |       | 741 |   |
| Deferred revenue                                                                           |       | (233                             | )          | (419 | ) |
| Other liabilities                                                                          |       | 1                                |       | (1 | ) |
| Net cash provided by  (used in) operating activities                                       |       | (4,301                           | )          | 2,786 |   |
| Cash flows from investing activities:                                                      |       |                             |       |   |   |
| Purchase of property and  equipment                                                        |       | (2,192                           | )          | (4,734 | ) |
| Capitalization of labor  costs                                                             |       | (3,003                           | )          | (3,593 | ) |
| Intangibles                                                                                |       | (20                              | )          | — |   |
| Sale or maturity of  short-term investments                                                |       | 42,744                           |       | 44,221 |   |
| Purchase of short-term  investments                                                        |       | (32,467                          | )          | (35,645 | ) |
| Net cash provided by investing  activities                                                 |       | 5,062                            |       | 249 |   |
| Cash flows from financing activities:                                                      |       |                             |       |   |   |
| Net proceeds from  issuance of common stock                                                |       | —                           |       | 1,109 |   |
| Principal payments under  capital lease obligations                                        |       | (117                             | )          | (71 | ) |
| Net cash provided by  (used in) financing activities                                       |       | (117                             | )          | 1,038 |   |
| Net increase in cash and  cash equivalents                                                 |       | 644                              |       | 4,073 |   |
| Cash and cash  equivalents at beginning of period                                          |       | 18,489                           |       | 33,626 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                | 19,133     |   | $ | 37,699 |   |
| Supplemental disclosure of cash flow information:                                          |       |                             |       |   |   |
| Cash paid for interest                                                                     |       | $                                | 62         |   | $ | 21 |   |
| Cash paid for income  taxes                                                                |       | $                                | 27         |   | $ | — |   |
| Summary of non-cash investing and financing  activities:                                   |       |                             |       |   |   |
| Equipment acquired or exchanged under capital lease  obligations                           |       | $                                | 51         |   | $ | 77 |   |
| Grant of  restricted stock                                                                 |       | $                                | 2,025      |   | $ | — |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

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**DIGIMARCCORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(IN THOUSANDS, EXCEPT PER SHARE DATA)(UNAUDITED)**

**1.   TheCompany, Basis of Presentation**

*Description ofBusiness*

Digimarc Corporation (“Digimarc,” the “Company,” “we,”“us,” or “our”) is one of the leading suppliers of secure personalidentification systems, providing more than 60 million personalidentification documents and driver licenses per year. The Company supplies theissuance systems for the majority of driver licenses produced in the UnitedStates (“U.S.”) and provides all or part of the issuance systems for nationalidentifications, voter identifications, and driver licenses in more than 20international programs.

The Company also is a leading provider of patenteddigital watermarking technologies and solutions that allow imperceptibledigital codes to be embedded in media content, including personalidentification documents, financial instruments, photographs, movies, music,and product packages. The embedded codes within various types of media contentcan be detected and read by software or hardware detectors in personalcomputers and other digital devices.

In December 2001, theCompany, through its wholly-owned subsidiary, Digimarc ID Systems, LLC,and certain of that subsidiary’s wholly-owned subsidiaries (also referred toherein as “DIDS”), acquired the assets and assumed certain liabilities of theU.S. large government programs identification systems and international digitalidentification systems businesses of Polaroid Corporation and certain otheraffiliated entities of Polaroid Corporation (“LGP”). The acquisition wasaccounted for using the purchase method of accounting.

*Interim FinancialStatements*

The condensed consolidated financial statementsinclude the accounts of Digimarc and its wholly-owned subsidiaries. Allsignificant inter-company transactions and balances have been eliminated. Thecondensed consolidated financial statements have been prepared from the Company’srecords without audit and, in management’s opinion, include all adjustments(consisting of only normal recurring adjustments) necessary to fairly reflectthe financial condition and the results for the periods presented, except for a$0.2 million inventory adjustment which resulted in a decrease in the netloss in the current period. The adjustment should have been recorded in a priorperiod, but the Company believes the amount to be immaterial to both thecurrent period and the prior period. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith U.S. generally accepted accounting principles have been condensed oromitted under the Securities and Exchange Commission’s rules andregulations.

These condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004, which wasfiled with the Securities and Exchange Commission (the “SEC”) on April 7,2005 and includes restated financial results for the fiscal year ended December 31,2003, including as of and for each of the quarters in the fiscal year ended December 31,2003, and the quarterly periods ended March 31, 2004 and June 30,2004 (see Note 2 “Restatement”). The results of operations for the interimperiods presented in these condensed consolidated financial statements are notnecessarily indicative of the results for the full year.

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*Use of Estimates*

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

*Reclassifications*

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

**2.   Restatement**

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

The key impacts of the restatement adjustments for thethree months ended March 31, 2004 was to decrease net income from $0.03per share to net loss of $0.04 per share and increase revenues by $168 for thethree months ended March 31, 2004.

The following tables setforth the restatement adjustments to our financial statements for the periodsindicated. The amounts in the tables are expressed in thousands.

***As of and for the three months ended March 31,2004:***

**Statement of operations**
| ** **                  | ** ** | **As previously** | ** ** | **Software**       | ** ** | **Project**    | ** ** | ** **  | ** ** | ** ** | ** ** | **As**       | ** ** |
|-----------------------------|------------|------------------------|------------|--------------------|------------|----------------|------------|-------------|------------|------------|------------|--------------|------------|
| ** **                  | ** ** | **reported**           | ** ** | **capitalization** | ** ** | **accounting** | ** ** | **Revenue** | ** ** | **Other**  | ** ** | **Restated** | ** ** |
| ** **                  |       |                   |       |               |       |           |       |        |       |       |       |         |       |   |   |   |   |   |   |   |   |
| Revenue                     |       |                   | 23,490     |               |       |           | —     |        |       |       | —     |         |       |   | 280 |   |   | (112 | ) | 23,658 |   |
| Cost of revenue             |       |                   | 13,714     |               |       |           | 21         |        |       |       | 1,139      |         |       |   | — |   |   | (30 | ) | 14,844 |   |
| Gross Profit                |       |                   | 9,776      |               |       |           | (21        | )           |       |       | (1,139     | )            |       |   | 280 |   |   | (82 | ) | 8,814 |   |
| Operating expense           |       |                   | 9,401      |               |       |           | 382        |        |       |       | 7          |         |       |   | — |   |   | (40 | ) | 9,750 |   |
| Operating income  (loss)    |       |                   | 375        |               |       |           | (403       | )           |       |       | (1,146     | )            |       |   | 280 |   |   | (42 | ) | (936 | ) |
| Other income, net           |       |                   | 200        |               |       |           |       |        |       |       |       |         |       |   |   |   |   |   |   | 200 |   |
| Provision for  income taxes |       |                   | (50        | )                  |       |           | —     |        |       |       | —     |         |       |   | — |   |   | — |   | (50 | ) |
| Net income (loss)           |       |                   | 525        |               |       |           | (403       | )           |       |       | (1,146     | )            |       |   | 280 |   |   | (42 | ) | (786 | ) |

 

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**Statement of cash flows**
| ** **                                           | ** ** | **As  previously  reported** | ** ** | **Software  capitalization** | ** ** | **Project  accounting** | ** ** | **Revenue** | ** ** | **Other** | ** ** | **As  reported** | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|-------------------------|------------|-------------|------------|-----------|------------|------------------|------------|
| Net cash provided  by (used in) operating activities |       |                         | 4,085      |                         |       |                    | (403       | )           |       |      | (882       | )                |       |   | — |   |   |   | (14 | ) |   |   | 2,786 |   |   |
| Net cash provided  by (used in) investing activities |       |                         | (1,050     | )                            |       |                    | 403        |        |       |      | 882        |             |       |   | — |   |   |   | 14 |   |   |   | 249 |   |   |
| Net cash provided  by financing activities      |       |                         | 1,038      |                         |       |                    | —     |        |       |      | —     |             |       |   | — |   |   |   | — |   |   |   | 1,038 |   |   |
| Net increase in cash and  cash equivalents      |       |                         | 4,073      |                         |       |                    | —     |        |       |      | —     |             |       |   | — |   |   |   | — |   |   |   | 4,073 |   |   |

 

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

Netincome (loss) per share (or earnings per share (“EPS”)) is calculated inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 128,*Earnings per Share*, whichprovides that basic and diluted net income per share for all periods presentedare to be computed using the weighted average number of common sharesoutstanding during each period, with diluted net income (loss) per shareincluding the effect of potentially dilutive common shares.
| ** **                         | ** ** | **Three Months Ended March 31, 2005** | ** ** | **Three Months Ended March 31, 2004** | ** ** |
|------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                         | ** ** | **Income**                                                     | ** ** | **Shares**                                                     | ** ** | **Per** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per** | ** ** |
| ** **                         | ** ** | **(000’s)**                                               | ** ** | **(000’s)**                                               | ** ** | **Share** | ** ** | **(000’s)** | ** ** | **(000’s)** | ** ** | **Share** | ** ** |
| ** **                         | ** ** | **(Numerator)**                                                | ** ** | **(Denominator)**                                              | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                         | ** ** | ** **                                                     | ** ** | ** **                                                     | ** ** | ** ** | ** ** | **(Restated)** | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| **Basic EPS**                 |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                           |       |                                                           | $          | (5,120                                                         | )          |   |   | 20,453 |   |   | $ | (0.25 | ) |   | $ | (786 | ) |   |   | 20,212 |   |   |   | $ | (0.04 | ) |   |
| **Effect  of Dilutive Securities** |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options                            |       |                                                           |       |                                                           |       |   | — |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Warrants                           |       |                                                           |       |                                                           |       |   | — |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| **Diluted  EPS**                   |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                           |       |                                                           | $          | (5,120                                                         | )          |   |   | 20,453 |   |   | $ | (0.25 | ) |   | $ | (786 | ) |   |   | 20,212 |   |   |   | $ | (0.04 | ) |   |

 

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Common stock equivalentsrelated to stock options and warrants of 6,431 and 5,375 were excluded fromdiluted net loss per share calculations for the three month periods ended March 31,2005 and 2004, respectively, as their exercise price was higher than theaverage market price of the underlying common stock for the period andtherefore their impact would be anti-dilutive. In addition, common stockequivalents related to stock options of 157 and 403 for the three month periodsended March 31, 2005 and 2004, respectively, were excluded from dilutednet loss per share as the Company was in a loss position and their inclusionwould be anti-dilutive.

**4.**   StockBased Compensation

The Company has variousstock-based compensation plans, including stock incentive plans and an employeestock purchase plan. The Company continues to apply the recognition andmeasurement principles of Accounting 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 (orearnings per share) if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation for thethree months ended March 31, 2005 and 2004, respectively (in thousands,except per-share amounts):
| ** **                                                                                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| ** **                                                                                                        | ** ** | ** **                                       | ** ** | **(Restated)** | ** ** |
| Net loss, as reported                                                                                             |       | $                                                | (5,120     | ) |   | $ | (786 | ) |   |
| Add: Stock-based  compensation expense determined under the intrinsic value method                                |       | 51                                               |       |   | — |   |   |
| Deduct: Total  stock-based employee compensation expense determined under  fair value based method for all awards |       | (1,676                                           | )          |   | (2,771 | ) |   |
| Pro forma net loss                                                                                                |       | $                                                | (6,745     | ) |   | $ | (3,557 | ) |   |
| *Net loss per share:*                                                                                             |       |                                             |       |   |   |   |   |
| Basic—as reported                                                                                            |       | $                                                | (0.25      | ) |   | $ | (0.04 | ) |   |
| Diluted—as reported                                                                                          |       | $                                                | (0.25      | ) |   | $ | (0.04 | ) |   |
| Basic—pro forma                                                                                              |       | $                                                | (0.33      | ) |   | $ | (0.18 | ) |   |
| Diluted—pro forma                                                                                            |       | $                                                | (0.33      | ) |   | $ | (0.18 | ) |   |

 

Stock based compensationexpense is based on the difference between the fair market value of the Company’scommon stock and the exercise price of options to purchase that stock on themeasurement date, and is being recognized over the vesting period of therelated options, usually four years.

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 Compensation Committee adopted a form ofrestricted stock agreement to be used in connection with such restricted stockawards. The agreement provides, among other things, that the shares will vestin full upon the termination of the officer’s employment without cause or theofficer’s resignation for good reason following a change in control of theCompany. Notwithstanding the foregoing, the plan administrator has 

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discretionaryauthority, among other things, to determine the terms and conditions of anyaward granted under the Plan. A copy of the agreement was previously filed by theCompany with the SEC as an exhibit to the Company’s Form 8-K filed on March 1,2005. The Compensation Committee approved grants of restricted stock awards tocertain of its named executive officers, effective as of March 1, 2005,totaling 270 shares. One-quarter of the restricted shares granted to theseexecutive officers will vest each December 31 beginning on December 31,2005. The Company recorded $51 of stock-based compensation related to theissuance of restricted stock for the three months ended March 31, 2005. TheCompany did not incur any stock-based compensation expense for the three monthsended March 31, 2004.

**5.   Segment Information**

The Company derives itsrevenue from a single reporting segment, secure media solutions. Revenue isgenerated in this reporting segment through licensing and subscription of itsvarious products and the delivery of contracted and consulting services relatedto these products. The Company markets its products in the United States and innon-U.S. countries through its sales personnel and its subsidiaries.

There was no singlecustomer in the three month periods ended March 31, 2005 or 2004 thataccounted for more than 10% of total revenue. There was one customer whoaccounted for 13% of trade and unbilled accounts receivable, net at March 31,2005, while no customer accounted for more than 10% of trade and unbilledaccounts receivable at December 31, 2004.

TheCompany has one reporting segment which is made up of two operating segments:Digimarc ID Systems (DIDS) and Digimarc Digital Watermarking (DWM). Informationregarding each of the operating segments is as follows:
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| ** **                             | ** ** | ** **                                       | ** ** | ** (Restated) ** | ** ** |
| **DIDS**                               | ** ** | ** **                                       | ** ** |   | ** ** | ** ** |   |
| Revenue                                |       | $                                                | 21,428     |   |   | $ | 20,942 | ** ** |   |
| Revenue as a percent of  Total Revenue |       | 88                                               | %          |   | 89 | % |   |
| Gross Profit percentage                |       | 32                                               | %          |   | 33 | % |   |
| **DWM**                                |       |                                             |       |   |   |   |   |
| Revenue                                |       | $                                                | 2,951      |   |   | $ | 2,716 |   |   |
| Revenue as a percent of  Total Revenue |       | 12                                               | %          |   | 11 | % |   |
| Gross Profit percentage                |       | 69                                               | %          |   | 69 | % |   |
| **Total  Company**                     |       |                                             |       |   |   |   |   |
| Revenue                                |       | $                                                | 24,379     |   |   | $ | 23,658 |   |   |
| Revenue as a percent of  Total Revenue |       | 100                                              | %          |   | 100 | % |   |
| Gross Profit percentage                |       | 36                                               | %          |   | 37 | % |   |

 

**6.**   Commitmentsand Contingencies

Beginning inSeptember 2004, three purported class action lawsuits were commencedagainst the Company and certain of the Company’s current and former directorsand officers by or on behalf of persons claiming to have purchased or otherwiseacquired the Company’s securities during the period from April 17, 2002 toJuly 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. The complaints assert claims under thefederal securities laws, specifically Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934, relating to the Company’s announcement that ithad discovered errors in its accounting for software development costs andproject capitalization and other project cost capitalization accountingpractices at the Company’s DIDS business unit, and that the Company likelywould be required to restate its previously reported financial statements for thefull fiscal year 2003 and the first two quarters 

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of 2004.Specifically, these actions allege that the Company issued false and misleadingfinancial statements in order to inflate the value of Digimarc stock, whichresulted in insider sales of personal holdings at inflated values, and that theCompany maintained insufficient accounting controls, which created anenvironment where improper accounting could be used to manipulate financialresults. The complaints seek unspecified damages. The Company believes that ithas substantial legal and factual defenses to the claims, which it intends topursue vigorously. Due to the inherent uncertainties of litigation and becausethe lawsuits are still at a preliminary stage, the ultimate outcome of thematter cannot be predicted. No accrual has been recorded because the amountsare not probable or reasonably estimable in accordance with SFAS No. 5, *Accounting for Contingencies.*

On or aboutOctober 19, 2004, two purported shareholder derivative lawsuits were filedagainst certain of the Company’s officers and directors, naming the Company asa nominal defendant, in the Superior Court of the State of California for theCounty of San Luis Obispo. On or about April 6, 2005, another purportedshareholder derivative suit was filed 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. On November 8, 2004, aletter was mailed to the chairman of the Company’s Board of Directors by a lawfirm purporting to represent a shareholder of the Company, demanding that theboard commence a civil action against each of the directors and officers onbehalf of the Company to recover for damages alleged to have been incurred as aresult of alleged breaches of fiduciary duties. The Company has appointed acommittee to investigate the claims asserted in the demand letter and in thederivative lawsuits.

Beginning inMay 2001, a number of substantially identical class action complaintsalleging violations of the federal securities laws were filed in the UnitedStates District Court for the Southern District of New York namingapproximately 300 companies, including the Company, certain of its officers anddirectors, and certain underwriters of the Company’s initial public offering asdefendants. The complaints have since been consolidated into a single action,and a consolidated amended complaint was filed in April 2002. The amendedcomplaint alleges, among other things, that the underwriters of the Company’sinitial public offering violated securities laws by failing to disclose certainalleged compensation arrangements (such as undisclosed commissions or stockstabilization practices) in the Company’s initial public offering registrationstatement and by engaging in manipulative practices to artificially inflate theprice of the Company’s stock in the after-market subsequent to the Company’sinitial public offering. The Company and certain of its officers and directorsare named in the amended complaint pursuant to Section 11 of theSecurities Act of 1933, and Section 10(b) and Rule 10b-5 of theSecurities Exchange Act of 1934 on the basis of an alleged failure to disclosethe underwriters’ alleged compensation arrangements and manipulative practices.The complaint seeks unspecified damages. The individual officer and directordefendants entered into tolling agreements and, pursuant to a court order datedOctober 9, 2002, were dismissed from the litigation without prejudice.Furthermore, in July 2002, the Company and the other defendants in theconsolidated cases filed motions to dismiss the amended complaint for failureto state a claim. The motion to dismiss claims under Section 11 was deniedas to virtually all the defendants in the consolidated actions, including the Company.The claims against the Company under Section 10(b), however, weredismissed. In June 2003, a committee of the Company’s Board of Directorsconditionally approved a proposed partial settlement with the plaintiffs inthis matter. In June 2004, an agreement of settlement was submitted to thecourt for preliminary approval. The settlement would provide, among otherthings, a release of the Company and of the individual defendants for theconduct alleged in the amended complaint to be wrongful. The Company wouldagree to undertake other responsibilities under the partial settlement,including agreeing to assign away, not assert, or release certain potentialclaims the Company may have against its underwriters. Any direct financialimpact of the proposed settlement (other than defense costs incurred andexpensed prior to May 31, 2003) is expected to be borne by the Company’s 

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insurers.The court granted the preliminary approval motion on February 15, 2005,subject to certain modifications. If the parties are able to agree upon therequired modifications, and such modifications are acceptable to the court,notice will be given to all class members of the settlement, a “fairness”hearing will be held and if the court determines that the settlement is fair tothe class members, the settlement will be approved. There can be no assurancethat this proposed settlement would be approved and implemented in its currentform, or at all. Due to the inherent uncertainties of litigation, the ultimateoutcome of the matter cannot be predicted.

The Company previouslyreceived a notice from the staff of the SEC stating that it was conducting aninformal inquiry relating to the Company’s previous announcement that it wasrestating its prior financial results. The SEC subsequently informed theCompany that it has terminated its informal inquiry without recommending anyenforcement action.

DIDS in its normal courseof business from time to time experiences delays in identification systemimplementation, timely acceptance for identification systems programs, concernsregarding identification system program performance, and other contractualdisputes. Management believes that such contingencies could have a materialeffect on the results of operations from time to time. In addition, from timeto time, customers have given notice of their intention to assert claims forliquidated damages. Management believes that these assertions are part of theresolution process involving commercial disagreements over the delivery termsof these contracts. Such disputes are not uncommon and tend to be resolved overtime. To date, we have not paid any material amounts in connection with adispute with a customer. While there is always risk that liquidated damagescould be assessed in the future, management does not believe that it isprobable that material amounts will be paid nor can we predict what the amountof any such damages would be if they were to be imposed.

Certain of the Company’sproduct license and services agreements include an indemnification provisionfor claims from third parties relating to the Company’s intellectual property.Such indemnification provisions are accounted for in accordance with SFASNo. 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*.

**7.**   ComprehensiveIncome (Loss)

TheCompany has adopted SFAS No. 130, *ReportingComprehensive Income*, which establishes standards of reporting anddisplaying comprehensive income (loss) and its components of net income (loss)and other comprehensive income (loss). Other comprehensive income (loss) refersto revenues, expenses, gains and losses that are not included in net income(loss) but rather are recorded directly in stockholders’ equity. Comprehensiveincome (loss) is defined as changes in stockholders’ equity exclusive oftransactions with owners. To date, only foreign currency translationadjustments are required to be reported in comprehensive income (loss). Thefollowing table provides a summary of comprehensive loss for the three monthperiods ended March 31, 2005 and 2004, respectively (in thousands):
| ** **                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                         | ** ** | **    2004    ** | ** ** |
| ** **                               | ** ** | ** **                                       | ** ** | **(Restated)** | ** ** |
| Net loss                                 |       | $                                                | (5,120     | ) |   | $ | (786 | ) |   |
| Foreign currency  translation adjustment |       | 17                                               |       |   | (84 | ) |   |
| Comprehensive loss                       |       | $                                                | (5,103     | ) |   | $ | (870 | ) |   |

 

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**8.**   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. FAS 151 also requires that allocationof fixed production overheads to the costs of conversion be based on the normalcapacity of the production facilities. This statement is effective for fiscalyears beginning after July 15, 2005. The Company does not expect that theadoption of this standard will have a material impact on its financialcondition or results of operations.

In December 2004, the FASB issued Statement No. 153(FAS 153), *Exchanges of Non-monetary Assets—an amendment ofAPB Opinion No. 29*. FAS 153 amends Opinion 29 to eliminate theexception for non-monetary exchanges of similar productive assets and replacesit with a general exception for exchanges of non-monetary assets that do nothave commercial substance. A non-monetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS No. 153is effective for fiscal periods after June 15, 2005. The Company does notexpect that the adoption of SFAS No. 153 will have a material impact on theCompany’s consolidated financial statements.

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.

**9.**   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 

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loss becomes determinable.Billing for services rendered generally occurs within one month following whenthe services are provided. Revenue earned which has not been invoiced is classifiedas unbilled trade receivables in the condensed consolidated balance sheets.

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, and collectibilityis probable. Maintenance contracts are, at times, paid in advance and revenueis 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. Softwarerevenue is 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*. Revenuefor licenses of the Company’s software products is recognized upon the Companymeeting the following criteria: persuasive evidence of an arrangement exists;delivery has occurred; the vendor’s fee is fixed or determinable; and collectibilityis probable.

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, *Revenue Arrangementswith Multiple Deliverables*. If the deliverables meet the criteria inEITF Issue No. 00-21, the deliverables are divided into separate units ofaccounting and revenue is allocated to the deliverables based on their relativefair values. The criteria specified in EITF Issue No. 00-21 are asfollows: (i) the delivered item has value to the customer on a stand-alonebasis, (ii) there is objective and reliable evidence of the fair value ofthe undelivered item, and (iii) if the arrangement includes a generalright of return relative to the delivered item, delivery or performance of theundelivered item is considered probable and substantially in the control of thevendor. For our purposes, fair value is generally defined as the price at whicha customer could purchase each of the elements independently from other vendorsor as the price at which the Company has sold the element separately to anothercustomer. Applicable revenue recognition criteria is considered separately foreach separate unit of accounting. Management applies judgment to ensureappropriate application of EITF Issue No. 00-21, including valueallocation among multiple deliverables, determination of whether undeliveredelements are essential to the functionality of delivered elements and timing ofrevenue recognition, among others.

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**10.**   Inventory

Inventoryconsists primarily of the components used to manufacture identification cards,such as inks, laminates, and adhesives and hardware for sale. Inventories arevalued on a first-in, first-out basis at the lower of cost or market value (netrealizable value).
| ** **                             | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Equipment and  deferred contract costs |       |                     | 565        |                        |       |   | 1,033 |   |   |
| Consumable  materials                  |       |                     | 8,790      |                        |       |   | 8,096 |   |   |
| Reserve                                |       |                     | (350       | )                           |       |   | (271 | ) |   |
| Inventory, net                         |       |                     | 9,005      |                        |       |   | 8,858 |   |   |

 

The reserve for slowmoving and obsolete items was $350 and $271 at March 31, 2005 and December 31,2004, respectively. While we do not currently expect to be able to sell orotherwise use the reserved inventory we have on hand based upon our forecastand backlog, it is possible that a customer or customers will decide in thefuture to purchase a portion of the reserved inventory. It is not possiblecurrently to predict if or when this will happen, or how much we may sell. Suchsales have not had a significant impact on gross profit margin, nor does theCompany expect such sales to have a significant impact in future periods.

**11.**   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.

**12.**   Related Party Transactions

During the three month periods ended March 31,2005 and 2004 the Company recognized revenue of $142 and $50, respectively,from a holder of common stock. At March 31, 2005, net accounts receivablefrom this holder was $42. At March 31, 2004, no receivables wereoutstanding from this holder.

The Company entered into two loans in 2002 with aformer executive officer of the Company prior to such officer’s departure fromthe Company. Both loans were entered into in connection with the former officer’srelocation to the Company’s facilities in Massachusetts. The first loan wasentered into on July 1, 2002, and has a principal amount of $100 and aninterest rate of 6.75% per year. Such loan is not due and payable to the Companyuntil June 30, 2006; provided, however, that the entire amount of the loanaccelerates if the former officer’s employment was terminated “for cause.” Thesecond loan was also entered into on July 1, 2002, and has a principalamount of $260 and an interest rate of 4.99% per year. The second loan providesthat it will be forgiven in full on a pro-rata basis over a term of four years;provided, however, that if the former officer voluntarily left the Company’semployment for any reason, or if the former officer was terminated “for cause,”then the outstanding balance of the loan accelerates and 

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the former officer shallbe responsible for paying the outstanding principal balance, plus any interestthat is accrued and unpaid, in full within 90 days of the date of his departure.The former executive officer’s employment with the Company was terminated in July 2004.The Company has reserved an amount equal to the remaining amount of the loansand is no longer accruing interest on the loans.

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**Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

*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 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. Readers arealso urged to carefully review and consider the various disclosures made by uswhich attempt to advise interested parties of the factors which affect ourbusiness, including without limitation the disclosures made under the caption “RiskFactors” in this Form 10-Q and the audited and restated consolidatedfinancial statements and related notes included in our Annual Report filed on Form 10-K forthe year ended December 31, 2004 filed on April 7, 2005, and otherreports and filings made with the Securities and Exchange Commission.*

**Overview**

We are one of the leading suppliers of secure personalidentification systems, providing more than 60 million personalidentification documents and driver licenses per year. We supply the issuancesystems for the majority of driver licenses produced in the United States (“U.S.”)and provide all or part of the issuance systems for national identifications,voter identifications, and driver licenses in more than 20 internationalprograms. We are developing and marketing enhanced security solutions forpersonal identification documents enabled by our proprietary digitalwatermarking technology.

We also are a leading provider of patented digitalwatermarking technologies and solutions that allow imperceptible digital codesto be embedded in media content, including personal identification documents,financial instruments, photographs, movies, music, and product packages. Theembedded codes within various types of media content can be detected and readby software or hardware detectors in personal computers and other digitalprocessing devices. We provide solutions based on this technology directly andthrough our licensees. We believe we have the broadest intellectual propertypatent portfolio and commercial deployment of watermarking-based applicationsamongst entities of which we are aware.

The majority of ourrevenue comes from multi-year contracts with government agencies, includingU.S. state departments of motor vehicles and federal agencies, and centralbanks from around the world. We intend to increase our revenue throughincreasing adoption of our products and services, marketing new digitalwatermarking applications, marketing our products in new secure identificationmarkets and components and subsystems markets, and licensing our intellectualproperty. We expect to target, among other sources of revenue, governmentagencies, commercial printers, packaging companies, publishers, advertisers,proprietors of large image collections, and other producers of printedmaterials. Our aim is to license our technologies to those content producers sothat they may embed our digital watermarks in their printed media, such asidentification documents, magazine advertisements and articles, direct mailcoupons, catalogs, stationery and envelopes, product packaging, labels andtags, trading cards, credit cards, and business cards. Our current andanticipated products are intended to enable content producers to controlreproduction and alteration of their content, as well as to enable theirprinted materials to provide a link to relevant network services. Revenue fromour new applications may include one-time license fees, time-based orvolume-based fees, subscription fees, royalties and revenue-sharingarrangements. We anticipate that the calculation of revenue and royalties forthese new applications will be based at least in part on the size of theinstalled base of personal computers, cameras, scanners, digital image captureand output devices, and software carrying our patented reader technology, aswell as the nature of the use and amount of licensed content carrying ourdigital watermarks.

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**Restatement ofPrior Financial Results**

In our Form 10-K forthe year ended December 31, 2004 we restated our audited consolidatedfinancial statements as of and for the fiscal year ended December 31,2003, including as of and for each of the quarterly periods in the year ended December 31,2003, and the quarterly periods ended March 31, 2004 and June 30,2004. We restated our financial statements to correct errors in the accountingfor software development costs, project accounting, revenue recognition, andtax accruals, among other areas. Please see Note 2 to the condensed consolidatedfinancial statements of the Company included herewith as well as our Form 10-Kfor the year ended December 31, 2004 for additional information about therestatement.

**Critical AccountingPolicies and Estimates**

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

Certain of ouraccounting 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 contingencies andlitigation. We believe the following critical accounting policies affect ourmore significant judgments and estimates used in the preparation of ourcondensed consolidated financial statements:

**Revenue recognition on long-termservice contracts:****  **We recognize revenue on long-termidentification and driver license production contracts using primarily aprice-per-card method. We use actual monthly volume amounts, if available, orwe estimate the card production volume on a monthly basis for certain of thesecontracts in order to recognize revenue earned during the period. In the caseof estimates, when the actual production information becomes available, whichis typically within four weeks, we bill the customer accordingly and anydifferences from the estimates are recognized in the month the billing occurs.These amounts represent our best estimates of cards produced and are based onhistorical trends, known events during the period, and discussions withcontract representatives. Prior to publicly reporting results, our practice isto compare the actual production volumes to estimated production volumes andadjust revenue amounts as necessary. Revisions to our estimates have been lessthan 0.5% of total revenue in every period reported since the LGP transaction. Anyestimated amounts are included in unbilled receivables on the balance sheetuntil the actual production information is available and the billing occurs.Any estimation process involves inherent risk. We reduce the inherent riskrelating to production estimation through our approval and monitoring processesrelated to accounting estimates.

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

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**Impairments and estimation of usefullives 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.

**Inventory valuation:****  **Inventory consistsprimarily of consumable supplies that are used in the production of driverlicenses and products held for resale to customers. We value inventory at thelower of cost or market value (which lower amount is the net realizable value).We reduce the value of our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.

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

**Contingenciesand Litigation:****  **We periodically evaluate all pendingor threatened contingencies or commitments, if any, that are reasonably likelyto have a material adverse effect on our operations or financial position. Weassess the probability of an adverse outcome and determine if it is remote,reasonably possible or probable as defined in accordance with the provisions ofSFAS No. 5, Accounting for Contingencies. If information available priorto the issuance of our financial statements indicates that it is probable thatan asset has been impaired or a liability has been incurred at the date of ourfinancial statements, and the amount of the loss, or the range of probable losscan be reasonably estimated, then such loss is accrued and charged tooperations. If no accrual is made for a loss contingency because one or both ofthe conditions pursuant to SFAS No. 5 are not met, but the probability ofan adverse outcome is at least reasonably possible, we will disclose the natureof the contingency and provide an estimate of the possible loss or range ofloss, or state that such an estimate cannot be made.

**Results ofOperations**

During the three month period ended March 31,2005, we invested in capital equipment and software development for several newprograms, including programs based in Florida and Alabama which, when 

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combined with our netloss, caused our working capital to decrease for the periods. These programsare expected to be fully deployed in 2005. Operating results were negativelyimpacted by higher staffing levels, increased legal, accounting, and consultingexpenses for our restatement, higher costs of our financial statement audit,and increased Sarbanes-Oxley compliance costs.

Thefollowing table presents our condensed consolidated statements of operationsdata for the periods indicated as a percentage of total revenue.
| ** **                              | ** ** | **Three Months**            | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **Ended**                        | ** ** |
| ** **                              | ** ** | **March 31,**               | ** ** |
| ** **                              | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| ** **                              | ** ** | ** **                       | ** ** | **(Restated)** | ** ** |
| Revenue:                                |       |                             |       |   |   |   |   |   |   |
| Service                                 |       |                             | 80         | % |   |   | 72 | % |   |
| Product and subscription                |       |                             | 20         |   |   |   | 28 |   |   |
| Total revenue                           |       |                             | 100        |   |   |   | 100 |   |   |
| Cost of revenue:                        |       |                             |       |   |   |   |   |   |   |
| Service                                 |       |                             | 54         |   |   |   | 42 |   |   |
| Product and subscription                |       |                             | 10         |   |   |   | 21 |   |   |
| Total cost of revenue                   |       |                             | 64         |   |   |   | 63 |   |   |
| Gross profit                            |       |                             | 36         |   |   |   | 37 |   |   |
| Operating expenses:                     |       |                             |       |   |   |   |   |   |   |
| Sales and marketing                     |       |                             | 16         |   |   |   | 11 |   |   |
| Research, development  and engineering  |       |                             | 10         |   |   |   | 7 |   |   |
| General and  administrative             |       |                             | 29         |   |   |   | 20 |   |   |
| Amortization of  intangibles            |       |                             | 3          |   |   |   | 3 |   |   |
| Total operating expenses                |       |                             | 58         |   |   |   | 41 |   |   |
| Operating loss                          |       |                             | (22        | ) |   |   | (4 | ) |   |
| Other income (expense):                 |       |                             |       |   |   |   |   |   |   |
| Interest income                         |       |                             | 1          |   |   |   | 1 |   |   |
| Interest expense                        |       |                             | —     |   |   |   | — |   |   |
| Other                                   |       |                             | —     |   |   |   | — |   |   |
| Total other income, net                 |       |                             | 1          |   |   |   | 1 |   |   |
| Loss before provision  for income taxes |       |                             | (21        | ) |   |   | (3 | ) |   |
| Provision for income  taxes             |       |                             | —     |   |   |   | — |   |   |
| Net Loss                                |       |                             | (21        | )% |   |   | (3 | )% |   |

 

*Revenue*

Total revenue was$24.4 million for the three month period ended March 31, 2005compared to total revenue of $23.7 million for the three month period ended March 31,2004. The changes in total revenue between the comparable three month period of2005 and 2004 resulted primarily from an increase in our service revenuerelated to new programs added at DIDS, namely Florida, Ohio, Mexico, andLatvia, partially offset by a non-recurring sale of voter identificationsupplies to a foreign customer during the three month period ended March 31, 2004at DIDS.

Based on projected driverlicense production volumes and other commitments we have for the periods undercontract with our respective customers, including driver license issuingauthority customers, we anticipate our current contracts as of March 31,2005 to generate approximately $240 million in revenue during the contractualterms of such contracts, currently up to eight years. We consider as backlogproduction volumes reasonably expected to be achieved under currently existingcontractual terms, government orders that are firm but not yet funded, andgovernment contracts awarded but not yet signed. However, there can be noassurance that our backlog will result in actual revenue in any particularperiod, 

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becauseour backlog includes contracts that extend for several years, during which timethey could be cancelled or suspended. Anticipated revenues from long-termcontracts may cover periods as long as eight years, and in many instances suchcontracts may be terminated by the customer throughout the period. We may neverrealize revenue on contracts included in our backlog or the timing of suchrecognition may change because the contract could be reduced, modified, orterminated early or the project schedule could be changed.

In non-U.S. markets, wherewe provide driver license, national identification, and voter identificationsystems, services, and components in partnership with local card producers,security printers, system integrators, and others, we may serve as primecontractor or sub-contractor, depending on the circumstances. As asub-contractor, we are responsible for delivering hardware, software, orconsumables to the prime contractor; and, as a prime contractor, we areresponsible for integrating the components of the system to the customer’sspecifications. Revenue from international customers was $4.4 million forthe three month period ended March 31, 2005 compared to $6.0 million forthe three month period ended March 31, 2004. International salesrepresented 18% and 26% of our total revenue during the three month periodsended March 31, 2005 and 2004, respectively. International sales for ushave typically taken the form of an outright sale of equipment and/orconsumables to non-U.S. government agencies or their prime contractors. Thesesales often can be large, carry relatively low margins and may cause noticeablespikes in quarterly revenue and variations in gross profit trends. We enterinto such contracts from time to time to maintain market presence and customerand partner relationships, as such programs often transition to more profitabledigital technologies over time. Due to the nature of such international programsand customers, the timing of these sales is somewhat less predictable than inthe context of service revenues provided to us by domestic customers and,consequently, international sales can occur unevenly during the course of ayear. We believe that international growth opportunities exist for us and weexpect to continue to invest in personnel and resources to support ourpotential revenue growth outside of the U.S.

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

Service revenue was $19.6million for the three month period ended March 31, 2005 compared to $17.1million for the three month period ended March 31, 2004. The $2.5 millionor 15% increase for the three month period resulted from increased issuancerevenue from program additions, such as Florida, Ohio, Mexico, and Latvia,which were not generating any revenue in the prior year period.

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

Product and subscriptionrevenue was $4.8 million for the three month period ended March 31, 2005compared to $6.6 million for the three month period ended March 31, 2004.The $1.8 million or 27% decrease for the three month period March 31, 2005as compared to the corresponding three month period of 2004, were due primarilyto a non-recurring sale of voter identification supplies to a foreign customerduring the three month period ended March 31, 2004 that was partially offset bythe sale of equipment to a domestic customer in the current year.

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*Cost of Revenue*

*Service.  *Costof service revenue primarily includes compensation for software developers,quality assurance personnel, product managers, field operations personnel, andbusiness development personnel, outside contractors, costs of consumables usedin delivering a service, depreciation charges for machinery, equipment,capitalized software, and deployment costs used specifically for servicedelivery, and travel costs directly attributable to service and developmentcontracts.

Cost of service revenuewas $13.1 million for the three month period ended March 31, 2005 comparedto $10.0 million for the three month period ended March 31, 2004. The $3.1million or 32% increase for the three month period ended March 31, 2005 ascompared to the corresponding three month period of 2004 were primarily theresult of higher consumables costs to support the identified higher revenueidentified above, higher depreciation on revenue-generating assets of $0.5million, increased costs to deliver support and maintenance for new andexisting programs, and increased freight costs of $0.1 million related tohigher shipping activity. Field operations employees totaled 136 and 145 at March 31,2005 and 2004, respectively.

*Productand subscription.  *Cost of product and subscriptionrevenue primarily includes compensation for operations personnel, costs ofconsumables sold to third parties, costs of machinery sold to third parties,Internet service provider connectivity charges and image search data fees tosupport the services offered to our subscription customers.

Cost of product andsubscription revenue was $2.4 million for the three month period ended March 31,2005 compared to $4.9 million for the three month period ended March 31,2004. The $2.5 million or 52% decrease for the three month period ended March 31,2005 as compared to the corresponding three month period of 2004 were theresult of lower product sales in our ID systems business. The sales in thefirst quarter of 2005 had higher margins compared to the non-recurring sale ofvoter identification supplies to a foreign customer during the three monthperiod ended March 31, 2004 at DIDS, yielding the decreased cost of product andsubscription revenue.

*Gross Profit*

Overall gross profit as apercentage of revenue remained comparable for the three month period ended March 31,2005 was 36% compared to the 37% for the three month period ended March 31,2004 for the reasons stated above.

*Operating Expenses*

*Salesand marketing.  *Sales and marketing expenses consistprimarily of compensation, benefits and related costs of sales and marketingemployees, product managers and sales engineers, as well as recruiting, travel,market research, and costs associated with marketing programs, such as tradeshows, public relations and new product launches. Sales and marketing expenseswere $3.8 million for the three month period ended March 31, 2005 comparedto $2.6 million for the three month period ended March 31, 2004. The $1.2million or 49% increase for the three month period ended March 31, 2005 ascompared to the corresponding three month period of 2004 resulted primarilyfrom additions of senior-level resources to our business of approximately $0.4million; increased presence at tradeshows, advertising, and event sponsorshipof approximately $0.2 million, and increased travel related costs of $0.1million. Sales and marketing employees totaled 56 and 54 as of March 31,2005 and 2004, respectively. We anticipate that we will continue to invest ator above the current run rate in sales and marketing for the foreseeablefuture.

*Research,development and engineering.  *Research, development andengineering expenses consist primarily of compensation, benefits and relatedcosts of software developers and quality assurance personnel and payments tooutside contractors. Research, development and engineering expenses were $2.5million for the three month period ended March 31, 2005 compared to $1.7million for the three 

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month period ended March 31,2004. The $0.8 million or 44% increase for the three month period ended March 31,2005 as compared to the same three month period of 2004 generally came fromincreased workforce (both full-time employees and contractors) in our IDsystems business of approximately $0.3 million as we added full-timeemployees and added more contractors to meet the demands of new productinitiatives and system development. In addition to the increased labor costs,we incurred approximately $0.4 million of increased travel related costs. Weanticipate that we will continue to invest at the current run rate or more inresearch, development and engineering for the foreseeable future. Research,development and engineering personnel totaled 157 and 124 as of March 31,2005 and 2004.

*Generaland administrative.  *General and administrative expensesconsist primarily of compensation, benefits and related costs of executive,finance and administrative personnel, facilities costs, legal, human resourcesand other professional fees, and depreciation and amortization expense notdirectly associated with programs. General and administrative expenses were$7.0 million for the three month period ended March 31, 2005 compared to$4.8 million for the three month period ended March 31, 2004.

The$2.2 million or 45% increase for the three month period ended March 31,2005 as compared to the corresponding three month period of 2004 resultedprimarily from:

·       Increasedcosts related to our restatement of approximately $0.7 million;

·       Increasedcosts related to the audit of our financial statements of approximately $0.4million;

·       Increasedcosts related to higher headcount of approximately $0.5 million;

·       Increasedbad debt expense of $0.1 million;

·       Increasedcosts related to Sarbanes-Oxley compliance efforts of $0.1 million;

·       Increasedcosts related to the grant of restricted stock for $0.1 million;

·       Increasedcosts related to the costs of derivative law suits of $0.1 million.

General and administrativeemployees totaled 72 and 59 as of March 31, 2005 and 2004, respectively. Weexpect general and administrative expenses to decrease somewhat in futureperiods as we have completed the restatement work, but still expect significantlegal and other professional fees related to the shareholder derivativelawsuits and increased accounting, audit and legal fees related to ourcompliance with Section 404 of the Sarbanes-Oxley Act of 2002. Weanticipate that we will continue to invest in finance and IT and theoperational infrastructure at our identification systems business to moreeffectively manage growth in the context of increased regulatory requirements.

*Amortizationof intangible assets*.   We account for intangible assetsresulting from acquisitions in accordance with FASB Statement Nos. 141, *Business Combinations*and 142, *Goodwill and Other Intangible Assets*. Thesestatements require the recording of intangible assets under purchase accountingrules, and require the amortization of such intangible assets over theirexpected useful life. As a result, in December 2001 we recorded $29.5million of intangible assets related to the acquisition of certain assets andcertain liabilities from Polaroid and affiliates. These intangible assets wereset 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 $0.8 million for the three month period endedMarch 31, 2005 compared to $0.6 million for the three month period ended March 31,2004. The $0.2 million or 26% increase for the three month period ended March 31,2005 as compared to the corresponding three month period of 2004 resultedprimarily from the accelerated amortization of an intangible balance related toa lost customer contract.

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*Total other income, net.  *Totalother income, net consists primarily of interest received and paid. Total otherincome, net was $0.2 million for the three month periods ended March 31,2005 and 2004. The flat amount resulted from higher interest earned on lowerbalances partially offset by higher interest expense related to leases.

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

**Liquidity andCapital Resources**

As of March 31, 2005, we had cash and cash equivalents,restricted cash, and short-term investments of $42.3 million, representing adecrease of approximately $9.5 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 due to thenet loss incurred during the quarter. As of March 31, 2005, $8.4 millionof cash and cash equivalents is restricted as a result of the requirements ofperformance bonds that we are obligated to maintain in connection with some ofour long-term contracts in our personal identification systems business. Due tothe losses incurred during 2004 the terms of restriction changed and we wererequired to classify the restricted cash as long-term, except for $1.1 millionwhich has been released subsequent to March 31, 2005. Working capital at March 31,2005 was $43.3 million, compared to working capital of $48.9 million at December 31,2004. The decrease in working capital resulted primarily from investments madein the new Florida and Alabama programs that we anticipate will contribute torevenue growth in 2005 and due to the net loss incurred during the quarter.

The $4.3 million of cash used in operations for thethree months ended March 31, 2005 resulted from a net loss of $5.1million, offset by non cash items related to depreciation and amortization of$3.4 million and an increase in accrued payroll and related costs of $1.3million. Items negatively affecting cash used in operations were a decrease inaccounts payable of $2.2 million and an increase in trade and unbilled accountsreceivable, net of $1.5 million. The $2.8 million of cash provided byoperations for the three months ended March 31, 2004 was positivelyimpacted by an increase in accounts payable of $4.4 million and depreciationand amortization of $2.8 million, partially offset by $0.8 million of net lossfor the period and an increase in trade and unbilled accounts receivable, netof $3.4 million.

The $5.1 million of cash provided by investingactivities for the three month period ended March 31, 2005 primarilyrelated to $10.3 million in net sale or maturity of short-term investmentspartially offset by $5.2 million for the purchase of property and equipment,including capitalization of labor costs. The $0.2 million of cash providedby investing activities for the three months ended March 31, 2004 wasrelated primarily to the net sale or maturity of short-term investments of $8.6million partially offset by the purchase of property and equipment of $8.3million, including capitalization of labor costs.

The $0.1 million of cash used in financing activitiesfor the three month period ended March 31, 2005 resulted primarily fromthe principal payments on capital leases. The $1.0 million of cash provided byfinancing activities for the three months ended March 31, 2004 primarilyrelated to the issuance of stock. On January 7, 2004, five holders ofwarrants to purchase shares of common stock exercised their warrants for anaggregate of 74,506 shares of common stock, which resulted in approximately$1.0 million of gross proceeds to us. The remaining proceeds resulted fromthe issuance of stock related to our stock incentive plans, which werepartially offset by principal payments on capital leases of $0.1 million.

Our significant commitments consist of obligationsunder non-cancelable operating leases, which totaled $10.0 million as of March 31,2005, and are payable in monthly installments through August 2011. Ourobligations under non-cancelable capital leases, which totaled $1.3 million asof March 31, 2005, are payable in monthly installments through March 2009.

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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 our program implementations in Florida and Alabama and buildinventory levels for these programs as such programs reach full production. Wemay utilize cash resources to fund acquisitions or investments in complementarybusinesses, technologies or product lines.

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

In order to take 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 SheetArrangements**

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

**Recent AccountingPronouncements**

In November 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standards No. 151, *Inventory Costs—an amendment of ARB 43, chapter 4* (FAS 151).FAS 151 clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage) in the determination ofinventory carrying costs. The statement requires such costs be recognized as acurrent-period expense. FAS 151 also requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. This statement is effective for fiscal yearsbeginning after July 15, 2005. The Company does not expect that the adoption ofthis standard will have a material impact on its financial condition or resultsof operations.

In December 2004, the FASB issued Statement No. 153(FAS 153), *Exchanges of Non-monetary Assets—an amendment ofAPB Opinion No. 29*. FAS 153 amends Opinion 29 to eliminate theexception for non-monetary exchanges of similar productive assets and replaces itwith a general exception for exchanges of non-monetary assets that do not havecommercial substance. A non-monetary exchange has commercial substance if thefuture cash flows of the entity are expected to change significantly as aresult of the exchange. SFAS No. 153 is effective for fiscal periods after June15, 2005. The Company does not expect that the adoption of SFAS No. 153 willhave a material impact on the Company's consolidated financial statements.

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 awards 

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previouslycalculated in developing the pro forma disclosures in accordance with theprovisions of Statement No. 123. The Company is currently assessing theimpact of adopting Statement 123(R) to its consolidated results ofoperations.

**Risk Factors**

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

**Risks Related toOur Business**

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

Digitalwatermarking is a new and developing technology, and our business and prospectsmust be considered in light of the risks and uncertainties to which companieswith new and rapidly evolving technologies, products and services, such asdigital watermarking, are exposed. These risks include the following:

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

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

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

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

*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 our quarterlyresults, and might limit our actual revenue in any given quarter, resulting inreduced and less predictable revenue and lower profitability.

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

Some of our business involvesembedding digital watermarks in traditional and digital media, includingidentification documents, secure documents, audio, video and imagery, andlicensing our intellectual property. Through 2001, our revenue stream was basedprimarily on a combination of development, consulting, subscription and licensefees 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. In addition, because some of our products and services are not yetwell-established in the marketplace, and because some such products andservices will not directly displace existing solutions, we cannot be certainthat the pricing structure and marketing for them will be effective. We cannotassure you that our anticipated digital watermarking products and services andlicensable intellectual property will be able to compete effectively againstother alternative technologies or that we will be able to compete effectivelyagainst current or future digital watermarking suppliers in terms of price,performance, applications or other features of their technologies. In addition,as we develop models for generating digital watermarking revenue, these modelsmay not gain market acceptance or may not be sustainable over time, and, as aresult, we may not be able to generate new or sustain existing revenue fromdigital watermarking.

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

Contracts betweengovernment agencies and DIDS have varying duration, averaging three to fiveyears in length. Some contracts we enter into contain cancellation clauses. Inaddition, after a contract period expires, generally the government agency canre-open the contract for competitive bidding. If we were to lose a contract dueto cancellation or in a competitive bidding situation, then, in addition to theloss of revenue and margin on a prospective basis, we could also incuraccelerated amortization expense or impairment of intangible assets related tothe customer.

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

We incurred significantnet losses from inception through the fiscal year ended December 31, 2002,during 2004, and the first quarter of 2005. Our accumulated deficit as of March 31,2005 was $70.0 million. In order to attain sustained profitability, wewill need to generate higher revenue than we have in prior years whilecontrolling expenditures. Even though we have achieved profitability in thepast, we were not profitable in 2004 or the first quarter of 2005 and do notexpect to return to profitability until late 2005, if not later. A return toprofitability will depend upon a variety of factors, including the impact ofnew regulatory mandates requiring us to expense stock options, the amount ofcosts we incur in connection with our compliance with Sarbanes-Oxley, and theextent of any ongoing expenses that we incur in connection with our restatementand related matters, such as our continuing remediation efforts with respect tofinancial controls as well as expenses related to litigation and otherproceedings that have arisen as a result of the restatement. In addition, weevaluate our strategy and market opportunities on an ongoing basis and willadjust our approach to market conditions that prevail from time to time. Accordingly,in the short term we may focus more on growing our revenue and taking advantageof market opportunities than an immediate return to profitability. Finally, variousadverse developments including the loss of large 

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contractsor cost overruns on our existing contracts could have a negative impact on ourrevenue or our margins. Accordingly, increases in our expenses may not beoffset by revenue increases and as a result we may not be able to regain and/orsustain profitability.

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

Our business and our strategy rely, in part, ondeployment of our watermark reader technology by third parties. For example,one form of our watermark reader is commonly deployed in image editingapplications (offered by vendors including Adobe, Corel and Ulead) to permitusers of these products to read watermarks embedded in imagery, and therebydiscern the identities of image owners. Another form of our watermark reader isused in our anti-counterfeiting product offerings. If third parties who includesuch technology in their products, and other parties who we expect to includesuch technology in their products, decline to do so, then we would lose aportion of our currently anticipated revenue and we may suffer other adverseaffects to our business model. Although such anticipated revenue amounts arenot currently significant, they may be in the future.

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

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

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

Our contracts for driver license and otheridentification issuance systems and their related products typically includeterms relating to supplier dependencies, time-based performance, developmentand delivery schedules and milestones, and other contract terms that may createsituations where a customer may assert that we are late in meeting our deliveryobligations and that we owe them late penalties, charges 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 

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anticipate that futurecontracts will continue to have such provisions unless and until industrypractices change.

In addition to our normal price-per-card issuancecontracts, we occasionally enter into fixed price contracts. Fixed pricecontracts typically consist of agreements to sell entire systems or portions ofa system for an agreed upon price. These contracts normally do not have clausesthat allow for recovery of cost overruns. Under fixed price contracts, weprovide specific tasks for a specific price and are typically paid on amilestone basis. We have experienced low margins or losses on such contracts inthe recent past. Such contracts involve greater financial risks because we bearthe risk if actual project costs exceed the amounts we are paid under the contracts.A material percentage of our revenues are derived from fixed price contractsand our reliance on fixed price contracts may grow.

A significant portion ofour business depends on a limited number of large, public-sector contracts,which are generally subject to termination for convenience, as determined bythe subject agency, or for lack of budgetary appropriation provided for thesubject agency. Some government contracts also may be one-time events, such asin the case of some personal identification systems in non-U.S. marketsinvolving voter registration programs. In such cases, we may generatesubstantial revenue that may not be subject to future renewal. Moreover,government contracts result from purchasing decisions made by public sector agenciesthat may be subject to political influence, unusual procurement procedures,strict legal requirements, budget changes and cutbacks during economicdownturns, variations in appropriations cycles, and protests of contractawards. Additionally, some governmental authorities require performance bondsthat we are obligated to maintain during the life of the contract. Often, theterms of these bonds require that we maintain large restricted cash reserves asa guarantee, reducing our ability to use these funds for our other businesspurposes. Even with the availability of such cash reserve guarantees, we maynot be able to obtain such performance bond underwriting at a favorable rate orat all. Our failure to be able to provide such performance bonds may precludeour ability to bid on new government contracts or maintain our existingcontracts for the entirety of their full terms. The size, nature and purposeof, and the risks and uncertainties associated with, public sector contractscan potentially cause our quarterly results to fluctuate and anticipatedrevenue to decrease significantly.

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

Government agenciessometimes insist on unduly onerous terms in their contracts with vendors ofsecure identification issuance systems. For example, it is customary for stateagencies to require that a vendor fund the capital-intensive initial deploymentof a driver license issuance system (the costs of which the vendor normallyrecoups over the life of the contract in per-card fees), while reserving theright to terminate the contract. Similarly, in connection with intellectualproperty rights, a contract may require that our pre-existing issuance systemsoftware be written in a different language and a state may then argue that itfalls within the class of works for which it owns the copyright, enabling thestate to turn the Digimarc-authored software over to one of our competitors,dedicate it to the public domain, or otherwise use the software in a mannerdetrimental to our business. Objectionable contract terms may lead us todecline to bid on identification issuance systems to new customers, or todecline to retain business with customers we have historically served, whichcould reduce our market share and lower our revenues or profits. In addition,if we decline to retain business with customers we have historically served, itcould result in the accelerated depreciation of intangible assets. Alternatively,we may decide to accept at least some level of objectionable terms rather thancede an important contract to a competitor, which could also lower our revenuesor profits.

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*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. During 2004we increased our initiatives in these areas and anticipate continuing to do soin future periods. We believe these new sales channels may contributesignificantly to our future results, as our products get placed into otherprograms and start generating recurring revenue streams. However, given thatthis is an emerging area of our business, involving significant time and effortin connection with the development of new products and distributionrelationships, there are ongoing risks that these market areas will not developin the manner or along the timeline that we are projecting, or at all,resulting in significant costs and expenses without corresponding increases inany revenues and profits.

*Our identificationsystems business expects to experience variability in gross margins.*

Our DIDS businesswill likely experience variability in gross margins on its 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 expenditure associatedwith such extension or renewal;

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

·       Variationsin costs of materials and manufacturing;

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

·       Seasonalityof issuance volumes;

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

·       Salesmix related to domestic sales compared to international sales;

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

·       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 DIDSbusiness.

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*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 DIDS, and our President and ChiefOperating Officer resigned. While we anticipate that these changes inleadership and staffing will improve operations, there is a risk that thesechanges may disrupt the operations of our business and, consequently, mayresult in some short-term inefficiencies as personnel complete theirtransitions and new leaders implement their new plans and procedures. We alsoexpect that these changes may require further modifications of our finance andbusiness processes and will likely cause additional costs to our business inthe short term before any benefits from such changes, if any, may be realized.

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

Due to concerns related toour restatement, late SEC filings, possible delisting from the Nasdaq NationalMarket and shareholder litigation, we could encounter significant departures ofkey employees from the Company. While we are taking steps to support employeeretention, there can be no assurances that key employees will not leave theCompany for other jobs, thus impairing our ability to meet commitments andsustain revenue. In addition, these events may have a negative impact on themarket price of our common stock, and employees and prospective employees mayfactor in the uncertainties relating to our stability and the value of anyequity-based incentives in their decisions regarding employment opportunitiesand decide to leave our employ. These uncertainties also could result in anerosion of morale, and affect the focus and productivity of our remainingemployees, including those directly responsible for revenue generation, whichin turn may affect our revenue in the future. Additionally, current employeesmay seek future employment with our business partners, customers or competitors.Although we generally attempt to control access to and distribution of ourproprietary information by our employees, there can be no assurances that theconfidential nature of our proprietary information will be maintained in thecourse of such future employment. Any of these events could have a materialadverse effect on our financial and business prospects. For more informationabout the shareholder litigation, see Item 1 of Part II of this Form 10-Q.

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

Our success depends to asignificant extent on the performance and continued service of our seniormanagement. Except for our Chief Executive Officer, our senior management doesnot have employment agreements. Although our employees generally have executedagreements containing non-competition clauses, there is no assurance that acourt would enforce all of the terms of these clauses or the clauses generally.If these clauses were not fully enforced, our employees could be able to freelyjoin our competitors. The loss of the services of any of our senior managementor any of our other key employees could delay projects or undermine customerrelationships.

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

Our ability to develop,market, sell and license successfully our products, services, and intellectualproperty depends to a significant degree upon the continued contributions ofour key personnel in engineering, sales, marketing, operations, legal andlicensing, many of whom would be difficult to replace. Similarly, without thecontinued contributions of our key finance personnel, we believe that ourability to meet our reporting obligations and operate successfully as a publiccompany may be limited. We believe our future success will depend in large partupon our ability to retain our current key employees and our ability toattract, integrate and retain such personnel in the future. It may not bepractical for us to match the compensation certain of our employees couldgarner at other employment. Our business is also 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.

*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 areengaged in litigation relating to the initial public offering of our securitiesand various other routine actions, in addition to the class actions filedagainst us in connection with our recently announced accounting errors. Litigationtypically is an expensive process and, due to its inherent uncertainties andbecause the settlement and trial preparation processes are lengthy andpotentially inconclusive, the ultimate cost and outcome of such matters cannotbe predicted. As a result, while we believe that litigation often is necessaryto preserve the interests of our company, it also can lead to additionalexpense and thus lower profits to our business without generating offsettingand lasting benefits.

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

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

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

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

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

Some of our contracts include provisions by which weassure non-infringement of third-party intellectual property rights. If aninfringement arose in a context governed by such a contract, we may have torefund to our customer amounts already paid to us or we may be sued by theparty allegedly infringed upon, our exposure could be large, and we may incursignificant litigation, settlement, or judgment expenses. Similarly, as we seekto broaden the number of companies licensed under our patent portfolio, somemay seek contractual assurances that we will pursue—by litigation ifnecessary—their competitors who use our patented technology but are notlicensed to do so. Compliance with any such contract provisions may requirethat we pursue litigation where our costs exceed our likely damages award.

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

We have registered “DIGIMARC”, “MARCSPIDER”, “MEDIABRIDGE”,“IMAGEBRIDGE”, “PICTUREMARC”, and the “D” logo, among other marks, astrademarks in the United States as well as other countries. We are pursuing theregistration of “DIGIMARC” in additional countries, and we are pursuing theregistration of certain other trademarks including “IDMARC”, “EXIAN”and “CENTRIAN”. However, our trade names or trademarks may be registered bythird parties in other countries, impairing our ability to enter and compete inthese markets. In the United States, the trademark “Digimark” and the domainnames “Digimark.com” and “Mediabridge.com” have been registered by unrelatedcompanies. While we have put in place formal arrangements for co-existence withone of these unrelated companies, and while we have co-existed successfully todate with the other, if we were forced to change our name or were preventedfrom using our other brand names, we would lose a significant amount of ourbrand 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 

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not beable to obtain these licenses on commercially reasonable terms or at all. Ouruse of protected technologies may result in liability that threatens ourcontinuing operation. In addition, we offer indemnification againstintellectual property infringement for some contracts to which we are a party.As deployment of our technology increases, and more companies enter ourmarkets, the likelihood of a third party lawsuit resulting from suchindemnification increases. If a claim were made under such an indemnityprovision, we could incur significant expense.

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

Our business relies on computers and 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. If unintendedparties obtain sensitive data and information, or create bugs or viruses orotherwise sabotage the functionality of our systems, we may receive negativepublicity, incur liability to our customers or lose the confidence of ourcustomers, any of which may cause the termination or modification of ourcontracts. Further, our insurance coverage may be insufficient to cover lossesand liabilities that may result from such events.

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

*Our products 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 as complex as those we offer ordevelop frequently contain undetected defects or errors. Despite testing,defects or errors may occur in existing or new products, which could result indelays in the development and implementation of products and systems, loss ofrevenue or market share, failure to achieve market acceptance, diversion ofdevelopment resources, injury to our reputation, increased insurance costs andincreased service and warranty costs. Furthermore, we often provideimplementation, integration, customization, consulting and other technicalservices in connection with the implementation and ongoing maintenance of ourproducts. The performance of these products typically involves working withsophisticated software, computing and communications systems. Our inability tomeet customer expectations or project milestones in a timely manner could alsoresult in a loss of, or delay in, revenue, loss of market share, failure toachieve market acceptance, injury to our reputation, increased costs andpotential claims of breach of contract and compensatory and/or liquidated damages.

Because many customers rely on our products forcritical security applications, defects or errors in our products or servicesmight discourage customers from purchasing future products and services. Thesedefects or errors could also result in product liability or warranty claims.Although we attempt to reduce the risk of losses resulting from these claimsthrough warranty disclaimers and liability limitation clauses in our salesagreements when we can, these contractual provisions are sometimes not includedand may not be enforceable in every instance. Furthermore, although we maintainerrors and omissions insurance, this insurance coverage may not adequatelycover these claims. If a court refuses to enforce the liability-limitingprovisions of our contracts for any reason, or if liabilities arose that werenot contractually limited 

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or adequately covered byinsurance, the expense associated with defending such actions or paying theresultant claims could be significant and decrease our profits.

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

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

As of March 31, 2005we had 421 employees and 204 contract workers. To effectively manage ouroperations, management must continue to improve our operational and financialsystems and train, improve and manage our employee base. As part of our goal tocontinue to improve operating efficiencies, we organized our operations into aportfolio of peer-level operating units under a corporate umbrella, consistingof two units, the first of which is Digital Watermarking and the second ofwhich is ID Systems, both of which are overseen by a corporate staff. While ourmanagement anticipates that this operating structure will facilitate effectivemanagement of the continuing growth and expansion of our business, we cannotassure you that the operating structure will be effective or achieve thedesired results. Additionally, less than optimal rates of growth of our productlines and areas of business may require us to restructure our business fromtime to time, which, in turn, could significantly strain our managerial andfinancial resources. If we cannot manage our growth effectively, we may not beable to coordinate the activities of our technical, legal, accounting andmarketing staffs and, as a result, we may experience higher expenses andreduced margins.

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

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

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*As international customers have accounted forapproximately 18% of our total revenue during the three months ended March 31,2005, 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;

·       exportlicense requirements, tariffs and taxes;

·       tradebarriers;

·       difficultyin protecting intellectual property;

·       difficultyin collecting accounts receivable;

·       currencyfluctuations;

·       difficultyin managing foreign operations; and

·       politicaland economic instability.

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

We generally do 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.

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

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

Management concluded 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 constitute material weaknesses as of March 31,2005. We made this determination in consultation with the audit committee ofthe Company’s board of directors. We have acted promptly to address theseissues and are engaged in an ongoing design and implementation process of newand enhanced controls and procedures. If we are unable to identify and remedyall such issues promptly and effectively, it could have a material adverseeffect on our business, as well as impair our ability to meet our quarterly andannual reporting requirements in a timely manner. While we are completing thedesign, implementation and testing of our enhanced controls environment, thecontrols and procedures on which we currently rely may fail to be sufficientlyeffective, and such controls and procedures may not be adequate to prevent or detecterrors or ensure the accuracy of our financial statements or reports filed withthe SEC. Further, any system of control, however well designed and operated, isbased in part on certain assumptions and can provide only reasonable, and not absolute,assurance that the objectives of the system are met. The failure orcircumvention of our controls, policies and procedures could have a materialadverse effect on our compliance with disclosure and listing requirements, andif they were to lead to a financial loss, could negatively affect the resultsof our operations and financial condition. For more information about thematerial weaknesses in our internal control over financial reporting, see Item4 of Part I of this Form 10-Q.

*We were not successful in meeting the requirementsunder Section 404 of the Sarbanes-Oxley Act of 2002 in a timelybasis and the market price of our common stock and our regulatorycompliance may be adversely affected as a result. Moreover, our assessment ofthe effectiveness of our internal control over financial reporting as requiredby Section 404 has identified additional issues relating to our internalcontrols and will result in an attestation with an adverse or disclaimedopinion from our independent registered public accounting firm, which mayadversely affect the market price of our common stock.*

We were not able to complete the evaluation andtesting of our internal control over financial reporting as required by Section404 of the Sarbanes-Oxley Act of 2002 within the time prescribed by SEC rules. Inorder for management to issue its report on our internal control over financialreporting, we must document both the design of our internal control overfinancial reporting and the operating effectiveness of our controls andprocedures.  Our management believes it has completed all processes and proceduresfor issuing its report, but additional time is needed by the Company’sindependent registered public accounting firm to complete all of its work toissue its related attestation report on management’s assessment of theeffectiveness of internal controls. The focused application of criticalresources to our accounting review in connection with the restatement of ourfinancial statements and the preparation of filings with the SEC reflecting therestatement had a significant impact on our Section 404 compliance efforts.As a result of our failure to meet our compliance and reporting obligations, wemay be subject to sanctions or investigation by regulatory authorities, such asthe SEC, and further review by The Nasdaq Stock Market, Inc. (“Nasdaq”),which may result in the delisting of our common stock from the Nasdaq NationalMarket. Any such action could adversely affect the market price of our commonstock.

Our internal controlassessment will confirm material weaknesses in our internal control overfinancial reporting that we have previously disclosed in our 2004 Form 10-K.Consequently, we expect our assessment will result in an attestation reportwith an adverse opinion, or a disclaimer of an opinion, from our independentregistered public accounting firm as to the effectiveness of our internalcontrol over financial reporting. Any such consequences of our Section 404assessment could have an adverse effect on investor perceptions of the Companyand cause a decline in the market price of our common stock.

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*We are investing significant time and resources toimplement the requirements of Section 404 the Sarbanes-Oxley Act of 2002, whichmay increase our operating expenses and reduce our profitability in the nearfuture.*

Changes in the laws andregulations that have recently been enacted, including provisions of theSarbanes-Oxley Act of 2002, are likely to continue to increase our expenses aswe devote resources in response to them. For example, we already have deployedsignificant resources to document, implement and test our financial processesas part of our implementation of the requirements under Section 404 of theSarbanes-Oxley Act of 2002, including the requirements under Section 404for our management to report on, and our independent registered publicaccounting firm to attest to, our internal control over financial reporting.Moreover, compliance with these rules could also cause us to furthermodify our existing review processes or divert our management’s time andattention away from otherwise running our business, either of which couldresult in our company experiencing additional costs and expenses withoutcorresponding increases in revenue. Consequently, as we take steps to furtherimprove and strengthen our financial management and controls, we anticipatecorresponding increases in our operating expenses that may reduce ourprofitability in the near future.

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

We announced in September 2004 that we likelywould be required to restate certain previously reported financial statements. Followingthis announcement, three class action lawsuits were commenced against us andcertain of our current and former officers by persons claiming to havepurchased or otherwise acquired our securities at specified dates. In addition,three purported shareholder derivative lawsuits were filed against the Companyand certain of our officers and directors, claiming that certain of ourofficers and directors breached their fiduciary duties to the Company’sstockholders and to the Company. Moreover, a letter was mailed to the chairmanof the Company’s board of directors by a law firm purporting to represent ashareholder of the Company demanding that the board commence an investigationand civil action against designated current and former directors and officerson behalf of the Company to recover for damages alleged to have been incurredas a result of alleged breaches of fiduciary duties. Additional lawsuits may befiled against us. Defending against existing and potential litigation relatingto the restatement of our consolidated financial statements, or responding toother regulatory inquiries or investigations, will likely require significanttime, attention and resources of management, which may adversely affect ourbusiness, results of operations and financial condition.

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

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

Our director and officerliability insurance policies provide 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.

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*We could face adverse consequences as a result of ourlate SEC filings and the restatement of our historical financial statements.*

We failed to timely file our Form 10-Q forthe quarterly period ended September 30, 2004 and our Form 10-Kfor the year ended December 31, 2004. In addition, our 2004 Form 10-Kfiling does not yet include the internal control reports required by Section 404of the Sarbanes-Oxley Act. As a result of these late filings, we will not beeligible to use a “short form” registration statement on Form S-3for a period of 12 months after we become current in our filings. Ourinability to use a short form registration statement for a period of 12 monthsafter becoming current in our SEC reporting obligations may impair our ability,or increase the costs and complexity of our efforts, to raise funds in thepublic 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 restatement and late SEC filings have resulted in negativepublicity and a Nasdaq delisting proceeding, and may have a negative impact onthe market price of our common stock. The effects of the restatement and lateSEC filings could cause some of our customers or potential customers to refrainfrom purchasing or defer decisions to purchase our products and services.Additionally, current or potential suppliers may re-examine their willingnessto do business with us, to develop critical interfaces to our products or tosupply products and services if they lose confidence in our ability to fulfillour commitments. Any of these losses could have a material adverse effect onour financial and business prospects.

**Risks Related to Our Industry**

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

Our future success will depend in part on 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

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

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

*If 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 and copy-control applications, can be impeded or frustrated bylarger, more influential companies or by standard-setting bodies orinstitutions downplaying, minimizing or rejecting the value or use ofwatermarking technology or any of our other technologies. Such a negativeposition by these companies, bodies or institutions, if taken, may result in obstaclesfor us that we would be incapable of overcoming and may make achieving ourbusiness objectives difficult or impossible, potentially diminishing ouranticipated revenue growth as a result.

*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. As we expand the applications for our technologies, we willexperience more competition from products and services that are substitutes forour applications. Because our digital watermarking business is new andemerging, we also may face competition from unexpected sources. Alternativetechnologies that may directly or indirectly compete with particularapplications of our watermarking technologies include:

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

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

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

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

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

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

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

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

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

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

In addition, as we more broadly apply our digitalwatermarking technologies to the Internet through new commercial solutionsapplications, we may begin to compete with a wide range of other types ofcompanies beyond those companies using digital watermarking technologies and alternativetechnologies. Moreover, many of the companies that currently compete with usfor some of our business, as well as other companies with whom we may competein the future, are larger and national or international in scope and may havegreater technical, financial, marketing, and political resources than we do.These resources could enable these companies to initiate severe price cuts ortake other measures in an effort to gain market share or otherwise impede ourprogress. We cannot assure you that digital watermarking technologies, and ourproducts 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 against alternativetechnologies, nor can we assure you that the competitive pressures we face willnot decrease our revenue and profits in the future.

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

Threats of terroristattacks in the United States, as well as future events occurring in response toor in connection with them, including, without limitation, future terroristattacks or threats against United States targets, rumors or threats of war,actual conflicts involving the United States or its allies, or military ortrade disruptions, may impact our operations by leading to deferred orcancelled projects, which may reduce our revenue and profits. While any ofthese terrorist-related events could result in an increased need for newsecurity features that may, as a result, favorably impact our revenue from ourDIDS operations and our sales of product and subscription and service inconnection with our digital watermarking technology, any of these events couldalso, or alternatively, result in increased volatility in the United States andworldwide financial markets and economies, or drive up our research,development and engineering costs associated with attempting to achieve heightenedeffectiveness in new products. Also, any of these terrorist-related eventscould result in economic recession in the United States or abroad. If suchnegative consequences were to occur, they could reduce our revenue and profitswithout the effect of reducing costs in the short-term and might result in thevolatility of the future market price of our common stock.

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**Risks Related to Our Common Stock**

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

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

Our quarterlyresults may fluctuate in the future as a result of several factors, many ofwhich are outside our control, including, among other things:

·       Timing,introduction and successful commercialization of our new products and services;

·       Lossof or reduction in revenue from any large customer;

·       Marketacceptance of our products and services;

·       Abilityto establish and maintain strategic relationships;

·       Potentialcosts of litigation and intellectual property protection;

·       Operatingcosts and capital expenditures related to the expansion of our businessoperations and infrastructure, domestically and internationally, including thehiring of key personnel and new employees;

·       Introductionof similar or substitute technologies by competitors;

·       Unpredictabilityand irregularity of our revenue from government contracts due to politicalfactors, budgetary appropriations, resident migrations, changes in driverlicense expiration periods, card renewal seasonal effects (particularly in thefourth quarter of each year when license renewals are lower), purchasing anddelivery constraints, potential cost overruns, or delays in contractimplementation or performance resulting in damages having to be paid for suchdelays;

·       Timingof future licensing revenues;

·       Costsassociated with marketing arrangements that we enter into during early marketdevelopment;

·       Manufacturingyield losses that we may incur as we develop new products;

·       Excessand obsolete inventory adjustments and charges that we determine may beappropriate at the termination of government contracts or during the course ofthose contracts; and

·       Failureof or delay in efforts to establish industry standards involving watermarking.

In addition, because themarket demand for certain of our products and services is new and rapidlyevolving, it is difficult for us to predict certain aspects of our futurefinancial results. Much of our research and development, sales and marketingefforts and business expenditures are based in part on our predictionsregarding developments involving counterfeiting and piracy, as well as othersecurity and intelligence needs, and on our estimates as to the use of digitalwatermarking as a solution to those problems. To the extent that thesepredictions and estimates prove inaccurate, our actual revenue and operatingresults will fluctuate from our anticipated results, which could decrease ourstock price or increase the volatility of our stock price.

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

On November 10, 2004, we were advised by Nasdaqthat our common stock may be delisted from the Nasdaq National Market becausewe were no longer in compliance with Nasdaq’s continued listing requirements asa result of our failure to timely file our Form 10-Q for the quarterended September 30, 2004. On April 6, 2005, we were advised by Nasdaqthat, due to our failure to timely file our Form 10-K for the yearended December 31, 2004, our common stock was subject to delisting fromThe Nasdaq Stock Market. On April 29, 2005, we were advised by Nasdaq thatthe Nasdaq Listing Qualifications Panel (the “Nasdaq Panel”) had determined tocontinue the listing of our common stock on the Nasdaq National Market providedthat we amend our 2004 Form 10-K on or before May 16, 2005 toinclude our internal control reports required by Section 404 of theSarbanes-Oxley Act, and provided that we timely file all periodic reports withthe SEC and Nasdaq for all reporting periods ending on or before December 31,2005. We have not yet amended our 2004 Form 10-K to include the report onmanagement’s assessment of the effectiveness of internal control over financialreporting or the related attestation report of our independent registeredpublic accounting firm as required by Section 404 of the Sarbanes-Oxley Act andthe Nasdaq Panel’s April 29, 2005 decision. In addition, we did not file this Form 10-Q until May 16, 2005, fivebusiness days after the prescribed due date, in reliance on Rule 12b-25.  Although we have requested that Nasdaqcontinue the listing of our common stock pending the filing of an amendment toour 2004 Form 10-K that includes such internal control reports, there can be noassurance that Nasdaq will grant our request.

Separately, on May 4, 2005, we were notified byNasdaq that the Nasdaq Listing and Hearing Review Council (the “Listing Council”)has called for review the March 22, 2005 decision by the Nasdaq Panelregarding Digimarc. In the March 22, 2005 decision, the Nasdaq Panelgranted our request to extend the deadline to March 31, 2005 to file our Form 10-Qfor the quarterly period ended September 30, 2004 and our 2004 Form 10-K,including all required restatements of prior periods. The March 22, 2005decision was called for review to consider whether the Nasdaq Panel’s decisionto grant such extension was appropriate. The Listing Council has the authorityto review on its own motion all decisions of the Nasdaq Listing QualificationsPanels and may affirm, modify, reverse, dismiss, or remand the March 22,2005 decision to the Nasdaq Panel. 

There can be no assurancethat Nasdaq will continue the listing of our common stock. The Nasdaq Panel orthe Listing Council may determine to delist our common stock from the Nasdaq NationalMarket and our common stock may be delisted from the Nasdaq National Market ifwe fail to timely file other periodic reports in the future. If our commonstock is delisted, it would be listed on some other quotation medium, such as the“pink sheets,” depending upon our ability to meet the specific listingrequirements of those quotation systems. In the event our common stock isdelisted from the Nasdaq National Market, the visibility, liquidity and priceof our common stock may be reduced, and our stockholders may find it moredifficult to dispose of, or to obtain accurate price quotations for, our shares.In addition, if our common stock is delisted from the Nasdaq National Market,it may also result in other negative implications, including the potential lossof confidence by suppliers, customers and employees, the loss of institutionalinvestor interest and fewer business development opportunities.

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

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

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We have thefollowing anti-takeover provisions in our charter documents:

·       Ourboard of directors is divided into three classes of directors, with a separateclass of directors being elected at each successive annual meeting for a termof three years;

·       Specialmeetings of the stockholders may be called only by our president or oursecretary, or at the discretion of our board of directors;

·       Vacancieson our board of directors may be filled by a majority of directors in office,without the approval of the stockholders; and

·       Ourboard of directors may issue preferred stock and determine the price,designations, rights and preferences as well as qualifications, limitations,and restrictions of those shares without any vote or further action by thestockholders.

In addition, on November 16, 2004, our board of directorsauthorized and declared a dividend of one right for each outstanding share ofour common stock to stockholders of record at the close of business on November 29,2004, and authorized the issuance of one right for each share of common stockissued by us under certain circumstances in the future. Each right entitles theregistered holder, subject to the terms of the Rights Agreement between us andthe rights agent, to purchase from us one one-hundredth of a share (a unit) of Series APreferred Stock, par value $0.001 per share, at a purchase price of $100.00 perunit, under circumstances described in the Rights Agreement. The purchaseprice, the number of units of preferred stock and the type of securitiesissuable upon exercise of the rights are subject to adjustment. The rights willexpire at the close of business November 16, 2014 unless earlier redeemedor exchanged. Until a right is exercised, the holder thereof, as such, willhave no rights as one of our stockholders, including the right to vote or toreceive dividends. The rights are not immediately exercisable. Subject to theterms and conditions of the Rights Agreement, they will become exercisable tenbusiness days after a person or group acquires, or commences a tender orexchange offer which would lead to the acquisition of beneficial ownership of15% or more of our outstanding common stock, subject to prior redemption orexchange and subject to exceptions specified in the Rights Agreement, includingan exception for certain existing large shareholders that have historicallyheld ownership positions in excess of 15 percent. Subject to these exceptions,once a person or group acquires beneficial ownership of 15% or more of ouroutstanding common stock, each right not owned by that person or group orcertain related parties will entitle its holder to purchase, at the right’sthen-current purchase price, units of Series A preferred stock or, at ouroption, shares of common stock or cash, property or other securities of ourcompany having a market value equal to twice the then-current purchase price,subject to terms and conditions of the Rights Agreement.

Our anti-takeoverprovisions as well as our Rights Agreement could have the effect ofdiscouraging a third party from making a tender offer or otherwise attemptingto gain control of us, even though the transactions could be profitable for ourstockholders. In addition, these provisions could limit the price thatinvestors might be willing to pay in the future for shares of our common stock.

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**Safe HarborStatement 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 incorporated herein byreference could cause our actual results to differ materially from thoseresults projected or suggested in such forward-looking statements. Statementsthat 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, statementsregarding the expected deployment of programs in 2005, statements regardinganticipated expenses, costs, margins and investment activities in theforeseeable future, statements regarding anticipated revenue to be generatedfrom current contracts and as a result of new programs, statements regardingour profitability in future periods, statements regarding businessopportunities that could require that we seek additional financing, statementsregarding the existence of international growth opportunities and our futureinvestment in such opportunities, statements regarding the continuance 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 the impact on theCompany of our recent restatement, late SEC filings, possible delisting fromNasdaq and shareholder litigation, statements regarding our expected short-termand long-term liquidity positions, statements regarding our use of cash inupcoming quarters, statements relating to the Company’s compliance with Nasdaq’sconditions for continued listing on the Nasdaq National Market, and otherstatements containing words such as “anticipate,” “estimate,” “expect,” “managementbelieves,” “we believe,” “we intend” and similar words or phrases, which areintended to identify forward-looking statements. Actual results may varymaterially due to, among other things, inherent limitations in all controlsystems and related procedures, risks as to litigation and related matters inconnection with our restatement of financial results, the actual timing andimpact of our compliance with Section 404 of the Sarbanes-Oxley Act of 2002,the actual filing date of the Company’s Form 10-K/A that includes the internalcontrol reports required by Section 404, changes resulting from any keypersonnel additions or changes, as well as changes in economic, business,competitive, technology and/or regulatory factors and trends. All forward-lookingstatements are necessarily only estimates of future results and there can be noassurance that actual results will not differ materially from expectations,and, therefore, investors are cautioned not to place undue reliance on suchstatements. Investors should understand that it is not possible to predict oridentify all risk factors and that the risks discussed above should not beconsidered a complete statement of all potential risks and uncertainties. Weundertake no obligation to update any forward-looking statements as a result offuture events or developments.

**Item3. Quantitative and Qualitative Disclosures About Market Risk.**

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

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**Item4. Controls and Procedures.**

As previously disclosed, we identified during thethird quarter of 2004 certain errors in the accounting for software developmentcosts and project capitalization at DIDS, and we postponed the release of ourfinancial results for the quarter ended September 30, 2004 pending thecompletion of our review of these accounting errors. We identified these errorsas a result of our review of our accounting and our review of our internalcontrol over financial reporting in preparation for compliance with Section 404of the Sarbanes-Oxley Act of 2002 and its implementing regulations. This reviewinvolves a detailed analysis and documentation of the processes that impact thepreparation of our financial statements, an assessment of the risks that couldadversely affect the accurate and timely preparation of those financialstatements and the identification of the controls that are in place to mitigatethe risks of untimely or inaccurate preparation of those financial statements. Duringthe course of our review, we determined that certain prior period financialstatements required restatement. As a result, we restated our consolidatedfinancial statements as of and for (1) the fiscal year ended December 31,2003, including each of the quarterly periods in the fiscal year ended December 31,2003, and (2) the quarterly periods ended March 31, 2004 and June 30,2004. Our restated quarterly information and our restated financial statementsare included in the Form 10-K for the year ended December 31, 2004, which wasfiled on April 7, 2005.

We identified andreported to our audit committee the following areas for improvement in ourinternal control over financial reporting. These matters constitute “materialweaknesses” as defined under standards established by the Public CompanyAccounting 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 recording ofsoftware capitalization, standard costing, and revenue recognition inaccordance with U.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.

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·       *Insufficient controls both for determining the nature and types ofcosts that should be capitalized and for ensuring allocation of costs toparticular projects are appropriate.*   Controls for determiningthe nature and types of costs that should be capitalized in accordance withU.S. GAAP, and for ensuring that costs were allocated to appropriate projects,were inadequate, which affected our fixed asset and research and developmentaccounts. We lacked enough personnel with sufficient expertise in complexsoftware capitalization and project accounting rules under U.S. GAAP andthere was not a clear understanding regarding the application of our internalpolicies in these areas. Some of our employees who performed accountingfunctions were not adequately trained and supervised, and there weredeficiencies in communication between functional departments within the Company.Such controls also were insufficient because the documentary support for thehistorical capitalization of certain software development costs and the systemfor tracking costs that qualify for capitalization needed improvement, and thedetective controls related to the capitalization of internally developedsoftware were not adequate. 

·       *Insufficient controls to ensure that various international, state, andlocal tax exposures were quantified and properly accrued on a timely basis.*   Internalcontrols related to the quantification and accrual of international, state, andlocal taxes incurred by the Company were insufficient. There was not sufficientstaff to properly quantify, accrue, and record such taxes on a timely basis inaccordance 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 reconciliation processes forcomplex revenue recognition requirements primarily related to internationaltransactions.*   Training and reconciliation processes related tocomplex revenue recognition requirements regarding distributor discounts,partial deliveries of goods and the acceptance criteria for shipped goods wereinsufficient to ensure these transactions were recorded in accordance with U.S.GAAP. This affected our revenue and our deferred revenue accounts. 

·       *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. 

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**RemediationActivities**

Digimarcplaces the highest priority on addressing these matters. Under the direction ofour senior management and the participation and oversight of our auditcommittee, we have implemented significant changes to our infrastructure andrelated processes over the past nine months, and continue to address thesematters and will make changes as appropriate. The numbers set forth oppositeeach identified area for improvement in the chart below correspond to thenumbered descriptions of the changes we have implemented, or are in the processof implementing, to improve such areas of our internal controls which appearimmediately following the chart. 
| **Identified  Areas for Improvement in Internal Controls**                                                                                                                    | ** ** | ** **              | ** ** | **Changes Implemented** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Inadequate  supervision and technical accounting expertise within the accounting and  finance department                                                                      |       | 1,  2, 3, 4, 8          |       |
| Inadequate design  and implementation of new accounting systems                                                                                                               |       | 1,  2, 3, 4, 6, 9       |       |
| Inadequate  quarterly and year-end financial statement close and review process                                                                                               |       | 1,  2, 3, 4, 5, 6, 7, 8 |       |
| Insufficient  controls for determining the nature and types of costs that should be  capitalized and for ensuring allocation of costs to particular projects are  appropriate |       | 1,  2, 3, 4, 8          |       |
| Insufficient  controls to ensure that various international,  state, and local tax exposures were quantified and accrued on a timely basis                                    |       | 1,  2, 4, 7             |       |
| Insufficient  training and inadequate reconciliation processes for complex revenue  recognition requirements primarily related to international transactions                  |       | 1,  2, 4, 7             |       |
| Insufficient  controls related to system access and segregation of duties                                                                                                     |       | 1,  2, 9                |       |
| Inadequacies related to  entity-level controls                                                                                                                                |       | 1, 2, 4, 5              |       |

 

*Description ofChanges Implemented to Improve Internal Controls*

1.      We hireda new Chief Financial Officer in June 2004, a new President of DIDS in April 2005,and a number of other personnel and consultants who have expertise in financialcontrols or accounting, and we are actively recruiting other senior levelmembers of the finance and accounting organization, including adding a Directorof Tax in May 2005, to improve the overall quality and level of experiencein our finance and accounting organization.

2.      We havemade, and will continue to make, changes in our finance and accountingorganization to provide clearer segregation of responsibilities and supervisionwith regard to, among others, documentation supporting our quarterly and annualfinancial statements.

3.      We haveinitiated additional training of our management and other employees at DIDSregarding timekeeping practices and other best practices.

4.      We areimplementing an enhanced quarterly and annual financial review close process toinclude additional analysis and support for the financial accounts.

5.      We havedeployed significant internal and external resources directed at documentingand testing our internal control over financial reporting as contemplated by Section404 of Sarbanes-Oxley, and such efforts have been helpful in improvingour overall process and control environment.

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6.      We havestrengthened our inventory management and controls systems and procedures,including those governing the usability and disposition of slow-moving orexcess inventories, by performing timely physical inventory counts thatreconcile to the general ledger, analyzing historical and expected usagelevels, and reviewing manufacturing standard costs.

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

8.      We 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 andfulfillment phases.

9.      We haveestablished a staff position to implement preventive control procedures relatedto system access and to monitor and control access to system modules inaccordance with appropriate guidelines in order to ensure safeguarding ofassets, and are in the process of implementing such preventative controls atthe system and procedural levels. In addition, we have implemented detectivecontrols such as the enhanced review of accounting transactions and financialstatements.

We continue to take remedial steps to strengthen ourinternal controls and enhance our reporting processes. We will also addressitems that have been or may be identified through our internal controlsassessment under Section 404 of the Sarbanes-Oxley Act of 2002 and relatedwork, which is continuing. Moreover, our on-going accounting review hasresulted 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.

Our 2004 Form 10-K does not include the report ofmanagement’s assessment of the effectiveness of internal control over financialreporting or the related attestation report of our independent registeredpublic accounting firm, KPMG LLP, as required by Section 404 of theSarbanes-Oxley Act. We currently expect that we will file an amendment to ourForm 10-K to include both management’s assessment of internal controls overfinancial reporting and the related attestation report of our independentregistered public accountants within the next several days. However, given thetime requirements and resources necessary to test our processes, there can beno assurance as to when we will be fully compliant with the requirementsrelating to internal controls over financial reporting and other aspects ofSection 404. Additionally, due to the nature of and the time necessary toeffectively remediate the deficiencies identified, these issues were not beingeffectively remediated as of December 31, 2004, the date of our assessment ofinternal control over financial reporting. As a result, based on the materialweaknesses identified, it is currently anticipated that management’s assessmentand KPMG’s report will conclude that the Company’s internal control overfinancial reporting was not effective as of December 31, 2004.

Our current management, with the participation of ourprincipal executive officer and principal financial officer, carried out aseparate evaluation of the effectiveness of our disclosure controls andprocedures (as defined in Rules 240.13a-15(e) and 240.15d-15(e) ofthe Securities Exchange Act of 1934) as of March 31, 2005, which includedan evaluation of disclosure controls and procedures applicable to the periodcovered by the filing of this periodic report. As noted above, we haveidentified a number of areas for improvement in our internal controls andprocedures, as they existed as of March 31, 2005. Based on the evaluationof the effectiveness of our disclosure controls and procedures as of March 31,2005, and subject to the information set forth in this Item 4, our principalexecutive officer and principal financial officer have concluded that ourdisclosure controls and procedures were not effective based on the matters 

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described in this Item 4.However, subsequent to March 31, 2005, and up to the filing date of thisreport, we implemented a detailed review and analysis of our accounting recordsin support of the financial statements contained herein utilizing consultantswith expertise in accounting under the direction of new financial management. Asinternal control issues have been identified, management has taken steps toremediate such matters. If additional internal control issues come to light,management intends to address them promptly.

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

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

The certifications of our principal executive officerand the principal financial officer required in accordance with Section 302of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Form 10-Q.The disclosures set forth in this Item 4 contain information concerning theevaluation of our disclosure controls and procedures, and changes in internalcontrol over financial reporting, referred to in paragraph 4 of thecertifications. This Item 4 should be read in conjunction with the officercertifications for a more complete understanding of the topics presented.

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**PART II.OTHER INFORMATION.**

**Item1. Legal Proceedings.**

Beginning in September 2004, three purportedclass action lawsuits were commenced against us and certain of our current andformer directors and officers by or on behalf of persons claiming to have purchasedor otherwise acquired our securities during the period from April 17, 2002to July 28, 2004.  These lawsuitswere filed in the United States District Court for the District of Oregon andwere consolidated into one action for all purposes on December 16, 2004. Thecomplaints assert claims under the federal securities laws, specificallySections 10(b) and 20(a) of the Securities Exchange Act of 1934,relating to our announcement that we had discovered errors in our accountingfor software development costs and project capitalization and other projectcost capitalization accounting practices at our DIDS business unit, and that welikely would be required to restate our previously reported financialstatements for full fiscal year 2003 and the first two quarters of 2004. Specifically,these actions allege that we issued false and misleading financial statementsin order to inflate the value of Digimarc stock, which resulted in insidersales of personal holdings at inflated values, and that we maintained insufficientaccounting controls, which created an environment where improper accountingcould be used to manipulate financial results. The complaints seek unspecifieddamages. We believe that we have substantial legal and factual defenses to theclaims, which we intend to pursue vigorously.  Due to the inherent uncertainties oflitigation and because the lawsuits are still at a preliminary stage, theultimate outcome of the matter cannot be predicted.

On or about October 19, 2004, two purportedshareholder derivative lawsuits were filed against certain of our officers anddirectors, naming the Company as a nominal defendant, in the Superior Court ofthe State of California for the County of San Luis Obispo. On or about April 6,2005, another purported shareholder derivative suit was filed against certainof the 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 these officers and directors breached theirfiduciary duties to our shareholders and to the Company. The complaints arederivative in nature and do not seek relief from the Company. On November 8,2004, a letter was mailed to the chairman of our board of directors by a lawfirm purporting to represent a shareholder of the Company, demanding that theboard commence a civil action against each of the directors and officers onbehalf of the Company to recover for damages alleged to have been incurred as aresult of alleged breaches of fiduciary duties.  The Company has appointed a committee toinvestigate 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 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 compensation arrangements(such as undisclosed commissions or stock stabilization practices) in theCompany’s initial public offering registration statement and by engaging inmanipulative practices to artificially inflate the price of the Company’s stockin the after-market subsequent to the Company’s initial public offering. TheCompany 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 

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claim. The motion todismiss claims under Section 11 was denied as to virtually all thedefendants in the consolidated actions, including the Company. The claimsagainst the Company under Section 10(b), however, were dismissed. In June 2003,a committee of the Company’s board of directors conditionally approved aproposed partial settlement with the plaintiffs in this matter. In June 2004,an agreement of settlement was submitted to the court for preliminary approval. The settlement would provide, among other things, a release of theCompany and of the individual defendants for the conduct alleged in the amendedcomplaint to be wrongful. The Company would agree to undertake otherresponsibilities under the partial settlement, including agreeing to assignaway, not assert, or release certain potential claims the Company may haveagainst its underwriters. Any direct financial impact of the proposedsettlement (other than defense costs incurred and expensed prior to May 31,2003) is expected to be borne by the Company’s insurers. The court granted thepreliminary approval motion on February 15, 2005, subject to certainmodifications. If the parties are able to agree upon the requiredmodifications, and such modifications are acceptable to the court, notice willbe given to all class members of the settlement, a “fairness” hearing will beheld and if the court determines that the settlement is fair to the classmembers, the settlement will be approved. There can be no assurance that thisproposed settlement would be approved and implemented in its current form, orat all. Due to the inherent uncertainties of litigation, the ultimate outcomeof the matter cannot be predicted.

The Company previously received a notice from thestaff of the SEC stating that it was conducting an informal inquiry relating tothe Company’s previous announcement that it was restating its prior financialresults. The SEC subsequently informed the Company that it has terminated itsinformal inquiry without recommending any enforcement action.

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.

**Item6. Exhibits.**

See attached exhibit index.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                         | DIGIMARC CORPORATION |
|-------------------------|----------------------|
| Date: May 16, 2005 | By:                  | /s/  MICHAEL MCCONNELL |
| * *                |                 | Michael McConnell |
| * *                |                 | *Chief  Financial Officer and Treasurer* |
| * *                |                 | *(Duly  Authorized Officer* |
| * *                |                 | *and  Principal Financial Officer)* |

 

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**EXHIBIT INDEX**
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                         | **Document** | ** ** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|------------|
| 3.1             |       | Second Amended and  Restated Certificate of Incorporation of the Registrant (incorporated by  reference to Exhibit 3.1 of Exhibits to the Registrant’s Quarterly  Report on Form 10-Q, as filed with the Securities and Exchange  Commission on November 14, 2000)                             |
| 3.2             |       | Certificate of Amendment  of Second Amended and Restated Certificate of Incorporation of the Registrant  (incorporated by reference to Exhibit 3.2 of Exhibits to the  Registrant’s Quarterly Report on Form 10-Q, as filed with the Securities  and Exchange Commission on November 14, 2000) |
| 3.3             |       | Amended and Restated  Bylaws of the Registrant, as amended (incorporated by reference to  Exhibit 3.3 of Exhibits to the Registrant’s Annual Report on  Form 10-K, as filed with the Securities and Exchange Commission on  March 15, 2004)                                                    |
| 31.1            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                       |
| 31.2            |       | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                       |
| 32.1            |       | Section 1350 Certification  of Chief Executive Officer                                                                                                                                                                                                                                                        |
| 32.2            |       | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                        |

 

 

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