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

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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 MARCH 31, 2004                
|OR                                                           
|o                                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the transition period
from                             to

Commission File Number: 000-28317

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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)                  

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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 April 30, 2004, there were 20,250,462 shares of the registrant's common stock, par value $0.001 per share, outstanding.



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Table of Contents

|PART I FINANCIAL INFORMATION |                                                                                                     |   
|---------------------------- | --------------------------------------------------------------------------------------------------- | --
|Item 1.                      | Financial Statements:                                                                               |   
|                             | Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003.                   |   
|                             | Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003. |   
|                             | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003. |   
|                             | Notes to Condensed Consolidated Financial Statements.                                               |   
|Item 2.                      | Management's Discussion and Analysis of Financial Condition and Results of Operations.              |   
|Item 3.                      | Quantitative and Qualitative Disclosures About Market Risk.                                         |   
|Item 4.                      | Controls and Procedures.                                                                            |   
|PART II OTHER INFORMATION    |                                                                                                     |   
|Item 2.                      | Changes in Securities and Use of Proceeds.                                                          |   
|Item 5.                      | Other Information.                                                                                  |   
|Item 6.                      | Exhibits and Reports on Form 8-K.                                                                   |   
|SIGNATURES                   |                                                                                                     | 35

2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

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

|                                     |                                        | March 31,
2004                             |        | December 31,
2003 (1) |        
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | --------------------- | -------
|ASSETS                               |                                        |                                            |        |                       |        
|Current assets:                      |                                        |                                            |        |                       |        
|                                     | Cash and cash equivalents              |                                            | $      | 51,099                |        
|                                     | Restricted cash                        |                                            |        | 1,980                 |        
|                                     | Short-term investments                 |                                            |        | 21,055                |        
|                                     | Trade accounts receivable, net         |                                            |        | 13,474                |        
|                                     | Unbilled trade receivables             |                                            |        | 3,120                 |        
|                                     | Inventory                              |                                            |        | 6,090                 |        
|                                     | Other current assets                   |                                            |        | 2,571                 |        
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total current assets                       |        |                       | 99,389 
|Property and equipment, net          |                                        |                                            | 45,294 |                       |        
|Intangibles, net                     |                                        |                                            | 23,076 |                       |        
|Other assets, net                    |                                        |                                            | 828    |                       |        
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total assets                               |        | $                     | 168,587
|                                     |                                        |                                            |        |                       |        
|LIABILITIES AND STOCKHOLDERS' EQUITY |                                        |                                            |        |                       |        
|Current liabilities:                 |                                        |                                            |        |                       |        
|                                     | Accounts payable                       |                                            | $      | 10,941                |        
|                                     | Accrued payroll and related costs      |                                            |        | 1,710                 |        
|                                     | Deferred revenue                       |                                            |        | 2,754                 |        
|                                     | Other current liabilities              |                                            |        | 210                   |        
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total current liabilities                  |        |                       | 15,615 
|Other long-term liabilities          |                                        |                                            | 1,317  |                       |        
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total liabilities                          |        |                       | 16,932 
|Stockholders' equity:                |                                        |                                            |        |                       |        
|                                     | Common stock                           |                                            |        | 20                    |        
|                                     | Additional paid-in capital             |                                            |        | 205,624               |        
|                                     | Accumulated other comprehensive income |                                            |        | 12                    |        
|                                     | Warrant                                |                                            |        |                      |        
|                                     | Accumulated deficit                    |                                            |        | (54,001               | )      
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total stockholders' equity                 |        |                       | 151,655
|                                     |                                        |                                            |        |                       |        
|                                     |                                        | Total liabilities and stockholders' equity |        | $                     | 168,587
|                                     |                                        |                                            |        |                       |        

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(1)
Derived from the Company's December 31, 2003 audited consolidated financial statements

See
Notes to Condensed Consolidated Financial Statements.

3

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

|                                         |                                             | Three Months Ended
March 31, |      
|---------------------------------------- | ------------------------------------------- | ---------------------------- | -----
|
|Revenue:                                 |                                             |                              |      
|                                         | Service                                     |                              | $    
|                                         | Product and subscription                    |                              |      
|                                         |                                             |                              |      
|                                         |                                             | Total revenue                |      
|Cost of revenue:                         |                                             |                              |      
|                                         | Service                                     |                              |      
|                                         | Product and subscription                    |                              |      
|                                         |                                             |                              |      
|                                         |                                             | Total cost of revenue        |      
|Gross profit                             |                                             |                              | 9,776
|Operating expenses:                      |                                             |                              |      
|                                         | Sales and marketing                         |                              |      
|                                         | Research, development and engineering       |                              |      
|                                         | General and administrative                  |                              |      
|                                         |                                             |                              |      
|                                         |                                             | Total operating expenses     |      
|                                         |                                             |                              |      
|                                         |                                             | Operating income (loss)      |      
|Other income (expense):                  |                                             |                              |      
|                                         | Interest income                             |                              |      
|                                         | Interest expense                            |                              |      
|                                         | Other                                       |                              |      
|                                         |                                             |                              |      
|                                         |                                             | Total other income, net      |      
|                                         |                                             |                              |      
|Income before provision for income taxes |                                             |                              | 575  
|Provision for income taxes               |                                             |                              | (50  
|                                         |                                             |                              |      
|                                         |                                             | Net income                   |      
|                                         |                                             |                              |      
|Net income per sharebasic               |                                             | $                            | 0.03 
|Net income per sharediluted             |                                             | $                            | 0.03 
|                                         | Weighted average shares outstandingbasic   |                              |      
|                                         | Weighted average shares outstandingdiluted |                              |      

See
Notes to Condensed Consolidated Financial Statements.

4

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

|                                                                                  |                                                                 | Three Months Ended
March 31,                         |                                          
|--------------------------------------------------------------------------------- | --------------------------------------------------------------- | ---------------------------------------------------- | -----------------------------------------
|
|Cash flows from operating activities:                                             |                                                                 |                                                      |                                          
|                                                                                  | Net income                                                      |                                                      | $                                        
|Adjustments to reconcile net income 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 and long-term liabilities              |                                          
|                                                                                  |                                                                 |                                                      |                                          
|                                                                                  |                                                                 |                                                      | Net cash provided by operating activities
|Cash flows from investing activities:                                             |                                                                 |                                                      |                                          
|                                                                                  | Purchase of property and equipment                              |                                                      |                                          
|                                                                                  | Capitalization of software development costs                    |                                                      |                                          
|                                                                                  | Sale or maturity of short-term investments                      |                                                      |                                          
|                                                                                  | Purchase of short-term investments                              |                                                      |                                          
|                                                                                  |                                                                 |                                                      |                                          
|                                                                                  |                                                                 | Net cash used in investing activities                |                                          
|Cash flows from financing activities:                                             |                                                                 |                                                      |                                          
|                                                                                  | Net proceeds from issuance of common stock                      |                                                      |                                          
|                                                                                  | Principal payments under capital lease obligations              |                                                      |                                          
|                                                                                  |                                                                 |                                                      |                                          
|                                                                                  |                                                                 | Net cash provided by financing activities            |                                          
|                                                                                  |                                                                 |                                                      |                                          
|                                                                                  |                                                                 | Net increase (decrease) 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                                          |                                                      | $                                        
|Summary of non-cash investing and financing activities:                           |                                                                 |                                                      |                                          
|                                                                                  | Equipment acquired or exchanged under capital lease obligations |                                                      | $                                        

See
Notes to Condensed Consolidated Financial Statements.

5

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

1. The Company, Basis of Presentation

Digimarc Corporation ("Digimarc," the "Company," "we," "us," or "our") is one of the leading suppliers of secure personal identification systems, providing more
than 60 million personal identification documents and driver licenses per year. The Company supplies the issuance systems for the majority of driver licenses produced in the United States
("U.S.") and provide all or part of the issuance systems for national identifications, voter identifications, and driver licenses in more than twenty international programs.

The
Company also is one of the leading providers of patented digital watermarking technologies that allow imperceptible digital codes to be embedded in all forms of media content,
including personal identification documents, financial instruments, photographs, movies, music 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.

In
December, 2001, the Company, through its wholly-owned subsidiary, Digimarc ID Systems, LLC, and certain of that subsidiary's wholly-owned subsidiaries (collectively "DIDS")
acquired the assets and assumed certain liabilities of the U.S. large government programs identification systems and international digital identification systems businesses of Polaroid Corporation and
certain other affiliated entities of Polaroid Corporation. 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, 2003 included in
the Company's 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2004. 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. Net Income Per Share Computation

Net income per share (or earnings per share) is calculated in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings per
Share, which provides that basic and diluted net income per share for all periods presented are to be computed using the weighted average

6

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number
of common shares outstanding during each period, with diluted net income per share including the effect of potentially dilutive common shares.

Three Months Ended March 31, 2004Income (000's)
(Numerator)

Shares (000's)
(Denominator)

Per-Share
AmountBasic Earnings per ShareIncome available to common stockholders

$
525

20,212

$
0.03Effect of Dilutive SecuritiesCommon stock equivalents




403Diluted Earnings per ShareIncome available to common stockholders

$
525

20,615

$
0.03


Three Months Ended March 31, 2003Income (000's)
(Numerator)

Shares (000's)
(Denominator)

Per-Share
AmountBasic Earnings per ShareIncome available to common stockholders

$
29

17,662

$
0.00Effect of Dilutive SecuritiesCommon stock equivalents




686Diluted Earnings per ShareIncome available to common stockholders

$
29

18,348

$
0.00


Common
stock equivalents related to stock options and warrants of 5,375 and 5,437 were excluded from diluted net income per share calculations for the three months ended March 31,
2004 and 2003, respectively, as their exercise price was higher than the average market price of the underlying common stock for the period and therefore their impact would be antidilutive.

3. Sale of Common Stock

On January 7, 2004, five holders of warrants to purchase shares of common stock exercised their warrants for an aggregate of 74,506 shares of common stock,
which resulted in approximately $1.0 million of gross proceeds to the Company. The warrants were issued as a result of the Company's issuance of 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 exercise price for the warrants was $14.00 per share and
the warrants were exercisable for 15 days after the effectiveness of the resale registration statement for the common stock sold in the private placement, which effective date was
December 23, 2003. No other warrants issued by the Company as part of the August 2003 private placement transaction were exercised prior to their termination as of 6:30 p.m. New
York City time on January 7, 2004.

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,and
related interpretations including Financial Accounting Standards Board ("FASB") Interpretation No. 44,Accounting for Certain Transactions involving Stock Compensation,
an

7

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Interpretation of APB Opinion No. 25, as allowed by FASB statement No. 123,Accounting for Stock-Based
Compensation. FASB statement No. 123 and FASB statement No. 148,Accounting for Stock-Based CompensationTransition and
Disclosure, an amendment of FASB Statement No. 123, established accounting and disclosure requirements using a fair-value-based method of accounting for
stock-based employee compensation plans. Under APB Opinion No. 25, stock-based compensation expense is recognized for stock awards granted with an exercise price below fair market value on the
date of grant.

The
following table illustrates the effect on net income and net income per share (or earnings per share) if the Company had applied the fair value recognition provisions of SFAS
No. 123 to stock-based employee compensation for the three months ended March 31, 2004 and 2003, respectively (in thousands, except per-share amounts):

Three Months Ended
March 31,2004

2003Net income, as reported

$
525

$
29Add: Stock-based compensation expense determined under the intrinsic value method





444Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards


2,771


5,389Pro forma net loss

$
(2,246
)
$
(4,916
)Earnings per share:Basicas reported

$
0.03

$
0.00Dilutedas reported

$
0.03

$
0.00Basicpro forma

$
(0.11
)
$
(0.28
)Dilutedpro forma

$
(0.11
)
$
(0.28
)


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. No stock-based compensation expense was recorded for the three months ended
March 31, 2004 while $444,000 of stock-based compensation expense was recorded for the three months ended March 31, 2003. Stock-based compensation expense is included in the respective
statements of operations expense categories for the employees to which it applies.

5. Segment Information

The Company derives its revenue from a single reporting segment, secure media solutions. There was one customer in the three months ended March 31, 2004
that accounted for approximately 15% of total revenue, while no single customer accounted for more than 10% of total revenue for the three months ended March 31, 2003.

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 the
Company'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

8

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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 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 defendants 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.

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.

Digimarc
is subject from time to time 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.

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 stockholders' equity. Comprehensive income is defined as changes in stockholders' equity exclusive of
transactions with owners. To date, only foreign currency translation adjustments are required to be

9

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reported
in comprehensive income. The following table provides a summary of comprehensive income (loss) for the three months ended March 31, 2004 and 2003, respectively (in thousands):

Three Months Ended
March 31,2004

2003Net income

$
525

$
29Foreign currency translation adjustment


(84
)

40Comprehensive income

$
441

$
69


8. Recent Accounting Pronouncements

In December 2003, the FASB issued Interpretation No. 46 (revised December 2003) ("FIN 46R"), Consolidation of
Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than
voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46,Consolidation of Variable Interest
Entities, which was issued in January 2003. The Company is required to apply FIN 46R to variable interests in variable interest entities ("VIEs") created after
December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN 46R will be applied beginning on January 1, 2005. For any VIEs that must be
consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities, and non-controlling interests of the VIEs initially would be measured at their
carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If
determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and non-controlling interest of the
VIEs. Digimarc does not currently have any variable interests in VIEs, and, as a result, the adoption of FIN 46R has not had an impact on us.

9. Revenue Recognition

Revenue from the Company's long-term identification and driver's license issuance systems is generated from the production of cards. The Company
recognizes revenue on these contracts based on the actual monthly production, if available and in limited situations of 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 condensed 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's license production contract 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 professional services arrangements is generally determined based on time and material or a cost plus a profit margin measures. Revenue for professional services 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

10

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which
has not been invoiced is classified as unbilled trade receivables in the condensed consolidated balance sheets.

Royalty
revenue is recognized when the royalty amounts owed to the Company have been earned, 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 professional 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 Accountant ("AICPA") Statement
of Position ("SOP") No. 97-2,Software Revenue Recognition, as amended by AICPA SOP No. 98-9, Modification of SOP 97-2,With Respect to Certain Transactions. Revenue for licenses of the
Company's software products is recognized upon the Company 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 be recognized using the "residual method" in circumstances when vendor specific objective evidence exists only for 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 15, 2004. 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 believe we are one of the leading suppliers of secure personal identification systems, providing more than 60 million personal identification documents
and driver licenses per year. We supply the issuance systems for the majority of driver licenses produced in the United States ("U.S.") and provide all or part of the issuance systems for national
identifications, voter identifications, and driver licenses in more than twenty international programs. We estimate that our next-closest competitor with regard to driver license issuance
systems held contracts with approximately 15 driver license issuing authorities in the United States as of December 31, 2003. We are developing and marketing enhanced security for personal
identification documents enabled by our proprietary digital watermarking technology.

11

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We also believe we are one of the leading providers of patented digital watermarking technologies that allow imperceptible digital codes to be embedded in all forms of media content,
including personal identification documents, financial instruments, photographs, movies, music, 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 provide solutions based on this technology directly and through our licensees. We believe we have the
broadest intellectual property patent portfolio and commercial deployment of watermarking-based applications amongst entities of which we are aware, including use of such intellectual property by more
than four thousand enterprises and individuals.

The
majority of our revenue comes from multi-year contracts with government agencies, including U.S. state departments of motor vehicles and central banks. We intend to
increase 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 revenue and royalties for these new applications 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 our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including 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 condensed consolidated financial statements:



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Results of Operations

During the three months ended March 31, 2004, we delivered on a film based international program that resulted in $3.5 million in revenue. We also
invested in capital equipment and software development for two new programs, based in Florida and Mexico, which caused our working capital to decrease for the period. These new programs are expected
to begin producing revenue in the second half of the year.

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

Three Months Ended
March 31,2004

2003Revenue:Service

73
%
78
%Product and subscription

27
%
22
%Total revenue

100
%
100
%Cost of revenue:Service

39
%
43
%Product and subscription

19
%
12
%Total cost of revenue

58
%
55
%Gross profit

42
%
45
%Operating expenses:Sales and marketing

11
%
14
%Research, development and engineering

6
%
10
%General and administrative

24
%
21
%Total operating expenses

41
%
45
%Operating income (loss)

1
%
0
%Other income (expense):Interest income

1
%
0
%Interest expense

0
%
0
%Other

0
%
0
%Total other income, net

1
%
0
%Income before provision for income taxes

2
%
0
%Provision for income taxes

0
%
0
%Net income

2
%
0
%


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Revenue

Total revenue was $23.5 million for the three months ended March 31, 2004 compared to total revenue of $21.7 million for the three months
ended March 31, 2003. The changes in total revenue between the comparable three month periods of 2004 and 2003 resulted primarily from a change in our product and subscription revenue for the
period. In particular, we experienced a one-time delivery of a large international film-based system to one customer that resulted in approximately
$3.5 million of total revenue, or fifteen percent of total revenue, in the three month period for 2004. In addition, we experienced an increase in revenue in our watermarking area from our
banknote counterfeit deterrence project.

Overall
trends in revenue are positive. The average price-per-card on which we recognize revenue appears to be moving upward. The upward trend comes as a result
of providing additional security features to active programs, which typically result in a higher price-per-card fee charged. A second factor is winning additional business from
new and existing customers, as newer identification programs tend to be more technically advanced and tend to include the latest security features, and as a result typically have higher
price-per-card fees to meet these requirements. Based on projected driver license production volumes for the periods under contract with our respective driver license issuing
authority customers, we anticipate our current contracts as of March 31, 2004 to generate approximately $250 million in revenue during the life of such contracts. Two recent additions to
our programs, in Florida and Mexico, are expected to significantly contribute to our revenue growth in the second half of 2004, although a delay in completing the Florida program or lower than
anticipated volumes in the Mexican program could have a significant adverse effect on our anticipated revenues for the period.

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 sub-contractor, depending on the circumstances. As a sub-contractor, 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, revenue from international customers was $6.0 million and $4.5 million for the three months ended March 31, 2004 and 2003,
respectively. International sales during the quarter ended March 31, 2004 represented approximately 26% of our total revenue for the quarter. 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. Generally,
these sales have relatively low margins and may cause noticeable spikes in quarterly revenue trends. We enter into such contracts from time to time to maintain market presence and customer and partner
relationships, as such programs often transition to more profitable digital technologies over time. 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.

Service.Service revenue consists primarily of card production on a price-per-card basis and software
development 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.

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Service
revenue was $17.2 million and $17.0 million for the three months ended March 31, 2004 and 2003, respectively. The $0.2 million or 1% increase for the
three months ended March 31, 2004 as compared to the corresponding three month period of 2003 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 payment from the various driver license issuing authorities. The higher prices continued to come as
a result of several factors, including security upgrades for existing programs and new programs starting that are generally higher in price due to the features requested and level of security
included.

Product and subscription.Product and subscription revenue consists primarily of the sale of equipment and consumables
related to identification card production systems, software license sales, and subscriptions related to the ImageBridge product. Product and subscription revenue was $6.3 million and
$4.7 million for the three months ended March 31, 2004 and 2003, respectively. The $1.6 million or 35% increase for the three months ended March 31, 2004 as compared to the
corresponding three month period of 2003 was due to the one-time delivery of a large, international film-based system to one customer.

Cost of Revenue

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 $9.3 million and $9.4 million for the three
months ended March 31, 2004 and 2003, respectively. The $0.1 million or 1% decrease for the three months ended March 31, 2004 as compared to the corresponding three month period
of 2003 was primarily the
result of relatively stable variable costs associated with service revenue, combined with a focus on continuing to streamline operations and manage spending within the fixed cost structure that
supports such revenue. Field operations employees totaled 151 and 142 at March 31, 2004 and 2003, respectively.

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 $4.4 million and $2.5 million for the three months ended March 31, 2004 and 2003, respectively. The
$1.9 million or 75% increase for the three months ended March 31, 2004 as compared to the corresponding three month period of 2003 was the result of increased material costs in
connection with the one-time delivery of the large international film based system to one customer during the three months ended March 31, 2004 noted above. This large delivery had
particularly low margins.

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 $2.5 million and $3.1 million for the three months ended March 31, 2004 and 2003, respectively. The overall decrease generally
resulted from managing costs effectively within the group, in particular by lowering headcount and tightening controls on spending. The $0.6 million or 17% decrease for the three months ended
March 31, 2004 as compared to the corresponding three month period of 2003 resulted primarily from decreased salaries and other employee related costs of approximately $0.2 million and
approximately $0.3 million in increased use of sales and marketing personnel to provide services for our revenue

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generating
contracts. Sales and marketing employees totaled 54 and 61 as of March 31, 2004 and 2003, respectively. Although overall sales and marketing expenses have decreased, we have recently
added resources to the marketing area of our watermarking business and have added experienced sales resources to help expand opportunities in identified markets in our DIDS business. We also
anticipate that we will continue to invest at or slightly above the current run rate in sales and marketing for 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 $2.2 million for the three months ended March 31, 2004 and 2003, respectively. The overall decrease generally came from lower headcount and tighter controls on
spending. The $0.9 million or 40% decrease for the three months ended March 31, 2004 as compared to the corresponding three month period of 2003 resulted primarily from approximately
$1.2 million in increased use of research, development, and engineering personnel to provide services for our revenue generating contracts, decreased salaries and other employee related costs
of approximately $0.5 million as a result of lower headcount, and decreased administrative costs related to research, development, and engineering activities of $0.2 million, partially
offset by the increased consulting expenses of $1.0 million. Research, development and engineering personnel totaled 118 and 124 as of March 31, 2004 and 2003, respectively. Although
overall research, development and engineering expenses have decreased, the number of research, development and engineering personnel has increased from 111 to 118 during the three months ended
March 31, 2004 as a result of increased engineering needs as a result of new program installations. We anticipate that we will continue to invest at the current run rate in product research,
development and engineering for 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
$5.6 million and $4.6 million for the three months ended March 31, 2004 and 2003, respectively. The $1.0 million or 22% increase for the three months ended March 31,
2004 as compared to the corresponding three month period of 2003 resulted from increased salaries and other employee related costs of $0.5 million, increased consulting and professional fees of
$0.7 million, and increased administrative costs of $0.4 million, which includes amortization and depreciation, partially offset by $0.6 million in increased use of general and
administrative employees to provide direct services for our revenue generating contracts and to other functional groups within the company. General and administrative employees totaled 59 and 50 as of
March 31, 2004 and 2003, respectively. We have accelerated investments to strengthen our finance and information technologies organizations. We have also incurred, and will continue to incur,
expenditures with respect to the continued implementation of the requirements of the Sarbanes-Oxley Act of 2002, in particular, with respect to Section 404 requiring management to report on,
and the independent auditors to attest to, internal controls. We anticipate that we will continue to invest at or slightly above the current run rate in general and administrative costs for 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 date of
grant, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $0.4 million was recorded for the three months ended
March 31, 2003, with no expense recorded during the comparable period in 2004. Stock-based compensation is included in the respective statements of operations expense categories for the
employees to which it applies.

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Total other income, net.Total other income, net consists primarily of interest received and paid. Total other income, net
was $0.2 million and $0.1 million for the three months ended March 31, 2004 and 2003, respectively. The $0.1 million or 72% increase for the three months ended
March 31, 2004 as compared to the corresponding three month period of 2003 resulted primarily from higher average cash balances and interest rates during 2004.

Provision for Income Taxes.We provided less than $0.1 million for income taxes for the three months ended
March 31, 2004 and 2003, respectively. We have available net operating loss carryforwards and, as such, have included no provision for U.S. federal and state income tax reporting purposes. The
provision for income taxes 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 March 31, 2004, we had cash and cash equivalents, restricted cash, and short-term investments of $74.1 million, representing a
decrease of approximately $4.5 million from $78.6 million at December 31, 2003. The decrease primarily resulted from investments in significant new program implementations, in
particular in Florida and Mexico. As of March 31, 2004, $2.0 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 March 31, 2004 was $83.8 million, compared
to working capital of $89.1 million at December 31, 2003. The decrease in working capital resulted primarily from investments made in the new Florida and Mexico programs that will begin
to produce revenue in the second half of the year.

The
$4.1 million of cash provided by operations for the three months ended March 31, 2004 resulted from net income of $0.5 million, which includes non cash items
related to depreciation and amortization of $2.8 million, along with an increase in accounts payable of $4.3 million and an increase in accrued payroll and related costs of
$0.7 million. Cash provided by operations was negatively impacted by an increase in trade and unbilled accounts receivable, net of $3.1 million. The $0.1 million of cash provided
by operations for the three months ended March 31, 2003 resulted from $29,000 of net income for the quarter, which included non cash items related to depreciation and amortization of
$2.3 million, and a decrease in other current assets of $0.7 million. Cash provided by operations for the three months ended March 31, 2003 was negatively impacted by a decrease
in accounts payable of $2.3 million.

The
$2.5 million of cash used in investing activities primarily related to $5.7 million for the purchase of property and equipment, and $3.9 million related to the
capitalization of software development costs, partially offset by $7.2 million in net sale or maturity of short-term investments. We also acquired approximately $0.1 million
of fixed assets during 2004 through capital lease arrangements. The $1.7 million of cash used in investing activities for the three months ended March 31, 2003 was primarily related to
the purchase of property and equipment of $1.9 million and $1.8 million of capitalized software development costs, partially offset by the sale or maturity of $2.0 million in
short-term investments.

The
$1.0 million of cash provided by financing activities resulted primarily from the sale of common stock. On January 7, 2004, five holders of warrants to purchase shares
of common stock exercised their warrants for an aggregate of 74,506 shares of common stock, which resulted in approximately $1.0 million of gross proceeds to us. The $0.1 million of cash
provided by financing activities for the three months ended March 31, 2003 was primarily the result of the issuance of stock for $0.1 million related to our stock incentive plans.

Our
significant commitments consist of obligations under non-cancelable operating leases, which totaled $10.9 million as of March 31, 2004, and are payable in
monthly installments through

18

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August 2011.
Our obligations under non-cancelable capital leases, which totaled $1.7 million as of March 31, 2004, are payable in monthly installments through 2007.

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, although we expect that investments in new programs during the fiscal year ending December 31, 2004 will exceed cash from operations for the next several
quarters. Thereafter, we anticipate continuing to use cash, cash equivalents, and short-term investment balances to satisfy our projected working capital and capital expenditure
requirements.

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.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, as such term is defined in recently enacted rules by the Securities and Exchange Commission, that
have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures
or capital resources that are material to investors.

Recent Accounting Pronouncements

In December 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 (revised December 2003) ("FIN 46R"), Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling financial interest
in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46,Consolidation of Variable
Interest Entities, which was issued in January 2003. We will be required to apply FIN 46R to variable interests in variable interest entities ("VIEs") created after
December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN 46R will be applied beginning on January 1, 2005. For any VIEs that must be consolidated
under FIN 46R that were created before January 1, 2004, the assets, liabilities, and non-controlling interests of the VIEs initially would be measured at their carrying amounts with
any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying
amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and non-controlling interest of the VIEs. We do not currently have
any variable interests in VIEs, and, as a result, the adoption of FIN 46R has not had an impact on us.

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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 and adoption by approximately 20% of the U.S. states indicates alignment with customer needs, we have yet to garner
broad adoption of reader applications, and while we believe that adoption could increase our revenue, 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 revenue is subject to government procurement processes that are subject to unpredictable delays or unexpected changes which might limit our actual revenue
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 continued budget pressures, 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, and might limit our actual revenue in any given quarter, resulting in reduced and less predictable revenue and
lower profitability.

Because some of our revenue models relating 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, audio, video and
imagery, 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 revenue 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

20

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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 revenue 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 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 incurred significant net losses from inception through the fiscal year ended December 31, 2002. Our accumulated deficit as of March 31, 2004 was
$54.0 million. In order to maintain profitability, we will need to generate higher revenue than we have in prior years while controlling expenditures related to the higher revenue. Even though
we achieved profitability during 2003 and in the first quarter of 2004, 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, we would not be able to bring our technologies to market and, consequently, we would not generate revenue as anticipated. In addition, if our
technologies do not perform according to market expectations, our future sales would suffer as customers sought other providers and, consequently, revenue would decrease.

We
are not materially dependent on any third party to produce systems or assemblies for us. However, our business relies, in part, on deployment of our watermark reader technology by
third parties. For example, one form of our watermark reader is commonly deployed in image editing applications (offered by vendors including Adobe and JASC) to permit users of these products to read
watermarks embedded in imagery, and thereby discern the identities of image owners. Another form of our watermark reader is used in our anti-counterfeiting product offerings. If the third
parties who include such technology in their products declined to do so, then we would lose a portion of our currently anticipated revenue, although such amounts are not currently foreseen to be
significant, but may be in the future.

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

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 revenue. 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
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 revenue 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.

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

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:



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 decrease our stock price.

We may not be able to adequately protect our intellectual property, and we may be subject to infringement claims and other litigation, 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 from time to time to engage in significant legal proceedings to enforce our patents,
the possibility

23

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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.

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 by which we assure non-infringement of third-party intellectual property rights. If an infringement arose in a context governed by
such a contract, we may have to refund to our customer amounts already paid to us or we may be sued by the party allegedly infringed upon and our exposure could be large and we may incur significant
litigation, settlement, or judgment expenses. Similarly, as we seek to broaden the number of companies licensed under our patent portfolio, some may seek contractual assurances that we will
pursueby litigation if necessarytheir competitors who use Digimarc's patented technology but are not licensed to do so. Compliance with any such contract provisions may
require that we pursue litigation where our costs exceed our likely damages award.

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", "MEDIABRIDGE", "PICTUREMARC" and the "D" logo, among other marks, 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

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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. As deployment of our technology increases, and more
companies enter the digital watermarking category, the likelihood of a third party lawsuit resulting from such indemnification increases. 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 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. 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.

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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, the expense associated with defending such actions or paying the resultant claims could be significant
and decrease our profits.

As
watermarking technology is more broadly deployed by our licensees, our potential exposure to litigation may increase through their success. For example, if we license large companies,
in industries such as the consumer electronics, information technology, or motion picture businesses, and the deployed technology is found to be flawed or subject to abuse (as is a possibility with
any technology), we may be the target of class action or other litigationeither alone or in conjunction with our licensee(s).

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 March 31, 2004, we had 382 employees and 123 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 organized our operations into a portfolio of peer-level operating units under a
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 operating structure will facilitate effective management of the continuing growth and expansion of our business, we cannot assure you that the 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 have reduced earnings 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

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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 may result in reduced earnings 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 delay projects or
undermine 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 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 delay projects or undermine 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, operations, legal and licensing, 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 and our ability to attract, integrate and retain such personnel in the future. It may not be practical for us to match the compensation
certain of our employees could garner at other employment. 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.

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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 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.

As international customers have accounted for approximately 26% of our total revenue during the quarter ended March 31, 2004, the loss of these customers or the failure
to find new customers may result in a decline in our international revenue, which could lower our profitability and slow our growth

We expect revenue from sales of products and services to governments and other customers outside the United States to represent a growing percentage of our total
revenue 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
revenue under our

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contracts
with such customers, and we may have limited recourse against them to recover any potential losses.

We
generally invoice our foreign sales in U.S. dollars, and, consequently, 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. We may elect in the future to take payment for foreign sales in 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. For the quarter
ended March 31, 2004, international customers accounted for approximately 26% of our total revenue and international customers 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 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. For example,
we have participated in an initiative known as the "VWM group" for several years that has proposed 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. The VWM group proposal to the DVD Copy Control Association, or DVDCCA, which considered the proposal as a multi-industry technical standard, could not reach the
necessary consensus for adoption. Although the DVDCCA has not discontinued its study, it does not currently have a clear process to select a standard because the relevant decision-makers (including
representatives of the motion picture, information technology, and consumer electronic industries) have been unable to reach consensus. Given that the process is stalled, the VWM group or the DVDCCA
could change or discontinue, thus frustrating our ability to market and license the proposed solution through this means.

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:



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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 overcoming and may make achieving our business objectives difficult
or impossible, 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:



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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 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.

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

Threats of terrorist attacks in the United States, as well as future events occurring in response to or in connection with them, including, without limitation,
future terrorist attacks or threats 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 by leading to deferred or cancelled projects, which may reduce our revenue and profits. While any of these terrorist-related events could result in an increased need for new security
features that may, as a result, favorably impact our revenue 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, or drive up our 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 reduce our revenue and profits without the effect of reducing costs in the short-term and might result in the volatility of the future
market price of our common stock.

Securities Safe Harbor 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 quarterly report on Form 10-Q 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

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provided
by Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such forward-looking statements include but are not limited to statements
relating to trends and expectations in revenue growth, including with regard to programs in Florida and Mexico, statements regarding anticipated expenses, costs and investment activities in the
foreseeable future, statements regarding our expected short-term and long-term liquidity positions, and other statements containing words such as "anticipate," "estimate,"
"plans," "projects," "continuing," "ongoing," "expects," "management believes," "we believe," "we intend" and similar words or phrases, which are intended 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, 2003 have
not changed materially.

Item 4. Controls and Procedures.

Evaluation of disclosure 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.

Changes in internal control over financial reporting.During our most recent fiscal quarter ended March 31, 2004, we
took corrective action, under the direction of our audit committee and our board of directors, to strengthen our internal controls and procedures to ensure that information required to be disclosed in
the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported accurately, within the time periods specified in the rules and
forms of the Securities and Exchange Commission. Specifically, in order to ensure that the functionality of our newly implemented accounting and material requirements planning system is designed and
tested properly, we hired additional finance and accounting personnel with experience in this area. In addition, we reallocated responsibilities and adjusted our resources to address the issues
related to our reconciliation process. We also established a task force to document failures in the established processes and the actions necessary to correct the identified process failures, which we
then carried out. As a result of these and other actions, we believe that we have reliable systems in place that will support timely and accurate reporting. Other than as described above, there has
been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter ended March 31, 2004 that has materially affected or is reasonably likely to
materially affect our internal control over financial reporting.

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PART II. OTHER INFORMATION.

Item 2. Changes in Securities and Use of Proceeds.

On January 7, 2004, five holders of warrants to purchase shares of common stock, par value $0.001 per share, of the Company exercised their warrants for an
aggregate of 74,506 shares of common stock. The five exercising holders were Crestview Capital Fund II, L.P., Portside Growth and Opportunity Fund, BayStar Capital II, L.P., UBS O'Connor LLC f/b/o
O'Connor Global Convertible Arbitrage Master Limited and UBS O'Connor LLC f/b/o Pipes Corporate Strategies Ltd. Each holder exercised its warrant for the maximum amount of whole shares issuable
pursuant to such warrant. The exercise price for the warrants was $14.00 per share. The aggregate offering price of the shares of common stock issued pursuant to such warrants was approximately
$1.0 million and net proceeds to the Company were approximately $988,000. The warrants had been issued to the five holders as part of the Company's private placement transaction completed on
August 25, 2003. As each of the exercising warrant holders was an accredited investor, the warrant exercises were exempt from the registration requirements of the Securities Act of 1933, as
amended, pursuant to Rule 506 of Regulation D thereunder. SG Cowen Securities Corporation acted as the placement agent for the transaction and the warrant exercises. No other warrants
issued by the Company as part of the August 2003 private placement transaction were exercised prior to their termination as of 6:30 p.m. New York City time on January 7, 2004.

Item 5. Other Information.

In February 2004, the board of directors of the Company amended and restated the Company's 2000 Non-Officer Employee Stock Incentive Plan and
its 1999 Employee Stock Purchase Plan to revise the definition of fair market value in each plan such that the fair market value of a share of the Company's common stock shall be determined based on
the closing price for a share of common stock on the date of determination. In addition, in March 2004, the board of directors of the Company amended and restated the Company's 1999
Non-Employee Director Option Program to provide that the board of directors may waive the issuance of option grants under the program, in
whole or in part, for any particular year. None of the above amendments and restatements required stockholder approval.

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





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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: May 10, 2004 |  | By:                 

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EXHIBIT INDEX

|Exhibit
Number |  | Document                                                                                                                                                                                                                                                                                                                       
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1            |  | Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of Exhibits to the Registrant's Quarterly Report on Form 10-Q, as filed with the Securities
and Exchange Commission on November 14, 2000)                                                                 
|3.2            |  | Certificate of Amendment of Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 of Exhibits to the Registrant's Quarterly Report on Form 10-Q, as filed with the Securities and
Exchange Commission on November 14, 2000)                                     
|3.3            |  | Amended and Restated Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 of Exhibits to the Registrant's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 15,
2004)                                                                                        
|10.1           |  | Registrant's 1999 Employee Stock Purchase Plan, as amended and restated on February 19, 2004, including forms of agreements thereunder (incorporated by reference to Exhibit 99.1 of Exhibits to the Registrant's Registration Statement on
Form S-8 (Commission File No. 333-115074) which became effective on April 30, 2004)
|10.2           |  | Registrant's 2000 Non-Officer Employee Stock Incentive Plan, as amended and restated on February 19, 2004                                                                                                                                                                                                                      
|10.3           |  | Registrant's 1999 Non-Employee Director Option Program, as amended and restated on March 10, 2004                                                                                                                                                                                                                              
|31.1           |  | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                                                                                                                                                                                                              
|31.2           |  | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                                                                                                                                                                                                              
|32.1           |  | Section 1350 Certification of Chief Executive Officer                                                                                                                                                                                                                                                                          
|32.2           |  | Section 1350 Certification of Chief Financial Officer                                                                                                                                                                                                                                                                          

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