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

FORM 10-Q

(Mark One)ý

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2008ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
from                             to


Commission File Number: 000-28317

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

Delaware(State or other jurisdiction of
incorporation or organization)

94-3342784(I.R.S. Employer Identification No.)9405 SW Gemini Drive, Beaverton, Oregon 97008(Address of principal executive offices) (Zip Code)(503) 469-4800(Registrant's telephone number, including area code)


Indicate
by check 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o

Accelerated filer ý

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company o


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

As of July 29, 2008, there were 24,566,078 shares of the registrant's common stock, par value $0.001 per share, outstanding.



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Table of Contents

PART I FINANCIAL INFORMATIONItem 1.

Financial Statements:

3Consolidated Balance Sheets as of June 30, 2008 and December 31, 2007 (Unaudited)

3Consolidated Statements of Operations for the three- and six-months ended June 30, 2008 and 2007 (Unaudited)

4Consolidated Statements of Stockholders' Equity as of June 30, 2008 and December 31, 2007 (Unaudited)

5Consolidated Statements of Cash Flows for the six-months ended June 30, 2008 and 2007 (Unaudited)

6Notes to Consolidated Financial Statements (Unaudited)

7Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

26Item 3.

Quantitative and Qualitative Disclosures About Market Risk

48Item 4.

Controls and Procedures

48PART II OTHER INFORMATIONItem 1.

Legal Proceedings

50Item 1A.

Risk Factors

51Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

64Item 4.

Submission of Matters to a Vote of Security Holders

64Item 6.

Exhibits

64SIGNATURES

65


2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

DIGIMARC CORPORATION        CONSOLIDATED BALANCE SHEETS        (In thousands, except share data)        (UNAUDITED)

June 30,
2008

December 31,
2007(1)ASSETSCurrent assets:Cash and cash equivalents

$
24,492

$
19,582Restricted cash





205Short-term investments


3,849


3,568Trade accounts receivable, net


17,481


18,498Inventory, net


5,035


7,316Other current assets


3,587


2,628Total current assets


54,444


51,797Restricted cash


8,573


9,358Property and equipment, net


68,929


66,277Intangibles, net


12,578


13,462Other assets, net


1,240


1,129Total assets

$
145,764

$
142,023LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:Accounts payable

$
7,471

$
6,092Accrued payroll and related costs


4,140


1,952Deferred revenue


5,078


6,239Other current liabilities


2,131


1,955Total current liabilities


18,820


16,238Long-term deferred revenue, net of current portion


7,138


7,007Other long-term liabilities


1,141


1,455Total liabilities


27,099


24,700Commitments and contingencies (Note 11)Stockholders' equity:Common stock (22,508,533 and 21,838,375 shares issued and outstanding at June 30, 2008 and December 31, 2007, respectively)


23


22Additional paid-in capital


221,998


217,341Accumulated deficit


(103,356
)

(100,040
)Total stockholders' equity


118,665


117,323Total liabilities and stockholders' equity

$
145,764

$
142,023


---

See
Notes to Unaudited Consolidated Financial Statements.

3

---





DIGIMARC CORPORATION        CONSOLIDATED STATEMENTS OF OPERATIONS        (In thousands, except per share data)        (UNAUDITED)

Three Months Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007Revenue:Service

$
25,920

$
22,538

$
50,594

$
43,837Product and subscription


4,825


4,826


10,721


10,373Total revenue


30,745


27,364


61,315


54,210Cost of revenue:Service


17,432


15,089


33,635


29,804Product and subscription


1,907


1,988


4,327


4,088Total cost of revenue


19,339


17,077


37,962


33,892Gross profit


11,406


10,287


23,353


20,318Operating expenses:Sales and marketing


4,473


4,365


9,096


8,642Research, development and engineering


2,488


1,883


4,766


3,925General and administrative


4,136


3,809


8,720


7,907Amortization of intangibles


463


509


883


1,009Intellectual property


513


476


1,058


975Acquisition related costs


1,448





2,537


Total operating expenses


13,521


11,042


27,060


22,458Operating income (loss)


(2,115
)

(755
)

(3,707
)

(2,140
)Other income (expense), net


362


402


715


784Income (loss) before provision for income taxes


(1,753
)

(353
)

(2,992
)

(1,356
)(Provision) benefit for income taxes


(202
)

(142
)

(324
)

(161
)Net income (loss)

$
(1,955
)
$
(495
)
$
(3,316
)
$
(1,517
)Net income (loss) per sharebasic

$
(0.09
)
$
(0.02
)
$
(0.15
)
$
(0.07
)Net income (loss) per sharediluted

$
(0.09
)
$
(0.02
)
$
(0.15
)
$
(0.07
)Weighted average shares outstandingbasic


21,502


20,898


21,422


20,847Weighted average shares outstandingdiluted


21,502


20,898


21,422


20,847


See
Notes to Unaudited Consolidated Financial Statements.

4

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DIGIMARC CORPORATION        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        (In thousands, except share data)        (UNAUDITED)

Common stockAdditional
paid-in
capital

Accumulated
deficit

Total
stockholders'
equityShares

AmountBALANCE AT DECEMBER 31, 2006


21,191,918

$
22

$
211,209

$
(99,740
)
$
111,491Initial adjustment to adopt FIN 48











145


145Exercise of stock options


325,709





1,624





1,624Issuance of employee stock purchase plan shares


119,143





920





920Issuance of restricted common stock


309,490











Purchase and retirement of common stock


(107,885
)




(357
)




(357
)Stock-based compensation expense








3,945





3,945Net loss











(445
)

(445
)BALANCE AT DECEMBER 31, 2007


21,838,375


22


217,341


(100,040
)

117,323Exercise of stock options


294,426


1


2,121





2,122Issuance of employee stock purchase plan shares


67,558





509





509Issuance of restricted common stock


347,280











Purchase and retirement of common stock


(39,106
)




(295
)




(295
)Stock-based compensation expense








2,322





2,322Net loss











(3,316
)

(3,316
)BALANCE AT JUNE 30, 2008


22,508,533

$
23

$
221,998

$
(103,356
)
$
118,665


See
Notes to Unaudited Consolidated Financial Statements.

5

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DIGIMARC CORPORATION        CONSOLIDATED STATEMENTS OF CASH FLOWS        (In thousands)        (UNAUDITED)

Six Months EndedJune 30,
2008

June 30,
2007Cash flows from operating activities:Net loss

$
(3,316
)
$
(1,517
)Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Depreciation and amortization


9,117


7,801Stock-based compensation expense


2,322


2,012Other non-cash charges





(49
)Changes in operating assets and liabilities:Restricted cash


990


378Trade and unbilled accounts receivable


1,017


(1,996
)Inventory, net


2,281


(430
)Other current assets


(959
)

(332
)Other assets, net


(111
)

54Accounts payable


1,379


142Accrued payroll and related costs


2,188


(1,887
)Deferred revenue


(1,030
)

2,651Other liabilities


102


(116
)Net cash provided by (used in) operating activities


13,980


6,711Cash flows from investing activities:Purchase of property and equipment and capitalized labor costs


(10,834
)

(11,109
)Sale or maturity of short-term investments


103,395


76,807Purchase of short-term investments


(103,676
)

(78,522
)Net cash provided by (used in) investing activities


(11,115
)

(12,824
)Cash flows from financing activities:Issuance of common stock


2,631


1,011Purchase of common stock


(295
)

(140
)Principal payments under capital lease obligations


(291
)

(312
)Net cash provided by (used in) financing activities


2,045


559Net increase (decrease) in cash and cash equivalents


4,910


(5,554
)Cash and cash equivalents at beginning of period


19,582


23,135Cash and cash equivalents at end of period

$
24,492

$
17,581Supplemental disclosure of cash flow information:Cash paid for interest

$
92

$
38Cash paid for income taxes

$
304

$
323Summary of non-cash investing and financing activities:Equipment acquired or exchanged under capital lease obligations

$
51

$
244


See
Notes to Unaudited Consolidated Financial Statements.

6

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DIGIMARC CORPORATION        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        (In thousands, except share and per share data)        (UNAUDITED)

1. Description of Business and Summary of Significant Accounting Policies

Description of Business

Digimarc Corporation ("Digimarc" or the "Company") is a supplier of secure identity solutions and advanced technologies for use in
media identification and management. The Company's solutions enable governments and businesses around the world to deter counterfeiting and piracy, enhance traffic safety and national security, combat
identity theft and fraud, facilitate the effectiveness of voter identification programs, improve the management of media content, and support new digital media distribution models that provide
consumers with more choice and access to media content.

Pending Acquisition of Digimarc and Spin-Off of Digital Watermarking Business

On March 23, 2008, the Company entered into a definitive agreement (the "Original Merger Agreement") with L-1
Identity Solutions, Inc. ("L-1") pursuant to which a subsidiary of L-1 would be merged with and into the Company, with the Company continuing after the merger as a
wholly-owned subsidiary of L-1. Immediately prior to the merger, the Company would contribute all of the assets and liabilities related to the Company's digital watermarking business,
together with all of the Company's cash, to a wholly-owned subsidiary of the Company, the shares of which will be distributed to the Company's stockholders in a taxable spin-off
transaction. The Original Merger Agreement provided for a combination of cash and L-1 common stock to be paid to the Company's stockholders upon effectiveness of the merger, with an
aggregate transaction value of approximately $250 million based on the market value of L-1 common stock on the date of the Original Merger Agreement.

On
June 29, 2008, the Company and L-1 entered into an Amended and Restated Agreement and Plan of Merger, which provides for cash consideration to the Company's
stockholders in an aggregate amount of $310 million following the spin-off of the Company's digital watermarking business and cash on hand. The proposed transaction will be effected
through a tender offer by L-1 for the Company's common stock, followed by a second-step merger of a wholly-owned subsidiary of L-1 with and into the Company, with
the Company continuing after the merger. In addition, all outstanding options to purchase shares of the Company's common stock will vest and become fully exercisable prior to the record date for the
spin-off (the "spin-off record date"). Holders of Digimarc stock options will be given the opportunity to exercise their stock options on or prior to the spin-off
record date and, to the extent the stock options are exercised, the holders of shares of the Company's common stock issued upon exercise can participate in the tender offer or receive cash
consideration for their shares in the merger. All outstanding shares of Digimarc restricted stock will become fully vested on or prior to the spin-off record date, and holders of shares of Digimarc
restricted stock will be stockholders for purposes of the spin-off and can participate in the tender offer or receive cash consideration for their shares in the merger.

L-1
commenced a tender offer for the Company's common stock on July 3, 2008 pursuant to an Offer to Purchase, which was filed as an exhibit to L-1's
Schedule TO ("tender offer") filed with the SEC on July 3, 2008 (as amended, the "Offer to Purchase"). The amended offer price is $12.25 per share of the Company's common stock
(including associated preferred stock purchase rights). Completion of the tender offer is subject to a minimum number of shares of the Company's common stock being tendered, completion of the
spin-off and certain other customary conditions, as described in

7

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

1. Description of Business and Summary of Significant Accounting Policies (Continued)

the
Offer to Purchase. If the Registration Statement on Form 10 filed by DMRC Corporation, an indirect wholly owned subsidiary of the Company that will be the surviving entity of the
spin-off, has not been declared effective by the SEC prior to the spin-off, the equity interests of the spin-off entity will be transferred to a newly-created trust
for the benefit of the Company's stockholders as of the spin-off record date, and the trust will distribute the equity interests to Company's stockholders as of the spin-off
record date upon effectiveness of the Registration Statement on Form 10.

The
completion of the merger is subject to payment by L-1 for the shares of the Company's common stock tendered in the tender offer, approval of the merger agreement by the
Company's stockholders, if required by law, and completion of the spin-off prior to the expiration of the tender offer and other customary closing conditions. On June 12, 2008 the
Federal Trade Commission granted early termination of the antitrust review process under the Hart-Scott-Rodino Act. The transaction is not subject to any financing condition. There is no
assurance that the tender offer, the merger and spin-off will be consummated in a timely manner, if at all.

The tender offer statement (including the offer to purchase, letter of transmittal and related tender offer documents) filed by L-1 with the SEC and
the solicitation/recommendation statement filed by Digimarc with the SEC contain important information which we encourage investors and securityholders to read.

Principles of Consolidation

The consolidated financial statements include the accounts of Digimarc and its wholly-owned subsidiaries. All significant intercompany
transactions and balances have been eliminated.

Interim Financial Statements

The accompanying 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 principles generally accepted in the United States (the "U.S.") have been condensed or omitted
under the rules and regulations of the SEC.

These
consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on
Form 10-K for the year ended December 31, 2007, which was filed with the SEC on February 29, 2008. The results of operations for the interim periods presented in these
consolidated financial statements are not necessarily indicative of the results for the full year.

Use of Estimates

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the U.S. requires
Digimarc to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets

8

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

1. Description of Business and Summary of Significant Accounting Policies (Continued)

and
liabilities. Certain of the Company's 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, reserves for uncollectible accounts receivable, valuation allowance for deferred tax
assets, contingencies and litigation and stock-based compensation. Digimarc bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions.

Investments

The Company considers all investments with original maturities over 90 days that mature in less than one year to be
short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities
represent the investment of cash that is available for current operations. Short-term investments include federal agency notes, company notes, and commercial paper. The Company's
marketable securities are generally classified as held-to-maturity as of the balance sheet date and are reported at amortized cost, which approximates market. The book value of
these investments approximates fair market value and, accordingly, no amounts have been recorded to other comprehensive income.

A
decline in the market value of any security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. The
impairment is charged to earnings and a new cost basis for the security is established. To determine whether an impairment is other-than-temporary, the Company considers
whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the
contrary. There have been no other-than-temporary impairments identified or recorded by the Company.

Premiums
and discounts are amortized or accreted over the life of the related security as an adjustment to yield using a method that approximates the effective-interest method. Dividend
and interest income are recognized when earned.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, short-term investments, trade accounts receivable, accounts payable and
accrued payroll approximate fair value due to the short-term nature of these instruments. The carrying amounts of capital leases approximate fair value as the stated interest rates
approximate current market rates. Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument when available. These estimates are
subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

9

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

1. Description of Business and Summary of Significant Accounting Policies (Continued)

Impairment of Long-Lived Assets

The Company accounts for long-lived assets in accordance with the provisions of Statement of Financial Accounting Standards
("SFAS") No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. This statement requires that long-lived
assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability
of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered
to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted
cash flows or appraised values, depending on the nature of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Software Development Costs

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

Internal
use software development costs are accounted for in accordance with AICPA SOP No. 98-1,Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. Costs incurred in the preliminary project stage are expensed as incurred and costs incurred in the application development stage, which
meet the capitalization criteria, are capitalized and amortized on a straight-line basis over the estimated useful life of the asset, generally three to five years. Costs incurred in the
post-implementation stage are expensed as incurred. Internal use software development projects that have been capitalized to date relate to card manufacturing and control systems software.

2. Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 157,Fair Value Measurements,which defines
fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value. This statement does not require any new fair value
measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. SFAS No. 157 is effective the first fiscal
year beginning after November 15, 2007. The Company has applied the provisions of this standard regarding the framework of measuring fair value and noted no material effect on the current
financial statements.

In
February 2007, the FASB issued SFAS No. 159,The Fair Option for the Financial Assets and Financial Liabilities,which permits
entities to choose to measure certain financial assets and liabilities

10

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

2. Recent Accounting Pronouncements (Continued)

at
fair value. SFAS No. 159 is effective the first fiscal year beginning after November 15, 2007. The Company has elected not to measure certain financial assets and liabilities at fair
value as permitted by SFAS No. 159.

In
April 2008, FASB issued Staff Position No. FAS 142-3Determination of the Useful Life of Intangible Assets(FSP
142-3). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142,Goodwill and Other Intangible Assets. The intent of this Staff Position is to improve the consistency between the useful life
of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141 (revised 2007), Business Combinations,
and other U.S. generally accepted accounting principles. FSP 142-3 is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Company is currently reviewing the effect, if any, the proposed
guidance will have on its consolidated financial statements.

In
May 2008, the FASB issued SFAS NO. 162,The Hierarchy of Generally Accepted Accounting Principles, which identifies the sources of
accounting principles and the framework for selecting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally
accepted accounting principles in the United States. This statement shall be effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board's amendments to AU
section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company is currently evaluating the impact of SFAS 162, but does not expect
the adoption of this pronouncement will have a material impact on the Company's financial statements.

3. Revenue Recognition

Certain customer arrangements encompass multiple deliverables, such as software, hardware sales, consumables sales, maintenance fees, and software development fees. The Company accounts
for these arrangements in accordance with EITF Issue No. 00-21. If the deliverables meet the criteria in EITF Issue No. 00-21, the deliverables are divided into
separate units of accounting and revenue is allocated to the deliverables based on their relative fair values. The criteria specified in EITF Issue No. 00-21 are as follows
(i) the delivered item has value to the customer on a stand-alone basis, (ii) there is objective and reliable evidence of the fair value of the undelivered item, and (iii) if the
arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor.
For our purposes, fair value is generally defined as the price at which a customer could purchase each of the elements independently from other vendors or as the price that the Company has sold the
element separately to another customer. Management applies judgment to ensure appropriate application of EITF Issue No. 00-21, including value allocation among multiple
deliverables, determination of whether undelivered elements are essential to the functionality of delivered elements and timing of revenue recognition, among others. Revenue is recognized in
accordance with SAB 104 when the following four criteria are met (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or
determinable, and (iv) collection is probable.

11

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

3. Revenue Recognition (Continued)

AICPA SOP No. 98-9 requires that revenue be recognized using the "residual method" in circumstances when vendor specific objective evidence ("VSOE") 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.

Applicable
revenue recognition criteria is considered separately for each separate unit of accounting as follows:



12

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

3. Revenue Recognition (Continued)



4. Segment Information



The Company derives its revenue from a single reporting segment: secure identification and media management solutions. Revenue is
generated in this segment through licensing and subscription of its various products and the delivery of contracted and consulting services related to these products. The Company markets its products
in the United States and in non-U.S. countries through its sales personnel and its subsidiaries. The Company's management evaluates resource allocation decisions and the performance of the
Company based upon revenue by the geographic regions of the segment and does not receive discrete financial information about asset allocation and expense allocation on a disaggregated basis.

Revenue
by geographic areas is as follows:

Three Months Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007United States

$
25,388

$
21,219

$
49,810

$
41,739International


5,357


6,145


11,505


12,471Total

$
30,745

$
27,364

$
61,315

$
54,210


13

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DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

4. Segment Information (Continued)



No single customer accounted for more than 10% of the Company's revenues for the three- and six-month periods ended
June 30, 2008 and June 30, 2007, respectively.

5. Stock-Based Compensation

Stock-based compensation includes expense charges for all stock-based awards to employees and directors. Such awards include option grants, restricted stock awards, and shares expected
to be purchased under an employee stock purchase plan.

Stock-based
compensation recognized in the Company's consolidated financial statements in the three-and six-month periods ended June 30, 2008 and 2007 is based on the
value of the portion of the stock-based award that vested during the period, adjusted for expected forfeitures for stock-based awards granted prior to, but not fully vested as of, December 31,
2005 and stock-based awards granted subsequent to December 31, 2005. The compensation cost for awards granted prior to January 1, 2006 is based on the grant date fair value estimated in
accordance with the pro forma provisions of FASB Statement No. 123,Accounting for Stock-Based Compensation, while awards granted on or after
January 1, 2006 follow the provisions of SFAS 123(R) to determine the grant date fair value and compensation cost. Compensation cost for all stock-based awards is recognized using the
straight-line method.



Valuation and Amortization Method.The Company estimates the fair value of stock-based awards granted using the Black-Scholes option pricing model. The Company
amortizes the fair value of all awards on a straight-line basis over the requisite service periods, which are generally the vesting periods. The fair value of each option grant is
estimated on the date of grant.

Expected Life.The expected life of awards granted represents the period of time that they are expected to be outstanding. The Company determines the expected life
based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules and pre-vesting and post-vesting forfeitures. Stock options
granted during the three- and six-month periods ended June 30, 2008 and 2007 generally vest over four years and have contractual terms of ten years.

Expected Volatility.The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of its common stock using the
Black-Scholes option pricing model based on historical stock prices over the most recent period commensurate with the estimated expected life of the award. This historical period excludes portions of
time when unusual transactions occurred, such as a significant acquisition.

Risk-Free Interest Rate.The Company bases the risk-free interest rate used in the Black-Scholes option pricing model on the implied yield
currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term approximately equal to the expected life of the award.

14

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

5. Stock-Based Compensation (Continued)

Expected Dividend Yield.The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable
future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option pricing model.

Expected Forfeitures.The Company uses relevant historical data to estimate pre-vesting option forfeitures. The Company records stock-based
compensation only for those awards that are expected to vest.

A
summary of the weighted average assumptions and results for options granted during the periods presented is as follows:

Three Months
Ended
June 30,

Six Months
Ended
June 30,2008

2007

2008

2007Expected life (in years)


5.7


5.8


5.7


5.8Expected volatility


44
%

44
%

44
%

44
%Risk-free interest rate


2.5
%

4.7
%

2.5
%

4.7
%Expected dividend yield


0
%

0
%

0
%

0
%Expected forfeiture rate


15
%

16
%

15
%

16
%Fair value

$
4.97

$
4.76

$
3.88

$
4.36




The Company also recognizes stock-based compensation in connection with its 1999 Employee Stock Purchase Plan. The plan, as amended on
November 2, 2006, allows employees to purchase shares of Digimarc common stock through payroll deductions of up to 15% of their base compensation during each three-month plan period, up to a
maximum deduction of $5.3 for each plan period, not to exceed $21 per year. The three-month plan periods begin December 1, March 1, June 1 and September 1. The price an
employee pays for the shares is 85% of the lower of (i) the fair market value of Digimarc common stock at the beginning of the plan period or (ii) the fair market value at the end of the
plan period. There were 33,644 and 67,558 shares purchased under the Company's stock purchase plan during the three- and six-month periods ended June 30, 2008, respectively. There
were 28,742 and 54,119 shares purchased under the Company's stock purchase plan during the three- and six-month periods ended June 30, 2007, respectively.

The
current offer period under the plan was terminated as of July 25, 2008 in connection with the anticipated close of the tender offer from L-1 and all payroll
deductions have been refunded.



The Compensation Committee of the Board of Directors (the "Board") awarded restricted stock shares under the Company's 1999 Stock
Incentive Plan, as amended, to certain officers, employees and directors. The shares subject to the restricted stock awards vest over a certain period, usually one to four years, following the date of
the grant.

15

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

5. Stock-Based Compensation (Continued)

The
fair value of restricted stock awards granted is based on the fair market value of the Company's common stock on the date of the grant (measurement date), and is recognized over the
vesting period of the related restricted stock using the straight-line method.

In
addition to restricted stock shares that vest over time, the Compensation Committee awarded restricted stock that vests upon satisfaction of either market based or employee
performance based conditions under the 1999 Stock Incentive Plan, as amended.

The
fair value of restricted stock awards that vest upon the satisfaction of market based conditions is calculated using a Monte Carlo valuation model that results in a discount factor
applied to the fair market value of the Company's common stock on the date of the grant (measurement date). Compensation cost is recognized over the derived service period, which is shorter than the
performance period, using the straight-line method. If the market condition is met prior to completion of the derived service period, all remaining expense is immediately recognized in the
period the awards vest. Expense for market based awards is recognized if the employee completes the derived service period, regardless of whether the market condition is met. If the market condition
is not met, the shares will be forfeited.

The
fair value of restricted stock awards that vest upon the satisfaction of employee performance conditions is based on the fair market value of the Company's common stock on the date
of grant (measurement date). Management has determined it is probable that all performance conditions can be achieved; therefore, compensation cost is recognized on a straight line basis over the
explicit service period. If the performance condition is satisfied early, all remaining compensation cost will be recognized in the period the condition is satisfied. If the performance vesting
condition is not met by the end of the explicit service condition, all previously recognized compensation cost will be reversed and the shares will be forfeited.

Specific
terms of the restricted stock awards (including market or performance based vesting share awards) are governed by restricted stock agreements between the Company and the award
recipients.



The following table summarizes stock-based compensation expense related to stock-based awards under SFAS 123(R) for the three-
and six-month periods ended June 30, 2008 and 2007, which was incurred as follows:

Three Months Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007Stock-based compensation:Cost of revenue

$
121

$
109

$
235

$
215Sales and marketing


191


185


359


392Research, development and engineering


119


101


232


173General and administrative


760


599


1,462


1,207Intellectual property


17


13


34


25Total stock-based compensation

$
1,208

$
1,007

$
2,322

$
2,012


16

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

5. Stock-Based Compensation (Continued)

At
June 30, 2008, the Company had 1.3 million non-vested stock options that had a weighted average grant date price of $7.83. As of June 30, 2008, the
Company had $9,530 of total unrecognized compensation cost related to non-vested stock-based awards granted under all equity compensation plans, including options, restricted stock, and
employee stock purchase plan. Total unrecognized compensation cost will be adjusted for any future changes in estimated forfeitures. The Company expects to recognize this cost over a weighted average
period of 1.34 years.



As of June 30, 2008, under all of the Company's stock-based compensation plans, options to purchase an aggregate of
6.7 million shares were outstanding, and options to purchase an additional 6.9 million shares were authorized for future grants under the plans. The Company issues new shares upon option
exercises.

Options
granted, exercised, canceled and expired under the Company's stock option plans are summarized as follows:

Three-months ended June 30, 2008:

Options

Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
LifeOutstanding at March 31, 2008


6,932,342

$
13,40Options granted


74,350

$
11.20Options exercised


(273,257
)
$
7.27Options canceled


(32,753
)
$
10.72Options expired





Outstanding at June 30, 2008


6,700,682

$
13.64

5.40 yearsExercisable at June 30, 2008


5,402,548

$
15.04

4.65 years




Six-months ended June 30, 2008:

Options

Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
LifeOutstanding at December 31, 2007


6,691,725

$
13.61Options granted


420,100

$
8.75Options exercised


(294,426
)
$
7.21Options canceled


(116,717
)
$
10.80Options expired





Outstanding at June 30, 2008


6,700,682

$
13.64

5.40 yearsExercisable at June 30, 2008


5,402,548

$
15.04

4.65 years


17

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

5. Stock-Based Compensation (Continued)

The
following table summarizes information about stock options outstanding at June 30, 2008:

Options Outstanding

Options ExercisableRange of Exercise Prices

Number
Outstanding

Remaining
Contractual
Life (Years)

Weighted
Average
Price

Number
Exercisable

Weighted
Average
Price$  1.50 - $  5.96


641,595


7.13

$
5.59


455,067

$
5.47$  6.00 - $  6.46


507,990


7.19

$
6.09


307,759

$
6.06$  6.52 - $  8.29


636,553


8.60

$
7.61


197,593

$
7.20$  8.46 - $  9.49


726,608


7.67

$
8.83


367,862

$
8.79$  9.50 - $11.98


779,424


6.31

$
11.15


674,255

$
11.23$12.07 - $12.55


221,550


3.40

$
12.54


221,550

$
12.54$13.00 - $13.87


363,900


5.31

$
13.17


355,400

$
13.17$14.02 - $14.11


124,300


2.86

$
14.02


124,300

$
14.02$14.13


521,500


2.48

$
14.13


521,500

$
14.13$14.40 - $14.95


105,400


4.54

$
14.52


105,400

$
14.52$15.06 - $15.25


429,000


4.42

$
15.24


429,000

$
15.24$15.34 - $15.71


311,228


5.03

$
15.69


311,228

$
15.69$16.00 - $16.91


83,784


4.85

$
16.56


83,784

$
16.56$17.00 - $17.88


222,500


3.49

$
17.03


222,500

$
17.03$18.13 - $18.61


291,100


3.45

$
18.18


291,100

$
18.18$19.35 - $19.93


130,500


3.52

$
19.86


130,500

$
19.86$20.00 - $53.94


603,750


1.81

$
36.57


603,750

$
36.57$0.50 - $53.94


6,700,682


5.40

$
13.64


5,402,548

$
15.04


At
December 31, 2007, 5,454,008 options were exercisable at a weighted average price of $15.04.

At
June 30, 2008, the aggregate intrinsic value of outstanding and exercisable stock options was $20,739 and $12,525, respectively. The aggregate intrinsic value is based on our
closing price of $14.16 per share on June 30, 2008, which would have been received by the optionees had all of the options with exercise prices less than $14.16 per share been exercised on that
date.



The following table reconciles the unvested balance of restricted and performance shares:

Three-months ended June 30, 2008:

Number of
SharesUnvested balance, March 31, 2008


788,659Granted


24,000Vested


(27,555
)Canceled


(3,010
)Unvested balance, June 30, 2008


782,094


18

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

5. Stock-Based Compensation (Continued)



Six-months ended June 30, 2008:

Number of
SharesUnvested balance, December 31, 2007


554,953Granted


347,280Vested


(115,424
)Canceled


(4,715
)Unvested balance, June 30, 2008


782,094


6. Net Income (Loss) Per Share Computation

Net income (loss) per share (or earnings per share ("EPS")) is calculated in accordance with SFAS No. 128,Earnings per Share,
which provides that basic and diluted net income (loss) per share for all periods presented are to be computed using the weighted average number of common shares outstanding during each period, with
diluted net income (loss) per share including the effect of potentially dilutive common shares.

The
following table shows the reconciliation of weighted average basic shares to weighted average diluted shares outstanding:

Three Months
Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007Shares (in 000's)Basic EPSWeighted average shares outstanding


21,502


20,898


21,422


20,847Effect of Dilutive SecuritiesOptions











Restricted stock and performance vesting shares











Diluted EPSWeighted average shares outstanding


21,502


20,898


21,422


20,847


Common
stock equivalents related to stock options of 3,948 and 4,077 were excluded from diluted net loss per share calculations for the three- and six-month periods ended
June 30, 2008, 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
anti-dilutive. In addition, common stock equivalents related to stock options and restricted stock of 759 and 467 for the three-and six-month periods ended June 30,
2008, respectively, were excluded from diluted net loss per share as the Company was in a loss position and the inclusion would be anti-dilutive.

Common
stock equivalents related to stock options of 4,429 and 4,366 were excluded from diluted net loss per share calculations for the three- and six-month periods ended
June 30, 2007, 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
anti-dilutive. In addition, common stock equivalents

19

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

6. Net Income (Loss) Per Share Computation (Continued)

related
to stock options and restricted stock of 729 and 891 for the three- and six-month periods ended June 30, 2007, respectively, were excluded from diluted net loss per share as
the Company was in a loss position and the inclusion would be anti-dilutive.

7. Trade Accounts Receivable



Trade accounts receivable are recorded at the invoiced amount and do not bear interest. Revenue earned which has not been invoiced as
of the balance sheet date, and generally billed the following month, is classified as unbilled trade receivables in the consolidated balance sheets.

June 30, 2008

December 31, 2007Billed trade receivables, net

$
10,184

$
12,396Unbilled trade receivables


7,297


6,102Trade accounts receivable, net

$
17,481

$
18,498


Trade
accounts receivable, net includes $2,035 and $3,060 at June 30, 2008 and at December 31, 2007, respectively, of deferred revenue, billed in accordance with the
provisions of the contracts with the Company's customers.



The allowance for doubtful accounts was $95 and $187 at June 30, 2008 and at December 31, 2007, respectively, and is the
Company's best estimate of the amount of probable credit losses in the Company's existing accounts receivable. The Company determines the allowance based on historical write-off experience
and current information. The Company reviews its allowance for doubtful accounts monthly. Account balances are charged off against the allowance after all means of collection have been exhausted and
the potential for recovery is considered remote.



There was one customer that accounted for more than 10% of the Company's trade and unbilled accounts receivable, net at June 30,
2008. No single customer accounted for more than 10% of the Company's trade and unbilled accounts receivable, net at December 31, 2007.

8. Inventory



Inventory consists primarily of the consumable materials used to manufacture identification cards, such as inks, laminates, and
adhesives (considered raw material), equipment held for sale (considered

20

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

8. Inventory (Continued)

finished
goods) and deferred contract costs (considered either finished goods or in-process). Inventories are valued on a first-in, first-out basis at the lower of
cost or market value (net realizable value).

June 30,
2008

December 31,
2007Equipment and deferred contract costs

$
502

$
1,213Consumable materials, net


4,533


6,103Inventory, net

$
5,035

$
7,316




The Company records a provision for excess and obsolete inventory based on changes in market conditions, sales orders, expected sales
volumes, and technology advances. The provision was recorded in the period the circumstances occurred or were identified.

The
reserve for slow moving and obsolete consumable materials was $94 and $138 at June 30, 2008 and at December 31, 2007, respectively. While the Company does not currently
expect to be able to sell or otherwise use the reserved inventory it has on hand based upon its forecast and backlog, it is possible that one or more customers will decide in the future to purchase a
portion of the reserved inventory.

9. Other Income (Expense), Net

Other income (expense), net consists primarily of interest received and paid and foreign currency translation gain or loss.

Three Months
Ended
June 30,

Six Months
Ended
June 30,2008

2007

2008

2007Other income (expense):Interest income

$
235

$
362

$
553

$
774Interest expense


(44
)

4


(92
)

(15
)Foreign currency and other


171


36


254


25Total other income (expense), net

$
362

$
402

$
715

$
784


10. Income Taxes

Provision for Income Taxes.The provision for income taxes reflects expected tax expense in certain foreign jurisdictions. The Company has recorded a full
valuation allowance against the Company's net deferred tax assets at June 30, 2008 due to the uncertainty of realization of the Company's net operating losses. The Company will continue to
evaluate the realizability of the Company's domestic and other foreign net deferred tax assets and may record additional benefits in future earnings if the Company determines the realization of these
assets is more likely than not.

21

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

11. Commitments and Contingencies



In 2004, three purported class action lawsuits were filed in the U.S. District Court for the District of Oregon against the Company and
certain of its current and former directors and officers on behalf of purchasers of the Company's securities during the period April 17, 2002 to July 28, 2004. These lawsuits were later
consolidated into one action for all purposes. The amended complaint, which sought unspecified damages, asserted claims under the federal securities laws relating to the Company's restatement of its
financial statements for 2003 and the first two quarters of 2004 and alleged that the Company issued false and misleading financial statements and issued misleading public statements about the
Company's operations and prospects. On August 4, 2006, the court granted the Company's motion to dismiss the lawsuit with prejudice and entered judgment in the Company's favor. Plaintiffs
appealed to the Ninth Circuit Court of Appeals. The appeal has been fully briefed but not yet scheduled for oral argument. Due to the inherent uncertainties of litigation, the Company cannot
accurately predict the ultimate timing of a decision in or the outcome of this matter.

On
or about October 19, 2004, two purported shareholder derivative lawsuits were filed against certain of the Company's officers and directors, naming the Company as a nominal
defendant, in the Superior Court of the State of California for the County of San Luis Obispo. These lawsuits were consolidated into one action for all purposes on March 14, 2005. This suit
claims that certain of these officers and directors breached their fiduciary duties to the Company's stockholders and to the Company. The complaint is derivative in nature and does not seek relief
from the Company. The Board appointed an independent committee to investigate the claims asserted in this derivative lawsuit. On July 19, 2005, the court granted the Company's motion to dismiss
these consolidated actions in favor of a shareholder derivative action to be filed by plaintiffs in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005,
the California plaintiffs filed two new derivative lawsuits in the United States District Court for the District of Oregon. On October 17, 2005, the defendants filed a motion to dismiss these
complaints for lack of subject matter jurisdiction and failure to state a claim. In May of 2006, the Board committee, after completing its investigation, concluded that pursuit of the allegations
would not be in the best interests of the Company or its stockholders. On August 24, 2006, the court granted the defendants' motion and dismissed the lawsuit with prejudice. Plaintiffs filed a
notice of appeal on September 22, 2006. The briefs to the Ninth Circuit were completed in June 2007, and the
Company anticipates oral argument and a decision in 2008. However, due to the inherent uncertainties of litigation, the Company cannot accurately predict the ultimate timing or outcome of the matter.

On
or about April 6, 2005, another purported shareholder derivative lawsuit was filed against certain of the Company's officers and directors, and also naming the Company as a
nominal defendant, in the Circuit Court for the State of Oregon for the County of Washington containing similar allegations to the complaints discussed above. That case was stayed pending the report
of the Board committee referenced above, and was ultimately dismissed following the Board committee's investigation.

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

22

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

11. Commitments and Contingencies (Continued)

District
of New York naming approximately 300 companies, including the Company, and their officers and directors and underwriters as defendants in connection with the initial public offerings of these
companies. The plaintiffs allege that the defendants fraudulently inflated the share prices of these companies during and after their initial public offerings through an elaborate scheme characterized
by tie-in agreements, undisclosed compensation and analyst conflicts. The plaintiffs also allege that the underwriter defendants required some substantial investors who requested
allocations in the initial public offerings to participate in the scheme. Some of the Company's 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. The plaintiffs have continued to litigate their claims primarily against the underwriter defendants. The
district court directed that the litigation proceed within a number of "focus cases" rather than in all of the 309 cases that have now been consolidated. The Company's case is not one of these focus
cases. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court's class certification decision for these six focus cases. In response to that ruling, the
plaintiffs amended their master allegations and the focus case complaints, and the defendants moved to dismiss those amended complaints. The court issued an opinion and order on March 26, 2008,
essentially denying the motion to dismiss and allowing the case to continue. The cases are currently in settlement discussions. Due to the inherent uncertainties of litigation, the Company cannot
accurately predict the ultimate outcome of the matter.

On
October 10, 2007, a stockholder of the Company filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted
as lead underwriters on the initial public offering of the Company. The complaint, which also named the Company as a nominal defendant but did not assert any claims against the Company, asserted
claims against the underwriters under Section 16(b) of the Securities Exchange Act of 1934 for recovery of alleged short-swing profits on trades of the Company's stock. On February 28,
2008, an amended complaint was filed, with the Company still named only as a nominal defendant. Similar complaints have been filed by this same plaintiff against a number of other issuers in
connection with their initial public offerings, and the factual allegations are closely related to the allegations in the litigation pending in the United States
District Court for the Southern District of New York which is described above in this Form 10-Q.

Certain
of the Company's product license and services agreements include an 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. To date, there have been no claims made
under such indemnification provisions.

The
Company 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, as of June 30, 2008, 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

23

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

11. Commitments and Contingencies (Continued)

Company.
No accrual has been recorded because the amounts are not probable or reasonably estimatable in accordance with SFAS No. 5,Accounting for
Contingencies.



Some governmental authorities require performance bonds that we are obligated to maintain during the life of the contract. Often, the
terms of these bonds require that we obtain letters of credit to secure our obligations under the bonds. The letters of credit may in turn require us to maintain large restricted cash reserves as
security, reducing our ability to use these funds for our other business purposes. Even with the availability of such cash reserve guarantees, we may not be able to obtain such performance bond
underwriting at a favorable rate or at all. Our failure to be able to provide such performance bonds may preclude us from bidding on new government contracts or maintaining our existing contracts for
their full terms. In addition, these performance bonds may provide for security interests covering our receivables or other assets, which could cause additional financing to be more difficult or more
expensive to obtain. The size, nature and purpose of, and the risks and uncertainties associated with, public sector contracts can potentially cause our results to fluctuate and anticipated revenue to
decrease significantly.

24

---



DIGIMARC CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(UNAUDITED)

12. Quarterly Financial Information

Quarter ended:

March 31

June 30

September 30

December 312008Total revenue

$
30,570

$
30,745Total cost of revenue


18,623


19,339Gross profit


11,947


11,406Gross profit percent


39
%

37
%Sales and marketing


4,623


4,473Research, development and engineering


2,278


2,488General and administrative


4,584


4,136Amortization of intangibles


420


463Intellectual property


545


513Acquisition related costs


1,089


1,448Operating income (loss)


(1,592
)

(2,115
)Net income (loss)


(1,361
)

(1,955
)Net income (loss) per sharebasic


(0.06
)

(0.09
)Net income (loss) per sharediluted


(0.06
)

(0.09
)2007Total revenue

$
26,846

$
27,364

$
27,132

$
28,422Total cost of revenue


16,815


17,077


16,367


17,769Gross profit


10,031


10,287


10,765


10,653Gross profit percent


37
%

38
%

40
%

37
%Sales and marketing


4,277


4,365


4,103


3,870Research, development and engineering


2,042


1,883


1,691


1,707General and administrative


4,098


3,809


3,724


3,978Amortization of intangibles


500


509


451


532Intellectual property


499


476


429


432Operating income (loss)


(1,385
)

(755
)

367


134Net income (loss)


(1,022
)

(495
)

772


300Net income (loss) per sharebasic


(0.05
)

(0.02
)

0.04


0.01Net income (loss) per sharediluted


(0.05
)

(0.02
)

0.04


0.01


25

---





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. Please see the discussion regarding forward-looking statements included in this Quarterly Report on Form 10-Q under the caption
"Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995."

The following discussion should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing
elsewhere in this Form 10-Q. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors
which affect our business, including without limitation the disclosures made in Part II, Item 1A (Risk Factors) of this Form 10-Q and in the audited consolidated
financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2007 filed on February 29, 2008, and other reports
and filings made with the Securities and Exchange Commission ("SEC").

Pending Acquisition of Digimarc and Spin-Off of Digital Watermarking Business

On March 23, 2008, we entered into the Original Merger Agreement with L-1 pursuant to which a subsidiary of
L-1 will be merged with and into Digimarc, with Digimarc continuing after the merger as a wholly-owned subsidiary of L-1. Immediately prior to the merger, we would contribute
all of the assets and liabilities related to our digital watermarking business, together with all of our cash, to our wholly-owned subsidiary, the shares of which will be distributed to our
stockholders in a taxable spin-off transaction. The Original Merger Agreement provided for a combination of cash and L-1 common stock to be paid to the Company's stockholders
upon effectiveness of the Merger, with an aggregate transaction value of approximately $250 million based on the market value of L-1 common stock on the date of the Original Merger
Agreement.

On
June 29, 2008, the Company and L-1 entered into an Amended and Restated Agreement and Plan of Merger, which provides for cash consideration to the Company's
stockholders in an aggregate amount of $310 million following the spin-off of the Company's digital watermarking business and cash on hand. The proposed transaction will be effected
through a tender offer by L-1 for the Company's common stock, followed by a second-step merger of a wholly-owned subsidiary of L-1 with and into the Company, with
the Company continuing after the merger. In addition, all outstanding options to purchase shares of the Company's common stock will vest and become fully exercisable prior to the Spin-Off
Record Date. Holders of Digimarc stock options will be given the opportunity to exercise their stock options on or prior to the Spin-Off Record Date and, to the extent the stock options
are exercised, the holders of shares of the Company's common stock issued upon exercise can participate in the tender offer or receive cash consideration for their shares in the merger. All
outstanding shares of Digimarc restricted stock will become fully vested on or prior to the spin-off record date, and holders of shares of Digimarc restricted stock will be stockholders
for purposes of the spin-off and can participate in the tender offer or receive cash consideration for their shares in the merger.

L-1
commenced a tender offer for the Company's common stock on July 3, 2008 pursuant to the Offer to Purchase. The amended offer price is $12.25 per share of the
Company's common stock (including associate preferred stock purchase rights). Completion of the tender offer is subject to a minimum number of shares of the Company's common stock being tendered,
completion of the spin-off and certain other customary conditions, as described in the Offer to Purchase. If the Registration Statement on Form 10 filed by DMRC Corporation, an
indirect wholly owned subsidiary of the Company that will be the surviving entity of the spin-off, has not been declared effective by the SEC prior to the spin-off, the equity
interests of the spin-off entity will be transferred to a newly-created

26

---



trust
for the benefit of the Company's stockholders as of the Spin-Off Record Date, and the trust will distribute the equity interests to Company's stockholders as of the
Spin-Off Record Date upon effectiveness of the Registration Statement on Form 10.

The
completion of the merger is subject to payment by L-1 for the shares of the Company's common stock tendered in the tender offer, approval of the merger agreement by our
stockholders, if required by law, and completion of the Spin-Off prior to the expiration of the ender offer and other customary closing conditions. On June 12, 2008 the Federal
Trade Commission granted early termination of the antitrust review process under the Hart-Scott-Rodino Act. The transaction is not subject to any financing condition. There is no assurance
that the tender offer, the merger and the spin-off will be consummated in a timely manner, if at all.

The tender offer statement (including the offer to purchase, letter of transmittal and related tender offer documents) filed by L-1 with the SEC and
the solicitation/recommendation statement filed by Digimarc with the SEC contain important information which we encourage investors and securityholders to read.

All
forward-looking statements in this Quarterly Report on Form 10-Q, including those in the Management's Discussion and Analysis of Financial Condition, Results of
Operations and Risk Factors, are based on management's plans for future operations without consideration given to the pending transaction.

Overview

Digimarc Corporation ("Digimarc," "our" or "we") is a leading supplier of secure identity solutions, and a leading innovator of
technology used to enrich everyday living by giving persistent digital identities to media objects that computers can see, hear, understand and react
to. Our solutions and technologies enable governments and businesses around the world to identify and manage all forms of media, enhance traffic safety and national security, combat identity theft and
fraud, deter counterfeiting and piracy, extend the value and communication ability of media content, and support new digital media distribution models that provide consumers with more choice and
access to media content. Our mission is two-fold:



We
issue more than 60 million identification documents ("IDs") annually and are the leading supplier of government-issued citizen IDs in North America, including supplying systems
that produce more than two-thirds of all driver licenses issued in the U.S. We are also a leading technology innovator and owner of intellectual property in a signal processing technology
innovation known as "digital watermarking" which allows imperceptible digital information to be embedded in all forms of produced or distributed media content and certain objects, including personal
identification documents, financial instruments, photographs, movies, music, television, and product packages. The embedded data gives media and objects a digital identity that can be detected and
read by software or hardware detectors in personal computers and other digital devicesmaking intuitive computing possible as these computing devices can then become aware of and respond
to their surroundings.

Digital
watermarking is a strategic component of nearly all of our product offerings. We provide media identification and management solutions based on this and related technologies
directly and through our licensees. Digital watermarking has already proven to be a powerful element of document security, giving rise to our long-term relationship with a consortium of
Central Banks and many leading companies in the information technology industry. We are working to achieve a similar success in secure identity management systems. We anticipate that by the middle of
2008 more than one out of

27

---



two
driver licenses being produced in the U.S. will carry digital watermarks as a means to provide cross-jurisdictional machine authentication. In addition, Digimarc and its licensees have
successfully propagated digital watermarking in music, movies, television broadcasts, images and printed materials. Digital watermarks have been used in these applications to provide improved media
rights and asset management, reduce piracy and counterfeiting losses, enhance marketing programs, enable more efficient and effective distribution of valuable media content, and open up new consumer
experiences.

Our
principal administrative, marketing, research, and intellectual property development facility is located in Beaverton, Oregon. Our secure ID systems business is headquartered in
Burlington, Massachusetts, and our logistics center is in Fort Wayne, Indiana.

Our
ID systems revenue is primarily generated pursuant to long-term contracts with government ID issuersprimarily U.S. State government agencies responsible for
driver license issuance and national governments of a number of countries. These customers rely on our systems design, integration and materials science expertise, and proprietary technologies such as
digital watermarking, to implement issuance systems and processes that improve the security of identity documents and banknotes.

Our
media identification and management revenue is generated through commercial and government applications of our digital watermarking and related technologies, primarily from patent
and technology license fees paid by business partners and our contracts with a consortium of Central Banks and with The Nielsen Company. Our licensing program, which is a core part of our business, is
built upon our extensive patent portfolio, which contains over 370 issued U.S. patents, and numerous foreign patents, as of June 30, 2008. Private sector media and entertainment industry
customers use secure solutions from our business partners and us to identify, track, manage and protect content as it is distributed and consumedeither digitally or
physicallyand to enable new consumer applications to improve access to networks and information from personal computers and mobile devices. We expect that patent and technology licensing
will continue to contribute most of our revenues from non-government customers for the foreseeable future.

Secure ID Systems

We issue more than 60 million IDs annually and are the leading supplier of driver licenses and citizen IDs in North America. We
also provide secure ID solutions to approximately 25 foreign governments.

In
North America, we generate most of our revenue through the issuance of State driver licenses and other IDs on a fixed price per credential issued basis. In North America, we are
generally a prime contractor, providing full issuance systems to Federal, State, and provincial departments of motor vehicles or other government issuing authorities. These systems typically include
hardware (including specialized cameras, printers, personal computers and servers), software, consumable supplies (such as ribbons, blank or preprinted card materials and laminated and related
consumables) and ongoing support services. These systems may also involve software and/or hardware development, integration services, and implementation services. When we provide a full issuance
system to a customer, we generally retain title to all equipment, software and consumables associated with the system and are responsible for maintaining the system over the contractual period.

Our
strategy regarding the REAL ID Act, a federal legislation passed in May 2005, is to provide complete solutions that address the requirements of the REAL ID Act: identity
verification; document scanning and archiving; individual background checking; data and image sharing; and migration to and production of REAL ID Act compliant driver license documents. These
solutions are available to customers as upgrades or complete issuance systems. Digimarc is currently offering the States program management assistance to develop transition plans and safely migrate to
current systems to those that are REAL ID Act compliant.

28

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In
markets outside of North America, we generally provide driver license, national identification and voter identification systems, services, and components in partnership with local
card producers, security printers, system integrators and others. In these markets, we may serve as prime contractor or sub-contractor, depending on the circumstances. As a
sub-contractor, we generally are responsible for delivering hardware, software, or consumables, and some degree of integration services to the prime contractor; whereas as a prime
contractor, we are responsible for integrating all components of the system to the customer's specifications.

Outside
of North America, our revenues are typically generated from sales of equipment, software and/or consumables to government agencies or their prime contractors. These sales may
occur at irregular intervals, can carry relatively low margins and cause variations in quarterly revenue and gross profit trends. We enter into low margin contracts and transactions from time to time
to maintain market presence and build relationships with customers and business partners, and often transition to more profitable digital technologies over time. Due to the nature of such
international programs and customers, the timing of these sales is less predictable than our service revenues provided by domestic customers and, consequently, international sales can occur unevenly
during the course of a year.

Media Identification and Management

We license our technology and patents and otherwise foster development of the market for solutions enabled by our technologies,
including digital watermarking, through our participation in industry activities and events for commercial as well as governmental uses. Our licenses primarily involve use of our technology and
patents in the media and entertainment area, but also support industrial and commercial enterprise applications as well as applications in Federal programs. We also have a multi-year
contract with an international consortium of Central Banks pursuant to which we have been, since 1997, developing, deploying, supporting and continuing to enhance a system to deter digital
counterfeiting of currency using personal computers and digital reprographics.

Commercial
customers use secure media solutions from our business partners and us to identify, track, manage and protect content as it is distributed and consumedeither
digitally or physicallyand to enable new consumer applications to access networks and information from personal computers and mobile devices. Many movie studios, record labels,
broadcasters, creative professionals and other customers rely on digital watermarking as a cost-effective means to:



Our
business partners and customers include AquaMobile, Cinea, Inc., a subsidiary of Dolby Laboratories, Inc., GCS Research LLC, MarkAny, MediaGrid, Microsoft
Corporation, Media Science International, Mobile Data Systems, Inc., The Nielsen Company, Overdrive, Royal Philips, Signum Technologies Limited, Thomson Multimedia, S.A., USA Video,
Verance Corporation, Verimatrix, Inc. and VCP (an affiliate of VEIL Interactive Technologies). Although each partner or customer addresses particular needs, as a whole these partners and
customers are propagating digital watermarking in music, movies, images and television as a means to improve media rights and asset management,
reduce piracy losses, improve marketing programs, and provide more efficient and effective distribution of valuable media content.

29

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Seasonality.We have observed seasonality in our U.S. driver license issuance revenues, with larger revenues in the second and third quarter of the year, and
generally lower revenues in the first and fourth quarters. The fourth quarter is usually the seasonally lowest quarter each year. We use the straight line method of depreciation and amortization for
program-related assets. The combination of the seasonality of our revenues and straight line depreciation and amortization can cause significant variations in quarterly gross margin trends, generally
increasing margins in the second and third quarters when our issuance revenues are higher and decreasing margins in the first and fourth quarters when our issuance revenues are typically lower, while
having a neutral effect on a yearly basis.

Variability of Capitalized and Deferred Costs.Our driver license and ID issuance programs generally require that we incur significant costs in developing,
building and deploying new systems which may be sold outright upon completion or used in generating recurring revenue in the future. Certain labor and other costs relating to these new systems may be
deferred and expensed upon completion, or capitalized and amortized over the life of the relevant contract, rather than expensed in the quarter in which they are incurred. We may experience
variability in our operating income, depending on the extent to which we are able to capitalize or defer these costs. If we are able to win new business, our capitalized or deferred costs and
operating income may increase as a result of an increased allocation of labor resources to capitalized or deferred items. On the other hand, if we experience delays or reductions in new business, our
capitalized or deferred costs may decrease, which may result in an increase in operating expenses for the relevant quarter and a decrease in operating income.

Depreciation.Our policy for depreciating fixed assets that are specifically used to provide services under long-term contracts to the shorter of the
original contract term plus 2.75 years or estimated useful life. Historically, 95% of contracts were extended beyond the original contract term, that the average contract had at least two
contract extensions during its life and that these extensions added on average 2.75 years to the length of the contracts' original terms.

Since
contract-specific program assets are tracked on a contract basis, the finding that contracts are routinely extended beyond the original term and that these extensions are not
generally accompanied by significant incremental capital investment indicates that the useful life of contract-related assets is
generally longer than the original term of the contract. Given these findings, we concluded that it was appropriate to change the estimated useful lives of these assets for purposes of depreciation.
In addition, the change in useful lives achieves a better matching of the utility of these assets with the resulting revenues. For the year ended December 31, 2007, we performed an updated
analysis on contract specific assets which resulted in no change to our previous conclusions. We will continue to analyze the useful lives of contract specific assets in future periods. The financial
impact of this change is discussed below under the "Cost of Revenue" heading.



Total

Revenue to be
Recognized for the
Remainder of 2008(in millions)Backlog by source:Media identification and management

$
60

$
9Identification


210


35Total

$
270

$
44


30

---



Based on projected government-issued credential production volumes and other commitments we have for the periods under contract with our respective customers, we anticipate our current
contracts as of June 30, 2008 will generate approximately $270 million in revenue during the contractual terms of such contracts, currently up to seven years. This amount includes
production volumes reasonably expected to be achieved under currently effective contracts and government orders that are firm but not yet funded, and government contracts awarded but not yet signed.
Backlog as of December 31, 2007 was approximately $225 million. The increase in backlog reflects factors noted below.

Some
factors that lead to increased backlog are:



Some
factors that lead to decreased backlog are:



The
mix of these factors, among others, dictates whether our backlog increases or decreases for any given period.

Over
the next few years, we anticipate several states to request bids on their driver license issuance system programs. This period of expected high bid activity could lead to additional
backlog if we are successful with our bids. Another factor that could affect backlog in this period is the revenue model utilized for a particular customer. From time to time we have sales to our
customers that are not made on a price-per-card basis, but instead include hardware and consumable sales. Although these types of revenue models are positive growth indicators
for our business, they can lead to lower reported backlog.

There
is no assurance that our backlog will result in actual revenue in any particular period, because the orders, awards and contracts included in our backlog may be subject to
modification, cancellation or suspension. We may not realize revenue on certain contracts, orders or awards included in our backlog or the timing of such realization may change.

Restructuring.During the last half of 2005 and continuing during 2006, we restructured our operations to improve productivity and reduce fixed costs. During the
second quarter of 2006 we accelerated those activities significantly, resulting in a reduction of our workforce by nearly 20%. Overall, our workforce was reduced by over 30% since mid 2005. Our
actions included the redeployment and reallocation of resources to better align with our operating strategies.

Additional Information

A more detailed discussion of our business is contained in our Annual Report on Form 10-K for the fiscal year ended
December 31, 2007.

31

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Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the U.S.
("U.S. GAAP") 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, fixed assets, 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, reserves for uncollectible accounts receivable, contingencies and litigation and stock-based
compensation. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue recognition on long-term service contracts:We recognize revenue on long-term identification and driver license production
contracts using primarily a price-per-card method. We use actual monthly volume amounts, if available, or we estimate the card production volume on a monthly basis for certain
of these contracts in order to recognize revenue earned during the period. In the case of estimates, when the actual production information becomes available, which is typically within four weeks, we
bill the customer accordingly and any differences from the estimates are recognized in the month the billing occurs. These amounts represent our best estimates of cards produced and are based on
historical trends, known events during the period, and discussions with contract representatives. Prior to publicly reporting results, our practice is to compare the actual production volumes to
estimated production volumes and adjust revenue amounts as necessary. Any estimated amounts are included in unbilled receivables on the balance sheet until the actual production information is
available and the billing occurs. Any estimation process involves inherent risk. We reduce the inherent risk relating to production estimation through our approval and monitoring processes related to
accounting estimates. We also evaluate contracts for multiple elements and account for these items under the appropriate accounting literature.

Revenue
from professional service arrangements is generally determined based on time and material or a cost plus a profit margin measure. Revenue for professional services is recognized
as the services are performed. Losses on contracts, if any, are provided for in the period in which the loss becomes determinable. Billing for services rendered generally occurs within one month
following when the services are provided. Revenue earned which has not been invoiced is classified as unbilled trade receivables, which is included in the balance of trade accounts receivable, net in
the consolidated balance sheets.

Impairments and estimation of useful lives of long-lived assets:We periodically assess long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets.This statement requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be
held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired,
the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or
appraised values, depending on the nature of the asset.

32

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Also,
we periodically review the useful lives of long-lived assets whenever events or changes in circumstances indicate that the useful life may have changed. If the estimated useful lives
of such assets do change, we adjust the depreciation or amortization period to a shorter or longer period, based on the circumstances identified.

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

Reserves for uncollectible accounts receivable:We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to
make required payments. We determine the allowance based on historical write-off experience and current information. We review, and adjust when appropriate, our allowance for doubtful
accounts on at least a quarterly basis. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be
required.

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

Stock-based compensation:We account for stock-based compensation in accordance with SFAS No. 123(R),Share-Based Payment (Revised
2004), which requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stock options and employee stock
purchases under a stock purchase plan based on estimated fair values. We use the Black-Scholes option pricing model as our method of valuation for stock-based awards. Our determination of the fair
value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables.
These variables include, but are not limited, to the expected life of the award, our expected stock price, volatility over the term of the award and actual and projected exercise behaviors. Although
the fair value of stock-based awards is determined in accordance with SFAS 123(R), the Black-Scholes option pricing model requires the input of highly subjective assumptions, and other
reasonable assumptions could provide differing results. The fair value of restricted stock awards granted is based on the fair market value of our common stock on the date of the grant (measurement
date), and is being recognized over the vesting period of the related restricted stock using the straight-line method. The fair value of performance vesting share awards granted is based
on a Monte Carlo valuation model that resulted in a factor applied to the fair market value of our common stock on the date of the grant (measurement date), and is being recognized over the derived
service period using the straight-line method.

33

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Results of Operations

The following table presents our consolidated statements of operations data for the periods indicated as a percentage of total revenue.
Unless otherwise indicated, all references to the three- and six-month periods relate to the three- and six-month periods ended June 30, 2008 and all changes discussed
with respect to such period reflect changes as compared to the three- and six-month periods ended June 30, 2007.

Three
Months
Ended
June 30,

Six Months
Ended
June 30,2008

2007

2008

2007Revenue:Service


84
%

82
%

83
%

81
%Product and subscription


16


18


17


19Total revenue


100


100


100


100Cost of revenue:Service


57


55


55


55Product and subscription


6


7


7


8Total cost of revenue


63


62


62


63Gross profit


37


38


38


37Operating expenses:Sales and marketing


15


16


15


15Research, development and engineering


8


7


8


7General and administrative


13


14


14


15Amortization of intangibles


1


2


1


2Intellectual property


2


2


2


2Acquisition related costs


5





4


Total operating expenses


44


41


44


41Operating income (loss)


(7
)

(3
)

(6
)

(4
)Other income (expense), net


1


1


1


1Income (loss) before provision for income taxes


(6
)

(2
)

(5
)

(3
)Provision for income taxes


0


0


0


0Net income (loss)


(6
)%

(2
)%

(5
)%

(3
)%


Our
total revenue for the three- and six-months ended June 30, 2008 was $30.7 million and $61.3 million, or 12% and 13% higher as compared to
$27.4 million and $54.2 million for the prior year periods, respectively.

We
reported a net loss for the three- and six-month periods ended June 30, 2008 of $2.0 million and $3.3 million, respectively, or $0.09 and $0.15 per
share, respectively, compared to a net loss of $0.5 million and $1.5 million for the corresponding three- and six-month periods ended June 30, 2007, respectively, or
$0.02 and $0.07 per share, respectively. Our results reflect increases in primarily two areas of cost. For the three- and six-month periods ended
June 30, 2008 we incurred $1.4 million and $2.5 million, respectively, or $0.07 and $0.12 per share, respectively, of non-recurring costs in connection with the
pending acquisition of our ID Systems business by L-1. We also accrued $1.1 million and $1.9 million for the three- and six-month periods ended June 30,
2008, respectively, or $0.05 and $0.09 per share, respectively, of costs associated with the corporate incentive bonus program. In 2007, there were no accrued amounts for the corporate incentive bonus
program.

34

---





Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Revenue:Service

$
25,920

$
22,538

$
3,382


15
%
$
50,594

$
43,837

$
6,757


15
%Product and subscription


4,825


4,826


(1
)

0
%

10,721


10,373


348


3
%Total

$
30,745

$
27,364

$
3,381


12
%
$
61,315

$
54,210

$
7,105


13
%Revenue (as % of total revenue):Service


84
%

82
%







83
%

81
%Product and subscription


16
%

18
%







17
%

19
%Total


100
%

100
%







100
%

100
%


Service.Service revenue consists primarily of:



The
majority of service revenue arrangements are typically structured as price-per-card product agreements, time and materials consulting agreements, or fixed
price consulting agreements.

The
increase in service revenue for the three-month period ended June 30, 2008 compared to the corresponding three-month period ended June 30, 2007 was due primarily
to:



The
increase in service revenue for the six-month period ended June 30, 2008 compared to the corresponding six-month period ended June 30, 2007 was
due primarily to:



Product and subscription.Product revenue consists primarily of the sale of equipment, software licenses and consumables related to identification card production
systems that are variable in nature and occur from time to time. Subscription revenue consists primarily of royalty revenue from our intellectual property licenses and the sale of our
web-based subscriptions related to various software products, both of which are more recurring in nature. Revenues from our licensing products have minimal associated costs and are nearly
all margin.

35

---



The product and subscription revenue for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month periods
ended June 30, 2007 reflect mix changes in both periods and an overall increase for the six-month period primarily due to:





Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Revenue by geography:Domestic

$
25,388

$
21,219

$
4,169


20
%
$
49,810

$
41,739

$
8,071


19
%International


5,357


6,145


(788
)

(13
)%

11,505


12,471


(966
)

(8
)%Total

$
30,745

$
27,364

$
3,381


12
%
$
61,315

$
54,210

$
7,105


13
%Revenue (as % of total revenue):Domestic


83
%

78
%







81
%

77
%International


17
%

22
%







19
%

23
%Total


100
%

100
%







100
%

100
%


Domestic revenue increased for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and
six-month periods ended June 30, 2007 due primarily to:



International
revenue decreased for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month periods ended
June 30, 2007 due primarily to:



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Revenue by source:Media identification and management

$
5,118

$
3,025

$
2,093


69
%
$
10,206

$
6,510

$
3,696


57
%Identification


25,627


24,339


1,288


5
%

51,109


47,700


3,409


7
%Total

$
30,745

$
27,364

$
3,381


12
%
$
61,315

$
54,210

$
7,105


13
%Revenue (as % of total revenue):Media identification and management


17
%

11
%







17
%

12
%Identification


83
%

89
%







83
%

88
%Total


100
%

100
%







100
%

100
%


36

---



The increase in media identification and management revenue for the three- and six-month periods ended June 30, 2008 compared
to the corresponding three- and six-month periods ended June 30, 2007 was due primarily to higher service and licensing revenue from the Nielsen contract.

The
increase in identification revenue for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month periods
ended June 30, 2007 was due primarily to higher production volumes from our Mexico and Atlantic Canada operations, and higher revenues from various states primarily from a volume mix, including
California and Iowa, offset by the expiration of the United Kingdom contract.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Cost of Revenue:Service

$
17,432

$
15,089

$
2,343


16
%
$
33,635

$
29,804

$
3,831


13
%Product and subscription


1,907


1,988


(81
)

(4
)%

4,327


4,088


239


6
%Total

$
19,339

$
17,077

$
2,262


13
%
$
37,962

$
33,892

$
4,070


12
%Cost of Revenue (as % of related revenue components):Service


67
%

67
%







66
%

68
%Product and subscription


40
%

41
%







40
%

39
%


Service.Cost of service revenue primarily includes:



Cost
of service revenue increased for the three-month period ended June 30, 2008 compared to the corresponding three-month period ended June 30, 2007 primarily due
to:



37

---





Cost
of service revenue increased for the six-month period ended June 30, 2008 compared to the corresponding six-month period ended June 30, 2007
primarily due to:



Product and subscription.Cost of product and subscription revenue primarily includes costs of equipment and consumables related to our ID production systems, as
well as 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 decreased for the three-month period ended June 30, 2008 compared to the corresponding three-month period ended June 30, 2007
primarily due to lower consumables sales related to the expiration of the United Kingdom contract, offset by increased consumables sales to other international customers.

Cost
of product and subscription revenue increased for the six-month period ended June 30, 2008 compared to the corresponding six-month period ended
June 30, 2007 primarily due to corresponding increases in revenues, including issuance production revenues, higher add-ons and upgrade revenues, and a large consumable film sale to
an international customer, offset by lower consumables sales related to the expiration of the United Kingdom contract.

The
costs included in our cost of revenue fall under three categories as described below:



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Cost of revenue:Variable

$
8,799

$
7,771

$
1,028


13
%
$
17,839

$
15,382

$
2,457


19
%Fixed field support and manufacturing


6,730


6,586


144


2
%

13,107


13,025


82


1
%Program depreciation


3,810


2,720


1,090


40
%

7,016


5,485


1,531


28
%Total

$
19,339

$
17,077

$
2,262


13
%
$
37,962

$
33,892

$
4,070


12
%Cost of revenue (as % of total revenue):Variable


29
%

28
%







29
%

29
%Fixed field support and manufacturing


22
%

24
%







22
%

24
%Program depreciation


12
%

10
%







11
%

10
%Total


63
%

62
%







62
%

63
%


38

---



Variable.Variable costs include:



The
increase in variable costs for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month periods ended
June 30, 2007 was primarily due to increased sales from a combination of issuances and various products to domestic and international customers, offset by lower sales of consumables related to
the end of the United Kingdom contract.

Fixed field support and manufacturing.Fixed field support and manufacturing costs include:



Fixed
costs remained relatively consistent for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month
periods ended June 30, 2007.

Program depreciation.Program depreciation primarily consists of amortization and depreciation of costs incurred during the delivery process, where such costs are
capitalized and then amortized or depreciated over the useful lives of the assets to which the costs relate. Costs capitalized during the delivery process typically include equipment, purchased
software, capitalized labor for software development and implementation and travel.

The
increase in program depreciation was primarily due to delivery of new programs in the later half of 2007 or implemented during the first half of 2008, and to a lesser extent to
acceleration of depreciation on programs whose systems will be replaced under upgrade contracts.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Gross Profit:Service

$
8,488

$
7,449

$
1,039


14
%
$
16,959

$
14,033

$
2,926


21
%Product and subscription


2,918


2,838


80


3
%

6,394


6,285


109


2
%Total

$
11,406

$
10,287

$
1,119


11
%
$
23,353

$
20,318

$
3,035


15
%Gross Profit (as % of related revenue components):Service


33
%

33
%







34
%

32
%Product and subscription


60
%

59
%







60
%

61
%Total


37
%

38
%







38
%

37
%


The changes in gross profit as a percentage of revenue, for both the revenue components and overall gross profit, for the three- and
six-month periods ended June 30, 2008 compared to the three- and six-month periods ended June 30, 2007 were primarily due to commensurate changes in revenues and
costs of revenues, as described above. In particular, the increase in gross profit for services for the six-month period reflects significant operating leverage improvement in the field
support and manufacturing areas from significant cost reductions and improved operating efficiencies.

39

---



Operating Expenses



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Sales and marketing

$
4,473

$
4,365

$
108


2
%
$
9,096

$
8,642

$
454


5
%Sales and marketing (as % of total revenue)


15
%

16
%







15
%

15
%


Sales and marketing expenses consist primarily of:



The
increase in sales and marketing expense for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and six-month
periods ended June 30, 2007 resulted primarily due to:



We
anticipate that we will continue to invest in sales and marketing at current or higher levels.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Research, development and engineering

$
2,488

$
1,883

$
605


32
%
$
4,766

$
3,925

$
841


21
%Research, development and engineering (as % of total revenue)


8
%

7
%







8
%

7
%


Research, development and engineering expenses consist primarily of:



The
increase in research, development and engineering expense for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and
six-month periods ended June 30, 2007 resulted primarily from increased employee compensation-related expenses of $0.5 million and $1.0 million, respectively resulting
from additional headcount and corporate incentive bonus program.

40

---



We anticipate that we will continue to invest in research, development and engineering expenses at current or above levels in the near term to support certain ongoing product
initiatives, and expect to moderate spending in the longer term.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)General and administrative

$
4,136

$
3,809

$
327


9
%
$
8,720

$
7,907

$
813


10
%General and administrative (as % of total revenue)


13
%

14
%







14
%

15
%


General and administrative expenses consist primarily of:



The
increase in general and administrative expenses for the three- and six-month periods ended June 30, 2008 compared to the corresponding three-and
six-month periods ended June 30, 2007 resulted primarily due to increased accrued benefits of $0.3 million and $0.6 million, respectively, for the corporate incentive
bonus program.

We
anticipate that we will continue to incur general and administrative expenses at or above current levels in the near term, while continuing to examine means to gain efficiencies to
reduce general and administrative spending as a percentage of revenue in the longer term.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Amortization of intangibles

$
463

$
509

$
(46
)

(9
)%
$
883

$
1,009

$
(126
)

(12
)%Amortization of intangibles (as % of total revenue)


1
%

2
%







1
%

2
%


We account for intangible assets resulting from acquisitions in accordance with Financial Accounting Standards Board ("FASB") Statement
Nos. 141,Business Combinationsand 142,Goodwill and Other Intangible Assets. These statements
require the recording of intangible assets under purchase accounting rules, and require the amortization of such intangible assets over their expected useful life. As a result, in December 2001, we
recorded $29.5 million of intangible assets related to the acquisition of certain assets and certain liabilities from Polaroid and affiliates. These intangible assets were set up to amortize
over an average of a 12-year period, representing the expected useful life. Changes in contract status and customer relationships may lengthen or shorten the expected useful life of such
intangible assets, or cause an impairment charge related to the intangible asset, so some variability is expected to exist related to intangibles depending on internal and external factors.

The
decrease in amortization of intangible assets for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and
six-month periods ended June 30, 2007

41

---



resulted
primarily from extended amortization periods from contract extensions with several domestic customers and the impact of certain international programs being fully amortized.



Three Months
Ended
June 30,





Six Months
Ended
June 30,Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)

Dollar
Increase
(Decrease)

Percent
Increase
(Decrease)2008

2007

2008

2007(in 000's)Intellectual property

$
513

$
476

$
37


8
%
$
1,058

$
975

$
83


9
%Intellectual property (as % of total revenue)


2
%

2
%







2
%

2
%


Intellectual property costs primarily consist of:



Intellectual
property expense remained relatively consistent for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and
six-month periods ended June 30, 2007 with the slight increase for both periods attributable to the corporate incentive bonus program as explained in other areas of our operating
expenses. We anticipate that we will continue to invest in intellectual property expenses at current levels or slightly higher.

Acquisition related costs.During the quarter, we entered into the Amended and Restated Agreement and
Plan of Merger to sell our ID Systems business in an all cash transaction effected through a tender offer by L-1 for our common stock following the spin-off of our digital
watermarking business and cash on hand. In connection with the sale we have incurred professional fees for legal, accounting and investment banking costs of $1.4 million and $2.5 million
for the three-and six-month periods ended June 30, 2008, respectively.

We
anticipate that we will continue to incur acquisition related costs at or above current levels in the near term until the proposed transactions are completed.

Stock-based compensation.Stock-based compensation includes expense charges for all stock-based awards to officers, employees and directors. Such awards include
option grants, restricted stock awards, and shares expected to be purchased under an employee stock purchase plan. We account for stock-based compensation in accordance with SFAS 123(R), which
requires the measurement and recognition of compensation for all stock-based awards made to officers, employees and directors including stock options and employee stock purchases under a stock
purchase plan based on estimated fair values. SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion ("APB") No. 25,Accounting for
Stock Issued to Employees,for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107
relating to the application of SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R).

We
adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of
our 2006 fiscal year. In accordance with the modified prospective transition method, our consolidated financial statements for periods prior to fiscal year 2006 have not been restated to reflect this
change. Stock-based compensation recognized in the year ended December 31, 2007 and 2006 is based on the value of the

42

---



portion
of the stock-based award that will vest during the period, adjusted for expected forfeitures. Stock-based compensation recognized in our consolidated financial statements in the year ended
December 31, 2007 and 2006 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, December 31, 2005 and stock-based awards granted subsequent to
December 31, 2005. The compensation cost for awards granted prior to January 1, 2006 is based on the grant date fair value estimated in accordance with the pro forma provisions of
SFAS 123 while awards granted on or after January 1, 2006 follow the provisions of SFAS 123(R) to determine the grant date fair value and compensation cost. Compensation cost for
all stock-based awards is recognized using the straight-line method.

Upon
adoption of SFAS 123(R), we continued to use the Black-Scholes option pricing model as its method of valuation for stock-based awards. Our determination of the fair value of
stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions
regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected life of the award, our expected stock price volatility over the term of the
award and actual and projected exercise behaviors. Although the fair value of stock-based awards is determined in accordance with SFAS 123(R) and SAB 107, the Black-Scholes option
pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results. The fair value of restricted stock awards granted is based on the
fair market value of our common stock on the date of the grant (measurement date), and is being recognized over the vesting period of the related restricted stock using the straight-line
method. The fair value of performance vesting share awards granted is based on a Monte Carlo valuation model that resulted in a factor applied to the fair market value of our common stock on the date
of the grant (measurement date), and is being recognized over the Stock-based compensation expense was recorded in the respective statement of operations expense categories for the employees to whom
it applies, as set forth in the table below:

Three Months
Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007(in 000's)Cost of revenue

$
121

$
109

$
235

$
215Sales and marketing


191


185


359


392Research, development and engineering


119


101


232


173General and administrative


760


599


1,462


1,207Intellectual property


17


13


34


25Total

$
1,208

$
1,007

$
2,322

$
2,012


The
increase in stock-based compensation expense for the three- and six-month periods ended June 30, 2008 compared to the corresponding three- and
six-month periods ended June 30, 2007 was primarily due to an additional layer of stock-based awards being expensed pursuant to SFAS 123(R). We anticipate incurring an
additional $9.5 million in stock-based compensation expense through fiscal 2012 for awards outstanding as of June 30, 2008. The future effect of the adoption of this statement on our
financial position and results of operations will be determined by stock-based awards granted in future periods and the assumptions on which the value of those stock-based awards is based. Our tax
accounting may also be affected by actual exercise behavior and the relative market prices at exercise.

43

---







Three Months
Ended
June 30,

Six Months Ended
June 30,2008

2007

2008

2007(in 000's)Interest income

$
235

$
362

$
553

$
774Interest expense


(44
)

4


(92
)

(15
)Foreign currency and other


171


36


254


25$
362

$
402

$
715

$
784


The
slight decrease in other income (expense) was due primarily to lower interest earned on cash and investment balances and, increased interest expense related to additional capitalized
leases, offset by the increases in both the realized and unrealized gain on foreign currency translation.

Provision for Income Taxes.The provision for income taxes reflects expected tax expense from profitability in certain foreign jurisdictions. We have recorded a
full valuation allowance against net deferred tax assets at June 30, 2008 due to the uncertainty of realization of the Company's net operating losses. We will continue to evaluate the
realizability of our domestic and foreign net deferred tax assets in future periods and may recognize income tax benefits in future earnings if we determine the realization of these assets is more
likely than not.

Liquidity and Capital Resources

As of June 30, 2008, we had cash and cash equivalents, restricted cash, and short-term investments of
$36.9 million, representing an increase of approximately $4.2 million from $32.7 million at December 31, 2007. As of June 30, 2008, $8.6 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 June 30, 2008 was $35.6 million, compared to working capital of $35.6 million at December 31, 2007. The increase in cash
primarily relates to improved cash flow from operating activities.

Operating Cash Flow.The components of operating cash flows were:

Six Months Ended
June 30,2008

2007(in 000's)Net income (loss)

$
(3,316
)
$
(1,517
)Non-cash items


11,439


9,764Changes in operating assets and liabilities


5,857


(1,536
)Net cash provided by (used in) operating activities

$
13,980

$
6,711


The
major changes in the non-cash charges related to:



44

---





The
major changes in the operating assets and liabilities for the six-month period ended June 30, 2008 primarily related to:



The
major changes in the operating assets and liabilities for the six-month period ended June 30, 2007 primarily related to:



The
$11.1 million of cash used in investing activities for the six-month period ended June 30, 2008 primarily related to $10.8 million for expenditures
of property and equipment on contracts signed over the prior two and one-half years, including capitalization of labor costs of $3.1 million, and $0.3 million in net purchase
of short-term investments.

The
$12.8 million of cash used in investing activities for the six-month period ended June 30, 2007 primarily related to $1.7 million in net purchase of
short-term investment activities and $11.1 million for the purchase of property and equipment related to new customer contracts, including capitalization of labor costs of
$2.9 million.

The
$2.0 million of cash provided by financing activities for the six-month period ended June 30, 2008 resulted primarily from the net issuance of stock of
$2.3 million, offset by principal payments on capital leases of $0.3 million.

The
$0.6 million of cash provided by financing activities for the six-month period ended June 30, 2007 resulted primarily from the net issuance of stock of
$0.9 million, offset by principal payments on capital leases of $0.3 million.

Our
significant commitments consist of obligations under non-cancelable operating leases, which totaled $6.3 million as of June 30, 2008, and are payable in
monthly installments through June 2012. Our obligations under non-cancelable capital leases, which totaled $1.3 million as of June 30, 2008, are payable in monthly
installments through April 2012.

Many
of our secure identity management contracts have significant capital requirements. The general industry model for supplying driver license issuance systems to state driver license
issuers is for

45

---



the
system supplier to develop and install the issuance system using the supplier's capital and to charge the customer on a per-card issued basis. As a result, during times of substantial
competitive wins and/or substantial system upgrades, the Company may experience significant working capital needs that may exceed cash flow from operations. To date, the Company has relied upon cash
reserves to fund such expenditures.

We
have driver license contracts with various states that are not yet fully deployed and we have pending add-on and upgrade orders. In order to complete these contracts and
pending orders, we estimate we will incur approximately $18 million of expenditures. The estimates are derived from information known to us as of quarter end, the time the estimates were
prepared. Actual expenditures may vary from our estimates. We anticipate that these expenditures will be recouped through receipts from the related long-term
price-per-card agreements and from the value of the add-on and upgrade orders we have received.

Our
planned operating expenses and capital expenditures may constitute a material use of our cash resources. In addition, we expect that we will continue to utilize cash in the upcoming
few quarters as we complete program implementations. We may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines.

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

In
order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities, although at this time we believe that
our long-term working capital is sufficient to cover our foreseeable capital expenditures. 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.

In
April 2007, we filed a shelf registration with the SEC. The shelf registration is intended to provide us flexibility to raise funds from time to time over a period of up to
3 years, subject to market conditions and our capital needs. Should we complete the pending acquisition of our ID Systems business by L-1, we will withdraw the shelf registration.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements 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 our business.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements,which
defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value. This statement does not require any new fair
value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. SFAS No. 157 is effective the first
fiscal year beginning after November 15, 2007. The Company has applied the provisions of this standard regarding the framework of measuring fair value and noted no material effect on the
current financial statements.

46

---



In
February 2007, the FASB issued SFAS No. 159,The Fair Option for the Financial Assets and Financial Liabilities,which permits
entities to choose to measure certain financial assets and liabilities at fair value. SFAS No. 159 is effective for first fiscal year beginning after November 15, 2007. The Company has
elected not to measure certain financial assets and liabilities at fair value as permitted by SFAS No. 159.

In
April 2008, FASB issued Staff Position No. FAS 142-3Determination of the Useful Life of Intangible Assets(FSP
142-3). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142,Goodwill and Other Intangible Assets. The intent of this Staff Position is to improve the consistency between the useful life
of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141 (revised 2007), Business Combinations,
and other U.S. generally accepted accounting principles. FSP 142-3 is effective for financial statements issued for
fiscal
years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Company is currently reviewing the effect, if any, the proposed
guidance will have on its consolidated financial statements.

In
May 2008, the FASB issued SFAS NO. 162,The Hierarchy of Generally Accepted Accounting Principles, which identifies the sources of
accounting principles and the framework for selecting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally
accepted accounting principles in the United States. This statement shall be effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board's amendments to AU
section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company is currently evaluating the impact of SFAS 162, but does not expect
the adoption of this pronouncement will have a material impact on the Company's financial statements.

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

Because this 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 in Part II, Item 1A or elsewhere in this Report on Form 10-Q or incorporated herein by reference 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 purposes of the safe harbor 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:



47

---





Such
forward-looking statements also include other statements containing words such as "anticipate," "estimate," "expect," "management believes," "we believe," "we intend," "should" and
similar words or phrases, which are intended to identify forward-looking statements. Actual results may vary materially due to, among other things, our failure to become profitable, the failure of the
potential markets for our digital watermarking technology to develop as anticipated, or the adoption of alternative technologies within these markets, as well as changes in economic, business,
competitive, technology and/or regulatory factors and trends, and the other factors described in this Form 10-Q or in our other documents filed with the SEC. 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 below should not be considered a
complete statement of all potential risks and uncertainties. We do not intend to update any forward-looking statements as a result of future events or developments.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The market risk disclosures as set forth in Item 7A of our Annual Report on Form 10-K for the year ended
December 31, 2007 have not changed materially.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of
our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered by this
Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures, as of the end of the period
covered by this Form 10-Q, were effective in ensuring that information required to be disclosed by us in reports

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that
we file or submit under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and
(ii) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required
disclosure.

Changes in Internal Controls

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) of the Securities Exchange Act of 1934) that occurred during the quarter ended June 30, 2008 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 1. Legal Proceedings.

In 2004, three purported class action lawsuits were filed in the U.S. District Court for the District of Oregon against us and certain
of our current and former directors and officers on behalf of purchasers of our securities during the period April 17, 2002 to July 28, 2004. These lawsuits were later consolidated into
one action for all purposes. The amended complaint, which sought unspecified damages, asserted claims under the federal securities laws relating to the restatement of our financial statements for 2003
and the first two quarters of 2004 and alleged that we issued false and misleading financial statements and issued misleading public statements about our operations and prospects. On August 4,
2006, the court granted our motion to dismiss the lawsuit with prejudice and entered judgment in our favor. Plaintiffs appealed to the Ninth Circuit Court of Appeals. The appeal has been fully briefed
but not yet scheduled for oral argument. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate timing of a decision in or the outcome of this matter.

On
or about October 19, 2004, two purported shareholder derivative lawsuits were filed against certain of our officers and directors, naming us as a nominal defendant, in the
Superior Court of the State of California for the County of San Luis Obispo. These lawsuits were consolidated into one action for all purposes on March 14, 2005. This suit claims that certain
of these officers and directors breached their fiduciary duties to our stockholders and to us. The complaint is derivative in nature and does not seek relief from us. The Board of Directors appointed
an independent committee to investigate the claims
asserted in this derivative lawsuit. On July 19, 2005, the court granted our motion to dismiss these consolidated actions in favor of a shareholder derivative action to be filed by plaintiffs
in the Circuit Court of the State of Oregon for the County of Washington. On August 25, 2005, the California plaintiffs filed two new derivative lawsuits in the United States District Court for
the District of Oregon. On October 17, 2005, the defendants filed a motion to dismiss these complaints for lack of subject matter jurisdiction and failure to state a claim. In May of 2006, the
Board committee, after completing its investigation, concluded that pursuit of the allegations would not be in the best interests of Digimarc or its stockholders. On August 24, 2006, the court
granted the defendants' motion and dismissed the lawsuit with prejudice. Plaintiffs filed a notice of appeal on September 22, 2006. The briefs to the Ninth Circuit were completed in June 2007,
and we anticipate oral argument and a decision in 2008. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate timing or outcome of the matter.

On
or about April 6, 2005, another purported shareholder derivative lawsuit was filed against certain of our officers and directors, and also naming us as a nominal defendant, in
the Circuit Court for the State of Oregon for the County of Washington containing similar allegations to the complaints discussed above. That case was stayed pending the report of the Board committee
referenced above, and was ultimately dismissed following the Board committee's investigation.

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, and their officers and directors and underwriters as defendants in connection with the initial public
offerings of these companies. The plaintiffs allege that the defendants fraudulently inflated the share prices of these companies during and after their initial public offerings through an elaborate
scheme characterized by tie-in agreements, undisclosed compensation and analyst conflicts. The plaintiffs also allege that the underwriter defendants required some substantial investors
who requested allocations in the initial public offerings to participate in the scheme. Some of our 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

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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. The plaintiffs have continued to litigate their claims primarily against the underwriter defendants. The district court directed that the litigation proceed within a number of
"focus cases" rather than in all of the 309 cases that have now been consolidated. We are not one of these focus cases. On December 5, 2006, the Court of Appeals for the Second Circuit reversed
the district court's class certification decision for the six focus cases. In response to that ruling, the plaintiffs amended their master allegations and the focus case complaints, and the defendants
moved to dismiss those amended complaints. The court issued an opinion and order on March 26, 2008, essentially denying the motion to dismiss and allowing the case to continue. The cases are
currently in settlement discussions. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the matter.

On
October 10, 2007, a Digimarc stockholder filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted as lead
underwriters for the Digimarc initial public offering. The complaint names Digimarc as a nominal defendant, and asserts claims against the underwriters under Section 16(b) of the Securities
Exchange Act of 1934 for recovery of alleged short-swing profits on trades of Digimarc stock. On February 28, 2008, an amended complaint was filed, with Digimarc still named only as a nominal
defendant. Similar complaints have been filed by this same plaintiff against a number of other issuers in connection with their initial public offerings, and the factual allegations are closely
related to the allegations in the litigation pending in the United States District Court for the Southern District of New York which is described above in this Form 10-Q.

Item 1A. Risk Factors

Our business, financial condition, results of operations and cash flows may be affected by a number of factors, including the factors
set forth below.

(1) Failure to complete the tender offer by, and the merger with, L-1 could negatively affect our stock price and our future businesses and financial results.

Completion of the tender offer is subject to a minimum tender condition and completion of the spin-off to Digimarc's stockholders or
the trust transfer for the benefit of Digimarc's stockholders, and completion of the merger is subject to a number of closing conditions, including obtaining requisite stockholder approvals, if
required by law, and completion of the spin-off. Digimarc and L-1 may be unable to satisfy such conditions on a timely basis or at all. If the tender offer and merger are not
completed, the price of our common stock may decline and our ongoing businesses may be adversely affected. If we fail to complete and realize any benefits from the merger, we will be subject to a
number of risks, including the following:



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We
could also be subject to litigation related to any failure to complete the tender offer, merger and spin-off. If the tender offer, merger and spin-off are not
completed, these risks may materialize and may adversely affect our financial results, stock price and ongoing businesses.

(2) Our obligation to pay a termination fee under certain circumstances and the restrictions on our ability to solicit other acquisition proposals may discourage other
companies from trying to acquire Digimarc.

Until the shares are first accepted for payment by L-1 pursuant to the tender offer, or the merger agreement is terminated,
with limited exceptions, the merger agreement prohibits us from entering into or soliciting any acquisition proposal or offer for a merger or other business combination with a party other than
L-1. In addition, we have agreed to pay L-1 a termination fee of $10.9 million and/or fees and expenses incurred in connection with the tender offer, the merger
agreement and performance under the merger agreement of up to $6.0 million under specified circumstances. These provisions could discourage other parties from trying to acquire Digimarc for a
higher price.

(3) We have a history of losses and we may not achieve or sustain profitability, particularly if we were to lose large contracts.

Except for the year 2003, we have incurred significant net losses from inception. Our accumulated deficit as of June 30, 2008
was $103.4 million. In the second half of 2005 and continuing through 2006, we restructured our operations to improve productivity and reduce fixed costs. During the second quarter of 2006, we
accelerated those activities significantly, resulting in a reduction of our workforce by nearly 20%. Overall, our workforce has been reduced by 30% since mid 2005. These actions resulted in an
increase in earnings to a near break even level in the second half of 2006. However, in order to achieve sustained profitability, we will need to generate higher revenue than we have in prior years
while controlling expenditures. Achieving sustained profitability will depend upon a variety of factors, including the impact of financial accounting mandates requiring us to expense stock options, as
well as the extent to which we may be required to increase the size of our workforce in order to execute our business strategy and capitalize on new opportunities. In addition, we evaluate our
strategy and market opportunities on an ongoing basis and will adjust our approach to market conditions that prevail from time to time. Finally, various adverse developments including the loss of
large contracts or cost overruns on our existing contracts could have a negative impact on our revenue or our margins. Accordingly, increases in our expenses may not be offset by revenue increases and
as a result we may not be able to achieve or sustain profitability.

(4) The loss of any large contract may result in loss of revenue and potential impairment of capital assets and/or intangible assets, including the acceleration of
depreciation and/or amortization expense.

Contracts between government agencies and Digimarc have varying durations, generally five or more years in length. Some contracts we
enter into contain termination for convenience provisions. In addition, as a contract nears expiration, generally the government agency begins a competitive procurement process. We anticipate that
several of our significant customers will award new contracts through such a competitive procurement process during the coming quarters. If we were to lose a contract due to termination for
convenience or in a competitive procurement situation, then, in addition to the loss of revenue and margin on a prospective basis, we could also incur impairment of capital and/or intangible assets
related to the customer, which could adversely affect our financial results.

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(5) The majority of our revenue is subject to government procurement processes that may involve unpredictable delays and other unexpected changes which might limit our
actual revenue in any given quarter or year.

We derive substantial portions of our revenue from government contracts which are subject to periodic open, competitive procurement.
The timing of such procurements is solely within the discretion of the governmental authority. Consequently, large components of new revenue are tied to procurement schedules, which could shift for
months, quarters or years as the needs of the related government procurement agencies change. Many of these governmental customers are facing continued budget pressures introducing added uncertainty.
In addition, the Department of Homeland Security's initiatives in passports and border crossing cards, as well as delays in disbursement of funding for REAL ID Act projects, could create confusion
within the U.S. driver license market that may delay purchase decisions by government customers. 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 affect the predictability of our quarterly and annual results, and might limit our actual revenue
in any given quarter or year, resulting in reduced and less predictable revenue and an adverse affect on profitability.

(6) The market for our products is highly competitive, and as a result, alternative technologies or larger companies may undermine, limit or eliminate the market for our
products' technologies, which would decrease our revenue and profits.

The markets in which we compete for business are intensely competitive and rapidly evolving. We expect competition to continue from
both existing competitors and new market entrants. We face competition from other companies and from alternative technologies. The potential for an influx of federal funds into our core U.S. driver
license market has drawn new competition and is likely to continue to do so. As we expand the applications for our technologies, we will experience more competition from products and services that are
substitutes for our applications. Because our digital watermarking business is still in an early stage of development, we also 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 digital watermarking 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. We do not assure you that digital watermarking technologies, and our products and
services using these technologies, will gain widespread market acceptance.

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

New
developments are expected to continue, and we do not 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 require greater revenue streams from such products and services to cover developmental costs. Many of the companies that currently compete with us for some of our business, 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 do not assure you that we will
be able to compete successfully against current or future participants in our market or against alternative technologies, or that the competitive pressures we face will not decrease our revenue and
profits in the future.

(7) We depend on our senior management and key employees for our future success. If we are not able to retain, hire or integrate these employees, we may not be able to meet
our commitments.

Our success depends to a significant extent on the performance and continued service of our senior management. Except for our Chief
Executive Officer, our senior management does not have employment agreements. The loss of the services of any of our senior management could delay projects or undermine customer relationships.

Due
to the high level of technical expertise that our industry requires, our ability to successfully develop, market, sell, license and support 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. Similarly, without the continued contributions of our key finance personnel, we believe that our ability to meet our reporting obligations and operate successfully as a public company may be
limited. We believe our future success will depend in large part upon our ability to retain our current key employees and our

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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. In addition,
we may encounter difficulties in hiring and retaining employees because of concerns related to our financial performance. In addition, these circumstances may have a negative effect on the market
price of our common stock, and employees and prospective employees may factor in the uncertainties relating to our stability and the value of any equity-based incentives in their decisions regarding
employment opportunities and decide to leave our employ. In addition, 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. 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 could be able to freely join our competitors. Although we generally attempt to control access to and distribution of our proprietary information by our
employees, there are no assurances that the confidential nature of our proprietary information will be maintained in the course of such future employment. Any of these events could have a material
adverse effect on our financial and business prospects.

(8) If leading companies in our industry or standard-setting bodies or institutions downplay, minimize, or reject the use of digital watermarking, its deployment may be
slowed and we may be unable to achieve revenue growthparticularly in the media and entertainment sectors.

Many of our business endeavors, such as our licensing of intellectual property in support of audio and video copy-control
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 block or impede the adoption of digital watermarkingparticularly in the media and entertainment market. In addition, potential customers in the media and entertainment industry may
delay or reject initiatives that relate to deployment of digital watermarking. Such a development would make the achievement of our business objectives in this market difficult or impossible.

(9) 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 products and services could be delayed or limited.

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
governmental standards, such as future regulations under the REAL ID Act, 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 certain products and services could be delayed or limited.

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
do not 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 and the deployment of our watermarking
technology could be adversely affected.

(10) We may need to retain additional employees or contract labor in the future in order to take advantage of new business opportunities arising from increased demand, which
could impede our ability to achieve or sustain profitability.

In the second half of 2005 and in 2006, we made significant reductions in our workforce as part of our efforts to reach profitability.
These reductions did not impede our ability to meet demand because they were accompanied by improvements in our internal business processes and coincided with a period of relatively low bid activity
with respect to development and deployment of new systems. We believe that this decrease in bid activity is temporary and that the U.S. driver
license market will demonstrate increased demand in future periods. Our current reduced staffing levels could affect our ability to respond to increased demand for our services. In addition, to meet
any increased demand and take advantage of new business opportunities in the future, we may need to increase our workforce through additional employees or contract labor, which would increase our
costs. If we experience such an increase in costs, we may not succeed in achieving or sustaining profitability.

(11) We may decline to pursue new, or renew existing, business opportunities in secure ID systems markets due to objectionable terms required by the contracting agencies, or
we may agree to objectionable contract terms for competitive reasons.

Government agencies sometimes insist on unduly onerous terms in their contracts with vendors of secure ID issuance systems. For
example, it is customary for state agencies to require that a vendor fund the capital-intensive initial deployment of a driver license issuance system (the costs of which the vendor normally recoups
over the life of the contract in per-card fees), while reserving the right to terminate the contract for convenience. Similarly, in connection with intellectual property rights, a contract
may require that our pre-existing issuance system software be written in a different language and a state may then argue that it falls within the class of works for which it owns the
copyright, enabling the state to turn the Digimarc-authored software over to one of our competitors, dedicate it to the public domain, or otherwise use the software in a manner detrimental to our
business. Objectionable contract terms may lead us to decline to bid on identification issuance systems to new customers, or to decline to retain business with customers we have historically served,
which could reduce our market share and lower our revenues or profits. In addition, if we decline to retain business with customers we have historically served, it could result in the accelerated
depreciation of intangible assets. Alternatively, we may decide to accept at least some level of objectionable terms rather than cede an important contract to a competitor, which could also lower our
revenues or profits.

(12) We expect our secure ID systems business to experience variability in gross margins.

We are likely to experience variability in gross margins on our government contracts due to numerous factors, including, among other
things, the following:



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The
numerous factors affecting gross margins make such margins complex and difficult to predict. We are continually refining our predictive tools and increasing our understanding of what
drives these various factors. For reasons such as those listed above, we expect that there will be fluctuations in our future operating results as a result of the variability in margins from period to
period in the secure ID systems business.

(13) Our future growth will depend to some extent on our successful implementation of our intellectual property in solutions provided by third parties, including partners
and suppliers.

Our business and strategy rely, in part, on deployment of our digital watermark reader technology by third-party software developers
and original equipment manufacturers. For example, one form of our digital watermark reader is commonly deployed in image editing applications to permit users of these products to read watermarks
embedded in imagery, and thereby discern the identities of image owners. Another form of our digital watermark reader is used in our anti-counterfeiting product offerings. If third parties
who include our technologies in their products cease to do so, or we fail to obtain other partners that will incorporate, embed, integrate or bundle our technologies, or these partners are
unsuccessful in their efforts, our efforts to expand deployment of our technologies would be adversely affected and, consequently, our ability to increase revenues would be adversely affected and we
may suffer other adverse effects to our business. In addition, if our technologies do not perform according to market expectations, our future sales would suffer as customers seek other providers.

(14) The loss of international customers or the failure to find new international customers could adversely affect our profitability and slow our growth.

We expect revenue from sales of products and services to governments and other customers outside the U.S. to represent a growing
percentage of our total revenue in the future. International

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sales
and services are subject to a number of risks that can adversely affect our sales of products and services to customers outside of the U.S., including the
following:



In
addition, our experience with large international issuance programs is more limited than our experience with domestic programs. We do not have an extensive operational infrastructure
for our international business. We generally act as a subcontractor or depend on local or international business partners and subcontractors for performance of substantial portions of these programs.
These factors may result in greater risk of performance problems or of reduced profitability with respect to our international programs. In addition, if foreign customers, in particular foreign
government authorities, terminate or delay the implementation of our products and services, we may have limited recourse against them to recover any potential losses.

We
generally do not invoice our foreign sales in U.S. dollars and, consequently, we are exposed to currency exchange 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, collared options, currency swap agreements or through similar hedging strategies.
However, no currency hedging strategy can fully protect against exchange-related losses.

(15) A significant portion of our business depends on contracts with fixed price terms. In the event of inflation occurring, or in the event of cost overruns in connection
with such contracts, our margins may be adversely affected.

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

(16) A significant portion of our business depends on contracts that are subject to a variety of terms and conditions, including damage payment obligations, as well as a
variety of other provisions that may cause our quarterly results to fluctuate and our anticipated revenue to potentially decrease significantly.

Our contracts for driver license and other identification issuance systems and related products typically include provisions imposing
(i) development, delivery and installation schedules and milestones, (ii) customer acceptance and testing requirements and (iii) other performance requirements. Such provisions
are common in large scale government contracts at the state and federal

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levels.
To the extent these provisions involve performance over extended periods of time, there may be increased risk of noncompliance. From time to time we have experienced delays in identification
system implementation, timely acceptance for identification systems programs, concerns regarding identification system program performance and other contractual disputes. Customers have asserted from
time to time, and may in the future assert, claims for compensatory or liquidated damages, or breach of contract, or other claims alleging that we have failed to meet timing or delivery requirements
and milestones pursuant to the terms of such contracts. Consequently, our failure to meet contractual milestones or other performance requirements as promised, or to successfully resolve customer
disputes, could result in our having to incur liability for damages, as well as increased costs, lower margins, or compensatory obligations in addition to other losses, such as harm to our reputation.
Such unexpected increases in costs to meet our contractual obligations or any other requirements necessary to address claims and damages with regard to our customer contracts could have a material
adverse effect on our business and financial results. We anticipate that future contracts will continue to have such provisions unless and until industry practices change.

A
significant portion of our business depends on a limited number of large, public-sector contracts, which are generally subject to termination for convenience, as determined by the
subject agency, or for lack of budgetary appropriation provided for the subject agency. Some government contracts also 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 that may not be subject to future 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 bonds that we are obligated to maintain during the life of the contract. Often, the terms of these bonds require that we
obtain letters of credit to secure our obligations under the bonds. The letters of credit may in turn require us to maintain large restricted cash reserves as security, reducing our ability to use
these funds for our other business purposes. Even with the availability of such cash reserve guarantees, we may not be able to obtain such performance bond underwriting at a favorable rate or at all.
In addition, these performance
bonds may provide for security interests covering our receivables or other assets, which could cause additional financing to be more difficult or more expensive to obtain.

Our
failure to be able to provide such performance bonds may preclude our ability to bid on new government contracts or maintain our existing contracts for their full terms. The size,
nature and purpose of, and the risks and uncertainties associated with, public sector contracts can potentially cause our quarterly results to fluctuate and anticipated revenue to decrease
significantly.

(17) Our products could have unknown defects or errors, which may give rise to claims against us, divert application of our resources from other purposes or increase our
project implementation and support costs.

Products and systems as complex as those we offer or develop may contain undetected defects or errors. Furthermore, we often provide
complex implementation, integration, customization, consulting and other technical services in connection with the implementation and ongoing maintenance of our products. Despite testing, defects or
errors in our products and services may occur, which could result in delays in the development and implementation of products and systems, inability to meet customer requirements or expectations in a
timely manner, loss of revenue or market share, increased implementation and support costs, failure to achieve market acceptance, diversion of development resources, injury to our reputation,
increased insurance costs, increased service and warranty costs and warranty or breach of contract claims. Although we attempt to reduce the risk of losses resulting from warranty or breach of
contract claims through warranty disclaimers and liability limitation clauses in our sales agreements, these contractual provisions are sometimes not included and may not be

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enforceable
in every instance. If a court refuses to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arise that are not contractually limited or adequately
covered by insurance, the expense associated with defending such actions or paying the resultant claims could be significant.

(18) The security systems used in our product and service offerings may be circumvented or sabotaged by third parties, which could result in the disclosure of sensitive
government information or private personal information or cause other business interruptions that could damage our reputation and disrupt our business.

Our business relies on computers and other information technologies, both internal and at customer and vendor locations. In addition,
many of the systems we sell manage private personal information and protect information involved in sensitive government functions. The protective measures that we use in these systems may not prevent
security breaches, and failure to prevent security breaches may disrupt our business, damage our reputation, and expose us to litigation and liability. A party who is able to circumvent security
measures used in these systems could misappropriate sensitive or proprietary information or materials 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 or otherwise sabotage the functionality of our systems, 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. Further, our insurance coverage may be insufficient
to cover losses and liabilities that may result from such events.

In
addition, 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. Such protection or remedial measures may not be available at a reasonable price or at all, or may not be entirely effective if commenced.

(19) A loss of a material supplier could have a material adverse effect on our ability to perform effectively under some of our contracts.

We are materially dependent on a limited number of third parties to produce systems or assemblies necessary for us to produce some of
our products. The loss of one or more of these suppliers could have a material adverse effect on our ability to perform effectively, if at all, under some of our contracts.

(20) 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:



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Some of our key technologies are 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 adversely affect our
profitability.

(21) We may not be able to protect adequately our intellectual property, and we may be subject to infringement claims and other litigation, which could adversely affect our
business.

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

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 that the validity or enforceability of our patents may be denied, and the possibility that third parties will be able to compete against us without infringing our patents. Budgetary
concerns may cause us not to file, or continue, litigation against known infringers of our patent rights, or may cause us not to file for, or pursue, patent protection for all of our inventive
technologies in jurisdictions where they may have value. Some governmental entities that might infringe our intellectual property rights may enjoy sovereign immunity from such claims. 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 or we may incur significant costs in bringing legal proceedings
against third parties who are infringing our patents.

Effective
protection of intellectual property rights may be unavailable or limited, both in the U.S. 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 U.S. and in various other countries. However, we do not 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 do not 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
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 even though we rely on some of these technologies for our products.

As
more companies engage in business activities relating to personal identification technologies and digital watermarking, and develop corresponding intellectual property rights, it is
increasingly likely that claims may arise which assert that some of our products or services infringe upon other parties'

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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.

Some
of our contracts include provisions by which we assure non-infringement of third-party intellectual property rights. As deployment of our technology increases, and more
companies enter our markets, the likelihood of a third party lawsuit resulting from such indemnification increases. If an infringement arises in a context governed by such a contract, we may have to
refund to our customer amounts already paid to us or pay significant damages, or we may be sued by the party allegedly infringed upon. 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 our 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 recovery.

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 U.S. where laws or law enforcement practices may not
protect our proprietary rights as fully as in the U.S.

(22) Products that we are developing for new secure identification markets and components and subsystems markets may not be accepted as quickly as we have projected or at
all, which may negatively impact our revenues, margins and earnings.

We have invested significant time and resources in product development activities for new secure identification markets, including
designing and developing numerous enhancements to our driver license systems and improving our cards' ability to withstand intrusions or alterations without detection. If we do not experience a
timely, positive reaction from issuing authorities to our new offerings, our projected revenues, margins and earnings may be negatively impacted.

(23) We are engaged in several lawsuits alleging violations of securities law and cannot predict the outcome or ultimate cost of these actions with certainty.

We currently are engaged in litigation relating to the initial public offering of our securities, in addition to the actions filed
against us in connection with our previously announced accounting errors. These matters are discussed in greater detail in Part II, Item 1 (Legal Proceedings) of this Quarterly Report on
Form 10-Q and in Note 11 (Commitments and Contingencies) of the Notes to Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
We have incurred significant costs relating to these matters. Due to the inherent uncertainties of such litigation, the ultimate cost and outcome cannot be predicted.

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(24) There is no assurance that our internal controls and procedures will succeed in achieving their stated goals under all potential future conditions, regardless of how
remote.

We have deployed significant resources to design, implement, and maintain effective internal controls and procedures, including
disclosure controls and procedures. While our internal controls and procedures are designed to provide reasonable assurance of achieving their objectives, the design of any system of controls is based
in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions,
regardless of how remote. Any failure to maintain adequate controls or to adequately implement required new or improved controls could harm our operating results or cause us to fail to meet our
reporting obligations in a timely and accurate manner.

(25) Some of our revenue models relating to anticipated products and services are under development. If these revenue models and pricing structures do not gain market
acceptance, the corresponding anticipated products and services may fail to attract or retain customers and we may not be able to generate new or sustain existing revenue.

Some of 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 providing security-related applications relating to secure personal identification, copyright protection, and counterfeit deterrence. We have not fully
developed revenue models for certain of our future digital watermarking applications and licensing endeavors. Because some of our products and services are not yet well-established in the
marketplace, and because some of such products and services will not directly displace existing solutions, we cannot be certain that the pricing structure for these products and services will gain
market acceptance or be sustainable over time or that the marketing for such products and services will be effective.

(26) If a judgment were to be entered against us and certain of our officers and directors and our director and officer liability insurance is inadequate or unavailable, the
obligation to pay the judgment may materially harm our business and financial condition.

Our director and officer liability insurance policies provide protection against certain liabilities relating to the securities class
action and derivative lawsuits against us and certain of our officers and directors up to prescribed policy limits. If these policies do not adequately cover expenses and certain liabilities relating
to these lawsuits, our financial condition could be materially harmed. In addition, if this insurance coverage becomes unavailable to us or premiums increase significantly in the future, it could make
it more difficult for us to retain and attract officers and directors and could expose us to potentially self-funding certain future liabilities ordinarily mitigated by director and
officer liability insurance.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

The following table sets forth information regarding purchases of our equity securities during the three-months ended June 30,
2008, all of which were shares subject to restricted stock awards that we purchased to cover applicable tax withholding obligations when these awards vested.

Period

(a)
Total number
of shares
(or units)
purchased

(b)
Average
price paid
per share
(or unit)

(c)
Total number
of shares (or units)
purchased as
part of publicly
announced plans
or programs

(d)
Maximum number
(or approximate
dollar value) of
shares (or units)
that may yet be
purchased under
the plans or
programsMonth 1April 1, 2008 to
April 30, 2008


38

$
10.03





Month 2May 1, 2008 to
May 31, 2008











Month 3June 1, 2008 to
June 30, 2008


84

$
13.29





Total


122

$
12.27








Item 4. Submission of Matters to a Vote of Security Holders.

We held our annual meeting of stockholders on May 1, 2008. Two proposals were voted on by our stockholders.

Proposal 1:Election of Three Class III Directors

Bruce
Davis, Brian J. Grossi and James T. Richardson were elected as Class III directors for a term of 3 years. The voting for each director was as follows:

For

WithheldBruce Davis


16,215,489


494,453Brian J. Grossi


16,028,264


681,678James T. Richardson


16,222,564


487,378


The
Company's Class I and II directors did not stand for reelection at the annual meeting. The terms of the Company's Class II directors, William J. Miller, Jim Roth and
Lloyd G. "Buzz" Waterhouse will continue until the 2009 annual meeting of stockholders. The terms of the Company's Class II directors, Philip J. Monego, Sr., Peter W. Smith and Bernard Whitney,
will continue until the 2010 annual meeting of stockholders.

Proposal 2:Ratification of the Appointment of Grant Thornton LLP as the Company's Independent Certified Public Accountants

Grant
Thornton was ratified as our independent certified public accountants for the fiscal year ending December 31, 2008 with 15,888,856 votes in favor, 806,240 votes against and
14,845 abstentions.

Item 6. Exhibits.

See attached exhibit index.

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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.

Date: August 1, 2008

DIGIMARC CORPORATIONBy:

/s/MICHAEL MCCONNELLMichael McConnell Chief Financial Officer and Treasurer
(Duly Authorized Officer
and Principal Financial Officer)


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EXHIBIT INDEX-*

Exhibit
Number

Document2.1

Amended and Restated Agreement and Plan of Merger, dated June 29, 2008, by and among Digimarc Corporation, L-1 Identity Solutions, Inc. and Dolomite Acquisition Co. (incorporated by reference to
Exhibit 2.1 to Digimarc's Report on Form 8-K, as filed with the Securities and Exchange Commission on July 3, 2008)2.2

Amendment No. 1 to the Amended and Restated Agreement and Plan of Merger, dated July 17, 2008, by and among Digimarc Corporation, L-1 Identity Solutions, Inc. and Dolomite Acquisition Co. (incorporated
by reference to Exhibit 2.1 to Digimarc's Report on Form 8-K, as filed with the Securities and Exchange Commission on July 17, 2008)3.1

Second Amended and Restated Certificate of Incorporation of the Registrant, as amended (incorporated by reference to Exhibit 3.1 of Exhibits to the Digimarc's Annual Report on Form 10-K, as filed with the
Securities and Exchange Commission on March 13, 2006)3.2

Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3.3 of Exhibits to Digimarc's Quarterly Report on Form 10-Q, as filed with the Securities and Exchange Commission on
August 9, 2005)31.1

Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer31.2

Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer32.1

Section 1350 Certification of Chief Executive Officer32.2

Section 1350 Certification of Chief Financial Officer


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