---

---

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

---

FORM 10-Q

|(Mark One)                                                    |                                                                                         
|------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|ý                                                             | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|For the quarterly period ended SEPTEMBER 30, 2003            
|OR                                                           
|o                                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the transition period
from                             to

Commission File Number: 000-28317

---

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

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

---

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

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

As
of October 31, 2003, there were 20,020,341 shares of the registrant's common stock, par value $0.001 per share, outstanding.

---

---

---

Table of Contents

|PART I     | FINANCIAL INFORMATION                                                                                            |    |   
|---------- | ---------------------------------------------------------------------------------------------------------------- | -- | --
|Item 1.    | Financial Statements:                                                                                            |    |   
|           | Condensed Consolidated Balance Sheets as of September 30, 2003
and December 31, 2002.                            |    | 3 
|           | Condensed Consolidated Statements of Operations for the three and nine months
ended September 30, 2003 and 2002. |    | 4 
|           | Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2003 and 2002.           |    | 5 
|           | Notes to Condensed Consolidated Financial Statements.                                                            |    | 6 
|Item 2.    | Management's Discussion and Analysis of Financial Condition and Results of Operations.                           |    | 11
|Item 3.    | Quantitative and Qualitative Disclosures About Market Risk.                                                      |    | 32
|Item 4.    | Controls and Procedures.                                                                                         |    | 33
|PART II    | OTHER INFORMATION                                                                                                |    |   
|Item 2.    | Changes in Securities and Use of Proceeds.                                                                       |    | 33
|Item 6.    | Exhibits and Reports on Form 8-K.                                                                                |    | 33
|SIGNATURES |                                                                                                                  | 34

2

---



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

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

|                                     |                                               | September 30,
2003                         |        | December 31,
2002 (1) |        
|------------------------------------ | --------------------------------------------- | ------------------------------------------ | ------ | --------------------- | -------
|ASSETS                               |                                               |                                            |        |                       |        
|Current assets:                      |                                               |                                            |        |                       |        
|                                     | Cash and cash equivalents                     |                                            | $      | 58,944                |        
|                                     | Restricted cash                               |                                            |        | 5,009                 |        
|                                     | Short-term investments                        |                                            |        | 14,029                |        
|                                     | Trade accounts receivable, net                |                                            |        | 8,412                 |        
|                                     | Unbilled trade receivables                    |                                            |        | 4,695                 |        
|                                     | Inventory, net                                |                                            |        | 5,078                 |        
|                                     | Other current assets                          |                                            |        | 2,643                 |        
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total current assets                       |        |                       | 98,810 
|Property and equipment, net          |                                               |                                            | 34,513 |                       |        
|Intangibles, net                     |                                               |                                            | 24,400 |                       |        
|Other assets, net                    |                                               |                                            | 1,004  |                       |        
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total assets                               |        | $                     | 158,727
|                                     |                                               |                                            |        |                       |        
|LIABILITIES AND STOCKHOLDERS' EQUITY |                                               |                                            |        |                       |        
|Current liabilities:                 |                                               |                                            |        |                       |        
|                                     | Accounts payable                              |                                            | $      | 4,100                 |        
|                                     | Accrued payroll and related costs             |                                            |        | 2,138                 |        
|                                     | Deferred revenue                              |                                            |        | 3,084                 |        
|                                     | Other current liabilities                     |                                            |        | 31                    |        
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total current liabilities                  |        |                       | 9,353  
|Other long-term liabilities          |                                               |                                            |       |                       |        
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total liabilities                          |        |                       | 9,353  
|Stockholders' equity:                |                                               |                                            |        |                       |        
|                                     | Common stock                                  |                                            |        | 20                    |        
|                                     | Additional paid-in capital                    |                                            |        | 202,963               |        
|                                     | Deferred stock compensation                   |                                            |        | (113                  | )      
|                                     | Accumulated other comprehensive income (loss) |                                            |        | 79                    |        
|                                     | Warrant                                       |                                            |        | 881                   |        
|                                     | Accumulated deficit                           |                                            |        | (54,456               | )      
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total stockholders' equity                 |        |                       | 149,374
|                                     |                                               |                                            |        |                       |        
|                                     |                                               | Total liabilities and stockholders' equity |        | $                     | 158,727
|                                     |                                               |                                            |        |                       |        

---

(1)
Derived from the Company's December 31, 2002 audited consolidated financial statements

See
Notes to Condensed Consolidated Financial Statements.

3

---

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

|                                                |                                               | Three Months Ended
September 30, |        | Nine Months Ended
September 30, |       
|----------------------------------------------- | --------------------------------------------- | -------------------------------- | ------ | ------------------------------- | ------
|
|Revenue:                                        |                                               |                                  |        |                                 |       
|                                                | Product and subscription                      |                                  | $      | 2,829                           |       
|                                                | Service                                       |                                  |        | 19,471                          |       
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Total revenue                    |        |                                 | 22,300
|Cost of revenue:                                |                                               |                                  |        |                                 |       
|                                                | Product and subscription                      |                                  |        | 1,277                           |       
|                                                | Service                                       |                                  |        | 10,429                          |       
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Total cost of revenue            |        |                                 | 11,706
|Gross profit                                    |                                               |                                  | 10,594 |                                 |       
|Operating expenses:                             |                                               |                                  |        |                                 |       
|                                                | Sales and marketing                           |                                  |        | 2,748                           |       
|                                                | Research, development and engineering         |                                  |        | 1,253                           |       
|                                                | General and administrative                    |                                  |        | 5,404                           |       
|                                                | Restructuring charges, net                    |                                  |        |                                |       
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Total operating expenses         |        |                                 | 9,405 
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Operating income (loss)          |        |                                 | 1,189 
|Other income (expense):                         |                                               |                                  |        |                                 |       
|                                                | Interest income                               |                                  |        | 162                             |       
|                                                | Interest expense                              |                                  |        | (2                              | )     
|                                                | Other                                         |                                  |        | (14                             | )     
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Total other income, net          |        |                                 | 146   
|                                                |                                               |                                  |        |                                 |       
|Income (loss) before provision for income taxes |                                               |                                  | 1,335  |                                 |       
|Provision for income taxes                      |                                               |                                  | 51     |                                 |       
|                                                |                                               |                                  |        |                                 |       
|                                                |                                               | Net income (loss)                |        | $                               | 1,284 
|                                                |                                               |                                  |        |                                 |       
|Net income (loss) per share-basic               |                                               | $                                | 0.07   |                                 | $     
|Net income (loss) per share-diluted             |                                               | $                                | 0.07   |                                 | $     
|                                                | Weighted average shares outstanding  basic   |                                  |        | 18,752                          |       
|                                                | Weighted average shares outstanding  diluted |                                  |        | 19,727                          |       

See
Notes to Condensed Consolidated Financial Statements.

4

---

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

|                                                                                         |                                                         | Nine Months Ended
September 30,                     |                                          
|---------------------------------------------------------------------------------------- | ------------------------------------------------------- | --------------------------------------------------- | -----------------------------------------
|
|Cash flows from operating activities:                                                    |                                                         |                                                     |                                          
|                                                                                         | Net income (loss)                                       |                                                     | $                                        
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |                                                         |                                                     |                                          
|                                                                                         | Depreciation and amortization                           |                                                     |                                          
|                                                                                         | Stock-based compensation expense                        |                                                     |                                          
|                                                                                         | Other non-cash charges                                  |                                                     |                                          
|                                                                                         | Changes in operating assets and liabilities:            |                                                     |                                          
|                                                                                         |                                                         | Restricted cash                                     |                                          
|                                                                                         |                                                         | Trade and unbilled accounts receivable, net         |                                          
|                                                                                         |                                                         | Inventory, net                                      |                                          
|                                                                                         |                                                         | Other current assets                                |                                          
|                                                                                         |                                                         | Other assets, net                                   |                                          
|                                                                                         |                                                         | Accounts payable                                    |                                          
|                                                                                         |                                                         | Accrued payroll and related costs                   |                                          
|                                                                                         |                                                         | Deferred revenue                                    |                                          
|                                                                                         |                                                         | Other current liabilities                           |                                          
|                                                                                         |                                                         |                                                     |                                          
|                                                                                         |                                                         |                                                     | Net cash provided by operating activities
|Cash flows from investing activities:                                                    |                                                         |                                                     |                                          
|                                                                                         | Purchase of property and equipment                      |                                                     |                                          
|                                                                                         | Capitalization of software development costs            |                                                     |                                          
|                                                                                         | Long-term investments                                   |                                                     |                                          
|                                                                                         | Sale or maturity of short-term investments              |                                                     |                                          
|                                                                                         | Purchase of short-term investments                      |                                                     |                                          
|                                                                                         |                                                         |                                                     |                                          
|                                                                                         |                                                         | Net cash provided by (used in) investing activities |                                          
|Cash flows from financing activities:                                                    |                                                         |                                                     |                                          
|                                                                                         | Net proceeds from issuance of common stock and warrants |                                                     |                                          
|                                                                                         | Principal payments under capital lease obligations      |                                                     |                                          
|                                                                                         |                                                         |                                                     |                                          
|                                                                                         |                                                         | Net cash provided by financing activities           |                                          
|                                                                                         |                                                         |                                                     |                                          
|                                                                                         |                                                         | Net increase in cash and cash equivalents           |                                          
|                                                                                         |                                                         | Cash and cash equivalents at beginning of period    |                                          
|                                                                                         |                                                         |                                                     |                                          
|                                                                                         |                                                         | Cash and cash equivalents at end of period          |                                          
|                                                                                         |                                                         |                                                     |                                          
|Supplemental disclosure of cash flow information:                                        |                                                         |                                                     |                                          
|                                                                                         | Cash paid for interest                                  |                                                     | $                                        

See
Notes to Condensed Consolidated Financial Statements.

5

---



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

1. The Company, Basis of Presentation

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

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

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

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

These
condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2002 included in
the Company's 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003. The results of operations for the interim periods presented
in these condensed consolidated financial statements are not necessarily indicative of the results for the full year.

2. Income (Loss) Per Share Computation

Basic and diluted net income (loss) per share is computed using the weighted average number of shares of common stock outstanding for the period. Totals of 2,109
outstanding stock options and 4,420 outstanding stock options and warrants for the three and nine months ended September 30, 2003, respectively, are excluded from the calculation of diluted net
income per share because their exercise price is greater than the average market value of the stock during the period, and as such the inclusion of these stock options and warrants would be
antidilutive. Totals of 6,110 and 5,630 outstanding stock

6

---

options
and warrants for the three and nine months ended September 30, 2002, respectively, are excluded from the calculation of diluted net loss per share for the periods presented because the
Company was in a loss position during these periods and their inclusion would be antidilutive.

The
following table shows the reconciliation of the numerators and denominators for the basic and diluted earnings per share computations for net income for the three and nine months
ended September 30, 2003, respectively (in thousands, except per-share amounts):

Three Months Ended September 30, 2003Income
(Numerator)

Shares
(Denominator)

Per-Share
AmountBasic Earnings per ShareIncome available to common stockholders

$
1,284

18,752

$
0.07Effect of Dilutive SecuritiesOptions




961Warrants




14Diluted Earnings per ShareIncome available to common stockholders

$
1,284

19,727

$
0.07


Nine Months Ended September 30, 2003Income
(Numerator)

Shares
(Denominator)

Per-Share
AmountBasic Earnings per ShareIncome available to common stockholders

$
1,600

18,072

$
0.09Effect of Dilutive SecuritiesOptions




768Diluted Earnings per ShareIncome available to common stockholders

$
1,600

18,840

$
0.08


3. Sale of Common Stock and Warrants

The Company issued common stock and warrants to purchase common stock in a private placement transaction completed on August 25, 2003. The transaction
involved the sale of 1,785,996 units, each of which consisted of one share of common stock and a warrant to purchase 0.15 of a share of common stock, to sixteen institutional and accredited investors.
The purchase price of each unit was $14.00. The aggregate offering price of the units was approximately $25.0 million and net proceeds to the Company, excluding the proceeds of any exercise of the
warrants, was approximately $23.7 million. The exercise price for the warrants is $14.00 per share and the warrants may be exercised until 15 days after the effectiveness of the resale registration
statement for the common stock sold in the placement.

4. Stock Based Compensation

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

7

---

The
following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation for the three and nine months ended September 30, 2003 and 2002, respectively (in thousands, except per-share amounts):

|                                                                                                                                            |  | Three Months Ended
September 30, |        | Nine Months Ended
September 30, |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | ------------------------------- | -
|
|Net income (loss), as reported                                                                                                              |  | $                                | 1,284  |                                 | $
|Add: Stock based compensation expense determined under the intrinsic value method                                                           |  |                                  | 316    |                                 |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects |  |                                  | 4,697  |                                 |  
|                                                                                                                                            |  |                                  |        |                                 |  
|Pro forma net loss                                                                                                                          |  | $                                | (3,097 | )                               | $
|                                                                                                                                            |  |                                  |        |                                 |  
|Net income (loss) per share:                                                                                                                |  |                                  |        |                                 |  
|Basicas reported                                                                                                                           |  | $                                | 0.07   |                                 | $
|Dilutedas reported                                                                                                                         |  | $                                | 0.07   |                                 | $
|Basicpro forma                                                                                                                             |  | $                                | (0.17  | )                               | $
|Dilutedpro forma                                                                                                                           |  | $                                | (0.17  | )                               | $

Stock
based compensation expense is based on the difference between the fair market value of the Company's common stock and the exercise price of options to purchase that stock on the
measurement date, and is being recognized over the vesting period of the related options, usually four years. Stock-based compensation expense of $316 and $1,178 was recorded for the three and nine
months ended September 30, 2003, respectively, and $447 and $1,381 for the three and nine months ended September 30, 2002, respectively. Stock-based compensation expense is included in
the respective statements of operations expense categories for the employees to which it applies. At September 30, 2003, $113 of stock-based compensation remains deferred and we expect the
entire balance to be amortized to expense in 2003.

5. Segment Information

The Company derives its revenue from a single reporting segment, secure media solutions. There was no single customer in the three or nine months ended
September 30, 2003 or 2002 that accounted for more than 10% of total revenue.

6. Commitments and Contingencies

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the
United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's
initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint
alleges, among other things, that the underwriters of the Company's initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as
undisclosed commissions or stock stabilization practices) in the Company's initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of
the Company's stock in the after-market subsequent to the Company's initial public offering. Digimarc and certain of its officers and directors are named in the amended complaint pursuant to
Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5 of

8

---

the
Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters' alleged compensation arrangements and manipulative practices. The complaint seeks unspecified
damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a Court Order dated October 9, 2002, were dismissed from the litigation without
prejudice. Furthermore, in July 2002, Digimarc and the other issuers in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss
claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including Digimarc. The claims against Digimarc under Section 10(b), however, were
dismissed. In June 2003, a committee of the Company's board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide,
among other things, a release of Digimarc and of the individual defendants for the conduct alleged in the amended complaint to be wrongful. Digimarc would agree to undertake other responsibilities
under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Digimarc may have against its underwriters. Any direct financial impact of the proposed
settlement (other than defense costs incurred and expensed prior to May 31, 2003) is expected to be borne by Digimarc's insurers. The committee agreed to approve the settlement subject to a
number of conditions, including the participation of a substantial number of other issuer defendants in the proposed settlement, the consent of Digimarc's insurers to the settlement, and the
completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the litigation. Due to the inherent
uncertainties of litigation and because the settlement process is still at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

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

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

The
Company's product license and services agreements include a limited indemnification provision for claims from third parties relating to the Company's intellectual property. Such
indemnification provisions are accounted for in accordance with SFAS No. 5,Accounting for Contingencies. The indemnification is generally
limited to the amount paid by the customer. To date, claims under such indemnification provisions have not been significant.

7. Comprehensive Income (Loss)

The Company has adopted SFAS No. 130,Reporting Comprehensive Income, which establishes standards of
reporting and displaying comprehensive income (loss) and its components of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to revenues, expenses,
gains and losses that are not included in net income (loss) but rather are recorded directly in

9

---

stockholders'
equity. The following table provides a summary of comprehensive income (loss) for the three and nine months ended September 30, 2003 and 2002, respectively (in thousands):

|                                        |  | Three Months Ended
September 30, |       | Nine Months Ended
September 30, |  
|--------------------------------------- |  | -------------------------------- | ----- | ------------------------------- | -
|
|Net income (loss)                       |  | $                                | 1,284 |                                 | $
|Foreign currency translation adjustment |  |                                  | 15    |                                 |  
|                                        |  |                                  |       |                                 |  
|Comprehensive income (loss)             |  | $                                | 1,299 |                                 | $
|                                        |  |                                  |       |                                 |  

8. Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46,Consolidation of Variable Interest
Entities. This interpretation requires that an enterprise's consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest.
At September 30, 2003, the Company did not have any unconsolidated variable interest entities. Accordingly, the Company does not expect that the adoption of this interpretation will have a
material impact on the Company's consolidated financial position or results of operations.

In
May 2003, the Emerging Issues Task Force reached a consensus on Issue 01-8 ("EITF 01-8"),Determining Whether an Arrangement
Contains a Lease. Under the provisions of EITF 01-8, arrangements conveying the right to control the use of specific property, plant or equipment must be evaluated
to determine whether they contain a lease. The new rules are to be applied prospectively to such contracts entered into or modified after July 1, 2003. Accordingly, the impact of EITF
01-08 on the Company's future results of operations and financial position will depend on the terms contained in contracts signed after such date. The Company does not expect this
statement to have a material impact on its consolidated financial position or results of operations.

9. Revenue Recognition

Revenue from the Company's driver license issuance systems is generated from the production of cards. The Company recognizes revenue under these arrangements
based on the actual monthly production, if available, and in limited situations on estimated volume information. When actual production information becomes available, typically within one month, the
Company bills the customer accordingly, and any differences from the estimates are recognized in the month the billing occurs. Revenue earned which has not been invoiced is classified as unbilled
trade receivables in the consolidated balance sheets. Revenue related to an enhancement of or upgrade to an existing system is deferred and recognized over the remaining life of the contract.

Revenue
for sales of consumables and equipment not related to a driver license issuance system is recognized 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 other service arrangements is generally determined based on time and material or a cost plus a profit margin measures. Revenue for these arrangements is recognized as the
services are performed. The Company also has limited long-term, fixed-price service contracts under which revenue and profit are recognized as work progresses on a method that approximates
using an output measure to determine the percent complete. Progress towards completion is measured using costs incurred compared to the budgeted amounts contained in the contract. Losses on contracts,
if any, are provided for in the period in which the loss becomes determinable. Billing for services rendered generally occurs within one month following when the services are provided. Revenue earned
which has not been invoiced is classified as unbilled trade receivables in the consolidated balance sheets.

10

---

Royalty
revenue is recognized when the royalty amounts owed to the Company have been earned and are determinable, and collection is probable. Subscriptions are paid in advance, and
revenue is recognized ratably over the term of the subscription.

Deferred
revenue consists of payments received in advance for services and subscriptions for which revenue has not been earned.

The
Company also generates revenue from the licensing of digital watermarking products and services for use in authenticating documents, detecting fraudulent documents and deterring
unauthorized duplication or alteration of high-value documents, for use in communicating copyright, asset management and business-to-business image commerce
solutions, and for use in connecting analog media to a digital environment. Software revenue is recognized in accordance with the American Institute of Certified Public Accountants ("AICPA") Statement
of Position ("SOP") No. 97-2,Software Revenue Recognition,as amended by AICPA by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2,
 and SOP 98-9,Software Revenue Recognition,
with Respect to Certain Arrangements. Revenue for licenses of the Company's software products is recognized upon the Company's meeting the following criteria: persuasive
evidence of an arrangement exists; delivery has occurred; the vendor's fee is fixed or determinable; and collectibility is probable.

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

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

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

Overview

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

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

11

---

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

Critical Accounting Policies and Estimates

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

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



12

---



13

---



Results of Operations

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

Three Months Ended
September 30,

Nine Months Ended
September 30,2003

2002

2003

2002Revenue:Product and subscription

13
%
31
%
17
%
23
%Service

87

69

83

77Total revenue

100

100

100

100Cost of revenue:Product and subscription

6

24

9

15Service

47

41

45

46Total cost of revenue

53

65

54

61Gross profit

47

35

46

39Operating expenses:Sales and marketing

12

13

14

17Research, development and engineering

6

10

8

12General and administrative

24

17

22

23Restructuring charges, net







1Total operating expenses

42

40

44

53Operating income (loss)

5

(5
)
2

(14
)Other income (expense):Interest income

1

1

1

1Interest expense







Other







Total other income, net

1

1

1

1Income (loss) before provision for income taxes

6

(4
)
3

(13
)Provision for income taxes





1

Net income (loss)

6
%
(4
)%
2
%
(13
)%


14

---

Revenue

Total revenue was $22.3 million and $66.6 million for the three and nine months ended September 30, 2003, respectively, compared to total
revenue of $26.5 million and $65.8 million for the three and nine months ended September 30, 2002, respectively. The changes in total revenue between each of the comparable three
and nine month periods of 2003 and 2002 resulted from increased issuance revenues from U.S. state driver license programs, and decreased international sales and services.

In
non-U.S. markets, where we provide driver licenses, national identification, and voter identification systems, services, and components in partnership with local card
producers, security printers, system integrators, and others, we may serve as prime contractor or subcontractor, depending on the circumstances. As a subcontractor, we are responsible for delivering
hardware, software, or consumables to the prime contractor and, as a prime contractor, we are responsible for integrating the components of the system to the customer's specifications. In
non-U.S. markets for the three and nine months ended September 30, 2003, revenue from international customers was $2.9 million and $11.2 million, respectively, and was
$7.1 million and $13.5 million for the three and nine months ended September 30, 2002, respectively. International sales for us have typically taken the form of an outright sale
of equipment and/or consumables to non-U.S. government agencies or their prime contractors. These sales often can be large, one-time events. Due to the nature of the
international customers, the timing of these sales is somewhat less predictable than in the context of service revenues provided to us by domestic customers and, consequently, international sales can
occur unevenly during the course of a year. We believe that international growth opportunities exist for us and we expect to continue to invest in personnel and resources to support our potential
revenue growth outside of the United States.

Product and subscription.Product and subscription revenue consists primarily of stand alone sales of equipment or
consumables related to the production of secure media (such as driver licenses or voter identification cards). Product and subscription revenue was $2.8 million and $11.2 million for the
three and nine months ended September 30, 2003, respectively, compared to $8.0 million and $15.3 million for the three and nine months ended September 30, 2002,
respectively. The $5.2 million or 65% decrease and $4.1 million or 27% decrease for the three and nine months ended September 30, 2003, respectively, was primarily due to the
fluctuation in volume of international sales activity and not price fluctuations.

A
portion of our revenue each year is generated from the licensing of technology. In the competitive environment in which we operate, product generation, development and marketing
processes relating to technology are uncertain and complex, requiring accurate prediction of demand as well as successful management of various development risks inherent in technology development. In
light of these
dependencies, it is possible that failure to successfully manage future changes in technology with respect to our technology could have a long-term impact on our revenue.

Service.Service revenue consists primarily of revenue generated from the issuance of identification cards through our driver
license issuance systems and other consulting services. These arrangements are typically structured as price-per-card product agreements, time and materials consulting agreements, or fixed price
consulting agreements. Service revenue is an umbrella category consisting of both service revenue and contract-based service revenue. The distinction between these two subcategories is that service
revenue is generated from long-term identification and driver license production contracts, while contract-based service revenue is generated from other long-term,
time-and-materials service contracts.

Service
revenue was $19.5 million and $55.4 million for the three and nine months ended September 30, 2003, respectively, compared to $18.4 million and
$50.6 million for the three and nine months ended September 30, 2002, respectively. The $1.1 million or 6% increase and $4.8 million or 9% increase for the three and nine
months ended September 30, 2003, respectively, as compared to the

15

---

corresponding
three and nine month periods of 2002 was primarily the result of increased revenue from driver license production contracts. This revenue increased primarily due to an increase in the
average price-per-card charged to the various driver license issuing authorities.

Cost of Revenue

Product and subscription.Cost of product and subscription revenue primarily includes compensation for operations personnel,
costs of consumables sold to third parties, costs of machinery sold to third parties, Internet service provider connectivity charges and image search data fees to support the services offered to our
subscription customers. Cost of product and subscription revenue was $1.3 million and $6.2 million for the three and nine months ended September 30, 2003, respectively, compared
to $6.4 million and $10.0 million for the three and nine months ended September 30, 2002, respectively. The $5.1 million or 80% decrease and $3.8 million or 38%
decrease for the three and nine months ended September 30, 2003, respectively, was a result of the fluctuation in the volume of international sales activity and domestic equipment sales
activity.

Service.Cost of service revenue primarily includes compensation for software developers, quality assurance personnel,
product managers, field operations personnel, and business development personnel, outside contractors, costs of consumables used in delivering a service, depreciation charges for machinery used
specifically for service delivery, and travel costs directly attributable to service and
development contracts. Cost of service revenue was $10.4 million and $29.7 million for the three and nine months ended September 30, 2003, respectively, compared to
$10.9 million and $30.0 million for the three and nine months ended September 30, 2002, respectively. The $0.4 million or 4% decrease and $0.2 million or 1% decrease
for the three and nine months ended September 30, 2003, respectively, as compared to the corresponding three and nine month periods of 2002 was primarily the result of incremental costs
associated with maintaining service levels to a broader number of customers, offset by our continued focus on cost controls. Field operations employees totaled 150 and 163 at September 30, 2003
and 2002, respectively.

Operating Expenses

Sales and marketing.Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and
marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research, and costs associated with marketing programs, such as trade shows, public relations and new
product launches. Sales and marketing expenses were $2.7 million and $9.1 million for the three and nine months ended September 30, 2003, respectively, compared to
$3.4 million and $11.2 million for the three and nine months ended September 30, 2002, respectively. The overall decrease generally came from lower headcount and tighter controls
on spending. The $0.6 million or 19% decrease for the three months ended September 30, 2003 as compared to the same period ended September 30, 2002 resulted primarily from
decreased salaries and other employee related costs of approximately $0.5 million, decreased administrative costs of approximately $0.2 million related to sales and marketing activities,
and decreased marketing and advertising costs of approximately $0.1 million, partially offset by increased use of outside consulting services of $0.1 million and $0.1 million in
decreased use of sales and marketing personnel to provide services for our revenue generating contracts that would have been included in cost of service revenue. The $2.1 million or 18%
decrease for the nine months ended September 30, 2003 as compared to the same period ended September 30, 2002 resulted primarily from decreased administrative costs of approximately
$0.7 million related to sales and marketing activities, decreased salaries and other employee related costs of approximately $0.7 million, decreased use of outside consulting services of
$0.3 million, decreased marketing and advertising costs of approximately $0.2 million, and $0.1 million in decreased deferred stock compensation charges related to sales and
marketing personnel. Sales and marketing employees totaled 52 and 63 as of September 30, 2003 and 2002, respectively. Although

16

---

overall
sales and marketing expenses have decreased in recent periods, we anticipate that we will invest significantly in sales and marketing in the foreseeable future.

Research, development and engineering.Research, development and engineering expenses consist primarily of compensation,
benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $1.3 million and
$5.5 million for the three and nine months ended September 30, 2003, respectively, compared to $2.7 million and $8.3 million for the three and nine months ended
September 30, 2002,
respectively. The overall decrease generally came from lower headcount and tighter controls on spending. The $1.5 million or 54% decrease for the three months ended September 30, 2003 as
compared to the same period ended September 30, 2002 resulted primarily from decreased costs related to outside consultants of approximately $1.0 million, decreased salaries and other
employee related costs of approximately $0.7 million, and decreased administrative costs related to research, development and engineering activities of approximately $0.2 million,
partially offset by $0.5 million related to decreased use of research, development and engineering personnel to provide services for our revenue generating contracts and to develop
internal-use software. The $2.8 million or 34% decrease for the nine months ended September 30, 2003 as compared to the same period ended September 30, 2002 resulted
from decreased costs related to outside consultants of approximately $3.6 million due to increased efficiency of internal employees and less need for the specialized skills that outside
consultants provide, decreased salaries and other employee related costs of approximately $0.8 million, and decreased administrative costs related to research, development and engineering
activities of $0.4 million, partially offset by $1.9 million related to decreased use of research, development and engineering personnel to provide services for our revenue generating
contracts and to develop internal-use software. Research, development and engineering personnel totaled 112 and 150 as of September 30, 2003 and 2002, respectively. Although overall
research, development and engineering expenses have decreased in recent periods, we anticipate that we will invest significantly in product research, development and engineering in the foreseeable
future.

General and administrative.General and administrative expenses consist primarily of compensation, benefits and related costs
of executive, finance and administrative personnel, facilities costs, legal and other professional fees, and depreciation and amortization expense. General and administrative expenses were
$5.4 million and $14.6 million for the three and nine months ended September 30, 2003, respectively, compared to $4.3 million and $15.1 million for the three and
nine months ended September 30, 2002, respectively. The $1.1 million or 25% increase for the three months ended September 30, 2003 as compared to the same period ended
September 30, 2002 resulted from increased salaries and other employee related costs of approximately $0.5 million, increased costs related to the use of outside consultants, including
legal services, of $0.3 million, increased administrative costs of $0.2 million, which includes depreciation, amortization, and bad debt expense. The $0.5 million or 3% decrease
for the nine months ended September 30, 2003 as compared to the same period ended September 30, 2002 resulted from decreased costs of $0.7 million related to outside consultants,
including legal services, and decreased administrative costs of $0.4 million, which includes depreciation, amortization, and bad debt expense, partially offset by increased costs of
$0.5 million related to salaries and other employee related costs. General and administrative employees totaled 53 and 47 as of September 30, 2003 and 2002, respectively. Although
general and administrative expenses have fluctuated in recent periods, we anticipate that we will invest in general and administrative costs in the foreseeable future.

Stock based compensation.Stock-based compensation expense includes costs relating to stock-based employee compensation
arrangements. Stock-based compensation expense is based on the difference between the fair market value of our common stock and the exercise price of options to purchase that stock on the measurement
date, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $0.3 million and $1.2 million

17

---

was
recorded for the three and nine months ended September 30, 2003, respectively, compared to $0.4 million and $1.4 million for the three and nine months ended
September 30, 2002, respectively. Stock-based compensation is included in the respective statements of operations expense categories for the employees to which it applies. At
September 30, 2003, $0.1 million of stock-based compensation remains deferred and we expect the entire amount to be recognized as expense in 2003.

Total other income, net.Total other income, net consists primarily of interest received and paid. Total other income, net
was $0.1 million and $0.4 million for the three and nine months ended September 30, 2003, respectively, compared to $0.2 million and $0.9 million for the three and
nine months ended September 30, 2002, respectively. The $0.1 million or 39% decrease and $0.4 million or 51% decrease for the three and nine months ended September 30,
2003, respectively, as compared to the same periods ended September 30, 2002 resulted primarily from lower average cash balances and interest rates during 2003.

Provision for Income Taxes.We provided less than $0.1 million and $0.2 million for income taxes for the three
and nine months ended September 30, 2003, respectively, compared to no provision for income taxes for the three and nine months ended September 30, 2002, respectively. We have available
net operating loss carryforwards and, as such, have provided no provision for U.S. income taxes. The provision relates to taxes we believe we will pay in non-U.S. countries due to our
profitable foreign operations.

Liquidity and Capital Resources

As of September 30, 2003, we had cash and cash equivalents, restricted cash, and short-term investments of $78.0 million, representing
an increase of $24.8 million from $53.2 million at December 31, 2002. As of September 30, 2003, $5.0 million of cash and cash equivalents is restricted as a result
of the requirements of performance bonds that we are obligated to maintain in connection with some of our long-term contracts in our personal identification systems business. Working
capital at September 30, 2003 was $89.5 million, compared to working capital of $63.3 million at December 31, 2002.

The
$20.0 million of cash provided by operations for the nine months ended September 30, 2003 was positively impacted by net income of $1.6 million for the period, a
decrease in restricted cash of $10.7 million, depreciation and amortization of $7.7 million, a decrease in trade and unbilled accounts
receivable, net of $2.0 million, stock-based compensation expense of $1.2 million, an increase in accrued payroll and related costs of $0.8 million, and a decrease in other
current assets of $0.5 million. Cash provided by operations for the nine months ended September 30, 2003 was negatively impacted by a decrease in accounts payable of $3.9 million
and a decrease in deferred revenue of $0.6 million. The $4.6 million of cash provided by operations in the nine months ended September 30, 2002 was positively impacted by
depreciation and amortization of $6.7 million, an increase in deferred revenue of $2.5 million, an increase in accounts payable of $2.0 million, stock-based compensation expense
of $1.4 million, a decrease in inventory, net of $0.7 million, and an increase of accrued payroll and related costs of $0.6 million. Cash provided by operations for the nine
months ended September 30, 2002 was negatively impacted by a net loss of $8.5 million and an increase in trade and unbilled accounts receivable, net of $0.6 million.

The
$18.6 million of cash used in investing activities for the nine months ended September 30, 2003 was related primarily to the purchase of property and equipment of
$6.5 million, $5.2 million of capitalized software development costs, and $6.9 million net purchases of short-term investments. The $11.0 million of cash
provided by investing activities for the nine months ended September 30, 2002 related primarily to net sales or maturities of $25.4 million of short-term investments,
partially offset by the addition of property and equipment of $8.2 million and $5.8 million of capitalized software development costs.

18

---

The
$27.2 million of cash provided by financing activities for the nine months ended September 30, 2003 primarily related to the issuance of common stock and warrants to
purchase common stock in our private placement transaction completed on August 25, 2003. The transaction involved the sale of 1,785,996 units, each of which consisted of one share of common
stock and a warrant to purchase 0.15 of a share of common stock, to sixteen institutional and accredited investors, including Goldman, Sachs & Co. The purchase price of each unit was $14.00.
The aggregate offering price of the units was approximately $25.0 million and net proceeds to us, excluding the proceeds of any exercise of the warrants, was approximately $23.7 million.
The exercise price for the warrants is $14.00 per share and the warrants may be exercised until 15 days after the effectiveness of our resale registration statement for the common stock sold in
the placement. As part of this private placement transaction, we agreed to prepare and file with the Securities and Exchange Commission, and to use our commercially reasonable efforts to cause the
Securities and Exchange Commission to declare effective, a registration statement for the resale of the common stock acquired by these investors as well as any shares of common stock issuable pursuant
to the exercise of their warrants. We have 120 calendar days after the closing date of the transaction to cause the Securities and Exchange Commission to declare the registration statement effective.
If the registration statement is not declared effective within the allotted time period, we shall be subject to a penalty payment per month until effective equal to 1.5% of the aggregate proceeds paid
by the investors to us, not to exceed 12% of the aggregate purchase price paid by the investors in the transaction. Once the registration statement is declared effective, we have agreed to use our
reasonable commercial efforts to keep it effective until the earliest of (i) two years after the expiration of the warrants received by the investors, (ii) such time as the shares of
common stock included in the registration statement have become eligible for resale by non-affiliates pursuant to Rule 144(k) under the Securities Act of 1933, as amended, or
(iii) such time as all shares of common stock purchased by the investors in the private placement transaction and included in the registration statement have been sold to the public.

The
remainder of the cash provided by financing activities for the nine months ended September 30, 2003 related to the issuance of common stock for $3.5 million related to
our stock incentive plans.

The
$1.1 million of cash provided by financing activities for the nine months ended September 30, 2002 primarily related to the issuance of stock for $1.6 million
related to our stock incentive plans partially offset by $0.5 million of principal payments under capital leases.

Our
significant commitments consist of obligations under non-cancelable operating leases, which totaled $6.8 million as of September 30, 2003, and are payable
in monthly installments through October 2010.

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

We
believe that our current cash, cash equivalents, and short-term investment balances will satisfy our projected working capital and capital expenditure requirements for at
least the next 12 months. Thereafter, we anticipate continuing to use cash, cash equivalents, and short-term investment balances to satisfy our projected working capital and capital
expenditure requirements. However, because of our concern that currently weak economic conditions may continue through 2003, if not longer, we have taken and continue to take steps to limit our
expenses and align our cost structure to our revenues. These steps include, among other things, considering and/or taking steps, as needed, to restructure our business, consolidating our operations,
negotiating volume pricing with vendors, centralizing certain services, and standardizing products. We recognize that our operating expense levels, including research, development, engineering,
selling, marketing, general and administrative expenses, depend on anticipated business activity levels. While research, development, engineering and marketing expenses

19

---

are
based on anticipated investment levels in technology development, product development and market development activities, the appropriate expense levels in selling, general and administrative
expenses are dependant on the level of infrastructure required to support our anticipated business volume. We review our business plans periodically to determine the appropriate level of such expenses
based on various business factors. In the past we have taken appropriate measures to control our expenses based on business circumstances. In the future we will continue to review our business plans
from time to time and make appropriate changes to our expense levels, as we have in the past, to reduce operating expenses where it is advantageous to do so to improve operational efficiencies.

In
order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities, although we do not believe at this time
that our long-term working capital and capital expenditures will be of such a nature that we would be required to take steps presently to remedy any such potential deficiency. If it were
necessary to obtain additional financings or credit facilities, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46,Consolidation of Variable Interest
Entities. This interpretation requires that an enterprise's consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest.
At September 30, 2003, we did not have any unconsolidated variable interest entities. Accordingly, we do not expect that the adoption of this interpretation will have a material impact on our
consolidated financial position or results of operations.

In
May 2003, the Emerging Issues Task Force reached a consensus on Issue 01-8 ("EITF 01-8"),Determining Whether an Arrangement
Contains a Lease. Under the provisions of EITF 01-8, arrangements conveying the right to control the use of specific property, plant or equipment must be evaluated
to determine whether they contain a lease. The new rules are to be applied prospectively to such contracts entered into or modified after July 1, 2003. Accordingly, the impact of EITF
01-08 on our future results of operations and financial position will depend on the terms contained in contracts signed after such date. We do not expect this statement to have a material
impact on our consolidated financial position or results of operations.

Risks Related to Our Business

The market for digital watermark applications is new and developing, resulting in less predictable and fluctuating revenue from quarter to quarter

Digital watermarking is a new and developing technology. Our success depends on the acceptance of this technology and the adoption of applications in areas such
as digital media commerce, counterfeiting and piracy deterrence, self-authentication of documents, and security and intelligence applications. The market for products and services using
digital watermarks is evolving and is characterized by an increasing number of market entrants who have introduced or developed products and services using digital watermarking or alternative
technologies. As is typical in a new and evolving industry, demand and market acceptance of recently introduced products and services are subject to a high level of uncertainty. Our products and
services relating to digital watermarking are currently used by only a limited number of customers. We are actively working, independently and with others, to expand the market for using digital
watermarking technology, such as in the monitoring and tracking of usage of programming content broadcast by television networks and stations and in the security features of driver licenses. While we
believe a trend may have begun in the use of digital watermarking security features in digital driver licenses during our second fiscal quarter of 2003, as a growing number of states, such as
Nebraska, Michigan, Vermont, New Jersey and Kansas, have begun to adopt digital

20

---

watermarking
security features in their digital driver licenses, and while we believe that such a trend, if it continues, may have a materially favorable impact on our revenues, it is difficult to
predict the future growth rate, if any, and ultimate size of this market opportunity or other new application opportunities. We cannot assure you that new applications and customers for our
technologies, products and services will develop or that our existing market will grow.

The majority of our revenues is subject to government procurement processes that are subject to unpredictable delays or unexpected changes which might limit our actual revenues
in any given quarter

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

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

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

The loss of any large contract may result in loss of revenues and potential acceleration of amortization expense or impairment of intangible assets

Contracts between government agencies and our wholly-owned subsidiary, Digimarc ID Systems, LLC, and/or its affiliates (collectively known as DIDS) have varying
duration, averaging four to five years in length, after which the government agency can re-open the contract for competitive bidding. If we were to lose a contract, in addition to the loss
of revenue and margin on a prospective basis, we

21

---

could
also incur accelerated amortization expense or impairment of intangible assets related to the customer.

We have a history of losses, and we cannot assure you that we will maintain profitability, particularly if we were to lose large contracts

We have incurred significant net losses since inception. Our accumulated deficit as of September 30, 2003 was approximately $54.5 million. In order
to maintain profitability, we will need to generate higher revenue than we have in prior years while controlling expenditures related to those higher revenues. Even though we achieved profitability
during the first three quarters of 2003, we may not be able to sustain or increase our profitability. In particular, if we lose large contracts, our revenue would grow more slowly than we anticipate,
and if our operating expenses at the same time exceed our expectations, we may not be able to sustain profitability.

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

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

We are subject to risks encountered by companies developing and relying upon new technologies, products and services for substantial amounts of their growth or revenues

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



Some
of our key technologies are still in the development stage. Consequently, products incorporating these key technologies are undergoing technological change and are in the early
stage of introduction in the marketplace. Delays in the adoption of these products or adverse competitive developments may result in delays in the development of new revenue sources or the growth in
our revenues. In addition, we may be required to incur unanticipated capital expenditures in the event product changes or improvements are required. Additionally, new industry standards might redefine
the products that we are able to sell, especially if these products are only in the prototype stage of development. If product changes or improvements are required, success in marketing these products

22

---

and
achieving profitability from these products could be delayed or halted. We also may be required to fund such changes or improvements out of operating income, which could reduce or eliminate our
profitability.

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

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

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

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

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



23

---



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

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

Our success depends in part on licensing our proprietary technologies. To protect our growing patent and related intellectual property investments, we rely on a
combination of patent, copyright, trademark and trade secret rights, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. However, unlicensed copying
and use of our intellectual property or illegal infringements of our intellectual property rights represent losses of revenue to our company.

We
face risks associated with our patent position, including the potential and sometimes actual need to engage in significant legal proceedings to enforce our patents, the possibility
that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our patents and the possibility that our
products may infringe patent rights of third parties. Budgetary concerns may cause us not to file, or continue, litigation against known infringers of our patent rights. Failure to reliably enforce
our patent rights against infringers may make licensing more difficult. If we fail to protect our intellectual property rights and proprietary technologies adequately, if there are changes in
applicable laws that are adverse to our interests, or if we become involved in litigation relating to our intellectual property rights and proprietary technologies or relating to the intellectual
property rights of others, our business could be seriously harmed because the value ascribed to our intellectual property could diminish and result in a lower stock price.

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

24

---



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

Some
of our contracts include provisions assuring non-infringement of third-party intellectual property rights. If an infringement arose in a context governed by such a
contract, our exposure could be large and our business could be materially harmed because we may incur significant litigation, settlement, or judgment expenses.

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

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

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

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

Many
of our products and services involve the embedding of digital code in media content that is imperceptible in normal use but that can be read by digital devices. The success of these
products and services depends on the security of our media commerce, anti-counterfeiting and piracy systems, self-authentication solutions, and supporting infrastructure.
Security breaches of these systems and solutions could damage our reputation and expose us to a risk of loss or litigation and possible liability. The security measures that we use may not prevent
security breaches, and failure to prevent these

25

---

security
breaches may disrupt our business. A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions or otherwise damage our
products, services and reputation and the property of our customers. If unintended parties obtain sensitive data and information, or create bugs or viruses in an attempt to sabotage the functionality
of our products and services, we may receive negative publicity, incur liability to our customers or lose the confidence of our customers, any of which may cause the termination or modification of our
contracts.

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

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

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

During
2002, DIDS engaged in activities in approximately five jurisdictions to either finish projects begun prior to our acquisition from Polaroid Corporation and its affiliates of the
U.S. large government programs identification systems and international digital identification systems operations or to correct legacy defects from installations prior to our acquisition that were
identified during or since the acquisition process as needing remedial action. However, there may be additional issues or defects that we have not yet identified that may require significant efforts
and resources to correct and that would cause us to divert resources away from other purposes.

If our new operating structure is not effective, or if we are required to restructure our business to address new growth rates, we may encounter higher expenses and reduced
margins

As
of September 30, 2003, we had 367 employees and 80 contract workers. To effectively manage our operations, management must continue to improve our operational and financial
systems and train, improve and manage our employee base. As part of our goal to continue to improve operating efficiencies, we re-organized our operations into a portfolio of
peer-level operating units under a

26

---

corporate
umbrella, consisting of two units, the first of which is Watermarking Solutions and the second of which is ID Systems, both of which are overseen by a small corporate staff. While our
management anticipates that this new operating structure will facilitate effective management of the continuing growth and expansion of our business, we cannot assure you that the new operating
structure will be effective or achieve the desired results. Additionally, less than optimal rates of growth of our product lines and areas of business may require us to restructure our business from
time to time, which, in turn, could significantly strain our managerial and financial resources. If we cannot manage our growth effectively, we may not be able to coordinate the activities of our
technical, legal, accounting and marketing staffs and, as a result, we may experience higher expenses and reduced margins.

If there is a sustained downturn in purchases or adoption of new technologies we may not achieve our future revenue objectives

Our growth plans assume, in part, that our watermarking technologies will gain broader market acceptance and be purchased by a growing number of customers. If
there is a sustained downturn in purchases or adoption of digital watermarking-based solutions or new technologies, we may be unable to realize anticipated future revenue.

We may acquire other businesses or technologies and, if we do, we may be unable to integrate them with our own business, or we may cause a negative effect on our financial
results from doing so and we may never achieve any of the benefits that we might anticipate from such acquisitions

One
part of our strategy is to pursue acquisitions of other businesses and technologies. The pursuit of such acquisitions involves certain risks. We may not be able to identify,
negotiate or finance any future acquisition successfully. We may incur additional or one-time charges related to the pursuit of acquisitions or restructurings or other matters in
connection with acquisitions. Other than the acquisition of the U.S. large government programs identification systems and international digital identification systems operations from Polaroid
Corporation and its affiliates, we have limited experience in integrating an acquired business into our existing business. The process of integration may produce operating difficulties and
expenditures and may require significant attention of our management that otherwise would be available for the ongoing development of our business. In the end, we may be unsuccessful in integrating an
acquired business or technology with our existing
business. Moreover, if we make acquisitions, we may issue shares of our stock that would dilute the equity holdings of our existing stockholders, incur debt, assume contingent liabilities or create
additional expenses related to amortizing intangible and other acquired assets. Any of these might negatively affect our financial results and cause our stock price to decline. Our due diligence of
acquired companies may fail to reveal material risks or liabilities. Additionally, in order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt
financing, or credit facilities, and we may not be successful in doing so on satisfactory terms. Any financing that we might need for future acquisitions may also place restrictions on our business.
Furthermore, we may never achieve any of the benefits that we might anticipate from a future acquisition.

We depend on key employees for our future success due to the high level of technical expertise that our industry requires and the loss of any of them could harm our business by
delaying projects or undermining customer relationships

Our
success depends to a significant extent on the performance and continued service of our senior management. Almost all of our senior management do not have employment agreements.
Although our employees generally have executed agreements containing non-competition clauses, there is no assurance that a court would enforce all of the terms of these clauses or the
clauses generally. If

27

---

these
clauses were not fully enforced, our employees would be freely able to join our competitors. The loss of the services of any of our senior management or any of our other key employees could harm
our business by delaying projects or undermining customer relationships.

If we are not able to retain, hire or integrate qualified personnel, we may not be able to deliver the products and services that our customers require

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

If the promotion of the Digimarc brand is unsuccessful, we will not attract new users and other strategic partners and we may be unable to increase our future revenue

We believe that establishing and maintaining our brand is important to our success and that the importance of brand recognition will increase due to the growing
number of technologies that compete with our watermarking technologies and the increasing number of competitors offering technologies similar to ours. If our brand-building strategy is unsuccessful,
the effort spent and expenses incurred may never be recovered, we will not attract new users and other strategic partners and we may be unable to increase our future revenue.

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

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

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



These
provisions could have the effect of discouraging a third party from making a tender offer or otherwise attempting to gain control of us, even though the transactions could be
profitable for our

28

---

stockholders.
In addition, these provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

There are many risks associated with our international operations which may limit future revenue growth

We expect revenues from sales of products and services to governments and other customers outside the United States to represent a growing percentage of our total
revenues in the future. International sales and services are subject to a number of risks, including the following:



If
our customers are affected by currency devaluations or general economic downturns or persistent economic difficulties, their ability to purchase our products and subscriptions and
services could be reduced significantly. Payment cycles for international customers typically are longer than those for customers in the United States. Foreign customers may decide to terminate or
delay the implementation of our products and services. Any action like this by foreign customers, in particular foreign government authorities, could potentially delay or reduce our anticipated
revenues under our contracts with such customers, and we may have limited recourse against them to recover any potential losses.

While
we generally invoice our foreign sales in U.S. dollars, we may elect in the future to take payment in other foreign currencies and, if we do, we may be exposed to losses as a
result of foreign currency fluctuations. We currently do not engage in foreign currency hedging transactions. We may in the future choose to limit our exposure by the purchase of forward foreign
exchange contracts or through similar hedging strategies. No currency hedging strategy can fully protect against exchange-related losses. In addition, if the relative value of the U.S. dollar in
comparison to the currency of our foreign customers should increase, the resulting effective price increase of our products and services to those foreign customers could result in decreased sales. For
the first nine months of 2003, international customers accounted for approximately 17% of overall revenues, and are expected to be a material driver of our growth. However, if any of the risks
described above occur, our future revenue growth and profitability could be limited.

Risks Related to Our Market

If we are unable to respond to regulatory or industry standards effectively, or if we are unable to develop and integrate new technologies effectively, our growth and the
development of our digital watermarking products and services could be delayed

Our future success will depend in part on our ability to enhance and improve the responsiveness, functionality and features of our products and services in
accordance with regulatory or industry standards. Our ability to remain competitive will depend in part on our ability to influence and respond to emerging industry and statutory standards, including
any standards that may be adopted for the protection of audio, video, and image content, and for other uses of metadata with such content, in a

29

---

timely
and cost-effective manner. If we are unable to influence these or other standards or respond to such standards effectively, our growth and the development of our digital watermarking products
and services could be delayed and we would be adversely affected. For example, we participate in an initiative known as the "VWM group," comprised of Macrovision Corporation, Koninklijke Philips
Electronics N.V., Sony Electronics, Hitachi, NEC, and Pioneer, that is proposing a solution to help motion picture studios to protect their copyrights and enable new business models. The proposed copy
prevention and play control solution would protect video programming on videocassettes, DVDs, or cable or satellite transmissions from unauthorized copying to recordable DVDs, DVHS and multimedia
personal computers. However, while our group already has submitted to the DVD Copy Control Association, or DVDCCA, a proposed technical standard, the DVDCCA to date has delayed its selection of a
standard because the relevant decision-makers (including representatives of the motion picture, information technology, and consumer electronic industries) have so-far been unable to reach consensus.
Even if a selection is made, the standard proposed by our group may not be adopted. If it is adopted, under the current DVDCCA process our video watermarking patents would be licensed to three classes
of licensees: (a) content producers; (b) providers of play-back and recording systems; and (c) semiconductor producers. Each license would be limited to the field(s) of use needed by the
respective licensee (e.g., the content producers would need a license to embedbut not normally detecta video watermark). However, licensing would still not commence until the
VWM group secures Department of Justice approval for the contemplated licensing arrangements, which may never occur or which may only occur after significant modifications to the contemplated
licensing arrangements, which may not be in our best interests or which may limit our ability to secure profits that we otherwise would expect to receive from such licensing arrangements.
Additionally, given that the process is continuing to evolve, the VWM group or the DVDCCA could change or discontinue, thus frustrating our ability to market and license the proposed solution.

Our
market is characterized by new and evolving technologies. The success of our business will depend on our ability to develop and integrate new technologies effectively and address the
increasingly sophisticated technological needs of our customers in a timely and cost-effective manner. Our ability to remain competitive will depend in part on our ability to:



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

If leading companies in our industry or standard-setting bodies or institutions downplay, minimize, or reject the use of watermarking, the deployment of digital watermarking
may be slowed and our revenue growth may be diminished

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

30

---

overcoming
and may make achieving our business objectives difficult or impossible, harming our business by potentially diminishing our anticipated revenue growth as a result.

The market for secure media solutions is highly competitive, and as a result, alternative technologies or larger companies may undermine, limit or eliminate the market or our
digital watermarking technologies, which would decrease our revenue and profits

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



In
addition, as we more broadly apply our technologies to the Internet through new commercial solutions applications, we may begin to compete with a wide range of other types of
companies beyond those companies using digital watermarking technologies and alternative technologies. Moreover, many of the companies that currently compete with us, as well as other companies with
whom we may compete in the future, are larger and national or international in scope and may have greater technical, financial, marketing, and political resources than we do. These resources could
enable these companies to initiate severe price cuts or take other measures in an effort to gain market share or otherwise

31

---

impede
our progress. We cannot assure you that digital watermarking technologies, and our products and services using these technologies, will gain widespread market acceptance.

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

Terrorist attacks and threats or actual war may negatively impact all aspects of our operations, revenues, costs and stock price

Threats of terrorist attacks in the United States, as well as future events occurring in response to or in connection with them, including, without limitation,
future terrorist attacks or threats against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies, or military or trade disruptions, may impact
our operations. While any of these events could result in an increased need for new security features that may, as a result, favorably impact our revenues from our DIDS operations and our sales of
product and subscription and service in connection with our digital watermarking technology, any of these events could also, or alternatively, result in increased volatility in the United States and
worldwide financial markets and economies, negatively impacting our business in other ways, such as by driving up research, development and engineering costs associated with attempting to achieve
heightened effectiveness in new products. Also, any of these terrorist-related events could result in economic recession in the United States or abroad. If such negative consequences were to occur,
they could have a significant impact on our operating results, revenues and costs and might result in the volatility of the future market price of our common stock.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

Because this quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform
Act of 1995, any of the risk factors set forth above or elsewhere in this report could cause our actual results to differ materially from those results projected or suggested in such forward-looking
statements. Statements that are not historical facts are hereby identified as "forward-looking statements" for the purpose of the safe harbor provided by Section 21E of the Securities Exchange
Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. We usually use words such as "may," "will," "should," "expect," "plan," "anticipate," "believe," "estimate,"
"predict," "future," "intend," or "certain" or the negative of these terms or similar expressions to identify forward-looking statements. All forward-looking statements are necessarily only estimates
of future results and there can be no assurance that actual results will not differ materially from expectations, and, therefore, investors are cautioned not to place undue reliance on such
statements. Investors should understand that it is not possible to predict or identify all risk factors and that the risks discussed above should not be considered a complete statement of all
potential risks and uncertainties. We undertake no obligation to update any forward-looking statements as a result of future events or developments.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The Company's market risk disclosures set forth in Item 7A of its Annual Report on Form 10-K for the year ended December 31, 2002 have
not changed materially. In addition, if market interest rates

32

---

were
to increase immediately and uniformly by 10% from levels as of December 31, 2002, the decline of the fair market value of our fixed income portfolio and loans outstanding would not be
material.

Item 4. Controls and Procedures.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. There has been no change in our
internal control over financial reporting that occurred during our most recent fiscal quarter ended September 30, 2003 that has materially affected or is reasonably likely to materially affect
our internal control over financial reporting.

PART II. OTHER INFORMATION.

Item 2. Changes in Securities and Use of Proceeds.

On August 25, 2003, Digimarc completed the sale of 1,785,996 units, each of which consisted of one share of common stock and a warrant to purchase 0.15 of
a share of common stock, to sixteen institutional and accredited investors, including Goldman, Sachs & Co., in a private placement transaction exempt from the registration requirements of the
Securities Act of 1933, as amended, pursuant to Section 4(2) thereof and Rule 506 of Regulation D thereunder. The purchase price of each unit was $14.00. The aggregate offering
price of the units was approximately $25.0 million and net
proceeds to Digimarc, excluding the proceeds of any exercise of the warrants, was approximately $23.7 million. The exercise price for the warrants is $14.00 per share and the warrants may be
exercised until 15 days after the effectiveness of Digimarc's resale registration statement for the common stock sold in the placement.

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





33

---



SIGNATURES

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

|                        |  | DIGIMARC CORPORATION
|----------------------- |  | --------------------
|                        |  |                     
|Date: November 14, 2003 |  | By:                 

34

---

EXHIBIT INDEX

|Exhibit
Number |  | Document                                                                                                                                                                                                                                                                                                        
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1            |  | Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Securities and Exchange
Commission on November 14, 2000)                                                      
|3.2            |  | Certificate of Amendment of Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 of Exhibits to Registrant's Quarterly Report on Form 10-Q, as filed with the Securities and Exchange
Commission on November 14, 2000)                          
|3.3            |  | Amended and Restated Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 of Exhibits to Registrant's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 31, 2003)                                                                             
|4.1            |  | Form of Warrant (incorporated by reference to Exhibit 4.1 of Exhibits to Registrant's Current Report on Form 8-K, as filed with the Securities and Exchange Commission on August 27, 2003)                                                                                                                      
|10.1           |  | Purchase Agreement by and between the Registrant and each of the purchasers whose names are set forth on the signature pages thereof (incorporated by reference to Exhibit 10.1 of Exhibits to Registrant's Current Report on Form 8-K, as filed with the
Securities and Exchange Commission on August 27, 2003)
|31.1           |  | Section 302 Certification of Chief Executive Officer of the Registrant                                                                                                                                                                                                                                          
|31.2           |  | Section 302 Certification of Chief Financial Officer of the Registrant                                                                                                                                                                                                                                          
|32.1           |  | Section 906 Certification of Chief Executive Officer of the Registrant                                                                                                                                                                                                                                          
|32.2           |  | Section 906 Certification of Chief Financial Officer of the Registrant                                                                                                                                                                                                                                          

35

---

QuickLinks