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

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FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

COMMISSION FILE NUMBER: 000-28317

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

Delaware

Delaware 94-3342784(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification Number)


19801 SW 72nd Ave, Ste 250, Tualatin, Oregon 97062(Address of principal executive offices)

Telephone: (503) 885-9699(Registrant's telephone number, including area code)

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

As
of October 31, 2002, 17,526,492 shares of common stock, $0.001 par value per share, of the registrant were outstanding.

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DIGIMARC CORPORATION  TABLE OF CONTENTS

|           |  |                                                                                                                 |  | Page No.
|---------- |  | --------------------------------------------------------------------------------------------------------------- |  | --------
|PART I.    |  | FINANCIAL INFORMATION                                                                                           |  |         
|Item 1.    |  | Financial Statements:                                                                                           |  |         
|           |  | Condensed Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001                            |  | 3       
|           |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2002 and 2001 |  | 4       
|           |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and 2001           |  | 5       
|           |  | Notes to Condensed Consolidated Financial Statements                                                            |  | 6       
|Item 2.    |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                           |  | 10      
|Item 3.    |  | Quantitative and Qualitative Disclosures about Market Risk                                                      |  | 27      
|Item 4.    |  | Controls and Procedures                                                                                         |  | 27      
|PART II.   |  | OTHER INFORMATION                                                                                               |  |         
|Item 1.    |  | Legal Proceedings                                                                                               |  | 28      
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                                                |  | 28      
|Signatures |  | 29                                                                                                             

2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

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

|                                     |                             | September 30,
2002                 |                                            | December 31,
2001 (1) |        
|------------------------------------ | --------------------------- | ---------------------------------- | ------------------------------------------ | --------------------- | -------
|ASSETS                               |                             |                                    |                                            |                       |        
|                                     | Current assets:             |                                    |                                            |                       |        
|                                     |                             | Cash and cash equivalents          |                                            | $                     | 41,474 
|                                     |                             | Short-term investments             |                                            |                       | 11,509 
|                                     |                             | Trade accounts receivable, net     |                                            |                       | 10,951 
|                                     |                             | Unbilled trade receivables         |                                            |                       | 5,161  
|                                     |                             | Inventory, net                     |                                            |                       | 4,945  
|                                     |                             | Other current assets               |                                            |                       | 2,226  
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total current assets                       |                       |        
|                                     | Property and equipment, net |                                    |                                            | 23,874                |        
|                                     | Intangibles                 |                                    |                                            | 27,324                |        
|                                     | Other assets, net           |                                    |                                            | 747                   |        
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total assets                               |                       | $      
|                                     |                             |                                    |                                            |                       |        
|LIABILITIES AND STOCKHOLDERS' EQUITY |                             |                                    |                                            |                       |        
|                                     | Current liabilities:        |                                    |                                            |                       |        
|                                     |                             | Accounts payable                   |                                            | $                     | 5,448  
|                                     |                             | Accrued payroll and related costs  |                                            |                       | 1,790  
|                                     |                             | Deferred revenue                   |                                            |                       | 2,960  
|                                     |                             | Other current liabilities          |                                            |                       | 92     
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total current liabilities                  |                       |        
|                                     | Other long-term liabilities |                                    |                                            | 10                    |        
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total liabilities                          |                       |        
|                                     | Stockholders' equity:       |                                    |                                            |                       |        
|                                     |                             | Common stock                       |                                            |                       | 18     
|                                     |                             | Additional paid-in capital         |                                            |                       | 174,914
|                                     |                             | Deferred stock compensation        |                                            |                       | (1,778 
|                                     |                             | Accumulated translation adjustment |                                            |                       | (87    
|                                     |                             | Warrant                            |                                            |                       | 675    
|                                     |                             | Accumulated deficit                |                                            |                       | (55,831
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total stockholders' equity                 |                       |        
|                                     |                             |                                    |                                            |                       |        
|                                     |                             |                                    | Total liabilities and stockholders' equity |                       | $      
|                                     |                             |                                    |                                            |                       |        

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See
Notes to Condensed Consolidated Financial Statements.

3

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

|                                                      |                                       | Three Months Ended
September 30, |        | Nine Months Ended
September 30, |       
|----------------------------------------------------- | ------------------------------------- | -------------------------------- | ------ | ------------------------------- | ------
|
|Revenue:                                              |                                       |                                  |        |                                 |       
|                                                      | Product and subscription              |                                  | $      | 8,093                           |       
|                                                      | Service                               |                                  |        | 18,421                          |       
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Total revenue                    |        |                                 | 26,514
|Cost of revenue:                                      |                                       |                                  |        |                                 |       
|                                                      | Product and subscription              |                                  |        | 6,399                           |       
|                                                      | Service                               |                                  |        | 10,876                          |       
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Total cost of revenue            |        |                                 | 17,275
|Gross profit                                          |                                       |                                  | 9,239  |                                 |       
|Operating expenses:                                   |                                       |                                  |        |                                 |       
|                                                      | Sales and marketing                   |                                  |        | 3,390                           |       
|                                                      | Research, development and engineering |                                  |        | 2,273                           |       
|                                                      | General and administrative            |                                  |        | 4,744                           |       
|                                                      | Restructuring charges, net            |                                  |        |                                |       
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Total operating expenses         |        |                                 | 10,407
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Operating loss                   |        |                                 | (1,168
|Other income (expense):                               |                                       |                                  |        |                                 |       
|                                                      | Interest income                       |                                  |        | 215                             |       
|                                                      | Interest expense                      |                                  |        | (4                              | )     
|                                                      | Other                                 |                                  |        | 29                              |       
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Total other income, net          |        |                                 | 240   
|                                                      |                                       |                                  |        |                                 |       
|Loss before provision for income taxes                |                                       |                                  | (928   | )                               |       
|Provision for income taxes                            |                                       |                                  |       |                                 |       
|                                                      |                                       |                                  |        |                                 |       
|                                                      |                                       | Net loss                         |        | $                               | (928  
|                                                      |                                       |                                  |        |                                 |       
|Net loss per sharebasic and diluted                  |                                       | $                                | (0.05  | )                               | $     
|Weighted average shares outstandingbasic and diluted |                                       |                                  | 17,461 |                                 |       

See
Notes to Condensed Consolidated Financial Statements.

4

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

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

See
Notes to Condensed Consolidated Financial Statements.

5

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

1.    The Company, Basis of Presentation

Digimarc Corporation ("Digimarc", the "Company", "our", "us" or "we") is a leading provider of patented digital watermarking technologies that allow imperceptible
digital code to be embedded in the printed or digital versions of media content, such as commercial and consumer photographs, movies, music, magazine advertisements, catalogs, product packages,
identification cards, financial instruments, passports and event tickets. In addition to a code that can be embedded within various types of media content, Digimarc's technologies include reader
software that, as a resident application on personal computers and other devices, enables the recognition of embedded codes. Digimarc also is a leading provider of identification card systems to
government agencies, which include driver's licenses, voter identification cards and similar systems.

On
December 21, 2001, the Company, through its wholly-owned subsidiary, Digimarc ID Systems, LLC and certain of that limited liability company's wholly-owned subsidiaries
(collectively "DIDS"), acquired certain assets of Polaroid Corporation, Polaroid ID Systems, Inc. and certain other affiliated entities of Polaroid Corporation. As part of the transaction,
Digimarc also assumed certain liabilities from the selling entities. The acquisition was accounted for using the purchase method of accounting. Hereinafter, the entity that resulted from this
transaction will be referred to as DIDS.

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

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

These
condensed consolidated financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2001 included in the
Company's 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC") on April 1, 2002.

2.    Loss Per Share Computation

Basic and diluted net loss per share is computed using the weighted average number of shares of common stock outstanding for the period. The effect of 686 and 843
outstanding stock options and warrants for the three and nine months ended September 30, 2002, respectively, and 1,395 and 1,349 outstanding stock options and warrants for the three and nine
months ended September 30, 2001, respectively, are excluded from the calculation of diluted net loss per share for the periods presented as their inclusion would be antidilutive.

6

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3.    Segment Information

The Company derives its revenue from a single operating segment, secure media solutions. Revenue concentration information is as follows:

|           |  | Three Months Ended
September 30, |   | Nine Months Ended
September 30, |  
|---------- |  | -------------------------------- | - | ------------------------------- | -
|
|Customer A |  | *                                |   | 70                              | %
|Customer B |  | *                                |   | 11                              | %
|Customer C |  | 19                               | % | *                               |  

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4.    Stock-based Compensation Expense Allocation

Stock-based compensation expense is based on the difference between the fair market value of the Company's common stock and the exercise price of options to
purchase that stock on the date of grant, and is being recognized over the vesting period of the related options, usually four years. Stock-based compensation expense of $447 and $1,381 was recorded
for the three and nine months ended September 30, 2002, respectively, and is included in the respective statements of operations expense categories for the employees to which it applies. At
September 30, 2002, $1,778 of stock-based compensation remains deferred and we expect approximately $446 and $1,332 to be amortized to expense in the remainder of 2002 and all of 2003,
respectively.

5.    Commitments and Contingencies

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the
United States District Court for the Southern District of New York naming Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's initial public offering as defendants.
The complaints have since been consolidated into a single action. The complaints allege, among other things, that the underwriters of the Company's initial public offering violated securities laws by
failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company's initial public offering registration statement.
Plaintiffs seek, among other things, damages in an unspecified amount as well as costs and expenses, including attorneys' fees. Similar complaints have been filed against multiple other issuers that
have had initial public offerings since 1998. The Company intends to defend these actions vigorously. During the third quarter, settlement discussions were initiated in connection with this
litigation. 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. Although no assurance can be given that this matter will be resolved favorably, the Company believes that the resolution of these lawsuits will not have a material adverse effect on its
consolidated financial position, results of operations or cash flows.

In
April 2000, Digimarc filed a patent infringement case against Verance Corporation in the United States District Court for the District of Oregon in connection with Digimarc's
patents 5,850,481, 5,636,292, and 5,832,119. In September 2000, Digimarc filed an additional patent infringement case against Verance Corporation in the United States District Court for the
District of Oregon in connection with Digimarc's patent 6,122,392. In September 2001, Digimarc filed a third patent infringement case against Verance Corporation in the United States District
Court for the District of Oregon in connection with Digimarc's patent 6,266,430. In November 2001, Verance Corporation filed counterclaims against Digimarc in the United States District Court
for the District of Oregon alleging patent infringement, fraud, and monopolistic activities. On August 1, 2002, Digimarc and Verance Corporation entered into a settlement agreement pursuant to
which each dismissed its claims against

7

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the other. Additionally, Verance Corporation entered into a royalty-bearing license for the use of Digimarc's patent portfolio in media content management products and services and media information
products and services pursuant to which Verance Corporation agreed to pay a license initiation fee and certain minimum guaranteed amounts during the term of the license, including a minimum guaranteed
royalty commitment by Verance Corporation to Digimarc in excess of $2 million.

In
October 2002, Digimarc filed a patent infringement case against Spectra Systems Corporation in the United States District Court for the District of Delaware alleging
infringement of Digimarc's patents 5,636,292, 5,745,604 and 6,385,330. The Company intends to prosecute vigorously its claims against Spectra Systems Corporation.

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

6.    Comprehensive Income (Loss)

The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 130,Reporting Comprehensive
Income, which establishes standards of reporting and display of comprehensive income (loss) and its components of net income (loss) and other comprehensive income (loss). Other
comprehensive income (loss) refers to revenues, expenses, gains and losses that are not included in net income (loss) but rather are recorded directly in stockholders' equity. The following provides a
summary of comprehensive loss:

|                                             |  | Three Months Ended
September 30, |      | Nine Months Ended
September 30, |  
|-------------------------------------------- |  | -------------------------------- | ---- | ------------------------------- | -
|
|Net loss                                     |  | $                                | (928 | )                               | $
|Change in accumulated translation adjustment |  |                                  | (51  | )                               |  
|                                             |  |                                  |      |                                 |  
|Comprehensive loss                           |  | $                                | (979 | )                               | $
|                                             |  |                                  |      |                                 |  

7.    Restructuring

The Company recorded restructuring charges that include employee severance costs associated with the June 2002 reduction of 30 positions and costs
associated with closing and relocating facilities from Tulsa, Oklahoma to Fort Wayne, Indiana. Gross restructuring charges were zero and $575 related to these actions for the three and nine months
ended September 30, 2002, respectively. Excess leased facility cost related to non-cancelable leases included in restructuring charges extend over the next 16 months. As of
September 30, 2002, approximately $430 of cash had been paid related to restructuring charges.

In
the second quarter of 2002 the Company adjusted its estimate relating to restructuring charges taken in the fourth quarter of 2001. The Company reduced its remaining restructuring
accrual by $82 related to a change in estimate for excess leased facility costs.

8.    Pro Forma Financial Information Related to Acquisitions

On December 21, 2001, the Company, through DIDS, acquired certain assets used primarily in the United States government identification systems business and
foreign government digital identification systems business of Polaroid Corporation, Polaroid ID Systems, Inc. and certain other affiliated entities of Polaroid Corporation (collectively known
as Large Government Program Identification Business (a division of Polaroid Corporation), or "LGP"). The acquisition was accounted for using the purchase method of accounting. The total purchase price
was approximately $61.4 million. The purchase price

8

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was allocated to assets acquired and liabilities assumed based on their fair values. Assets acquired consisted primarily of long lived assets including fixed assets and intangibles of approximately
$42.1 million, accounts receivable of approximately $13.5 million and inventories of approximately $6.0 million.

The
following unaudited pro forma financial information combines the results of operations of the Company and LGP assuming the acquisition was consummated at the beginning of the periods
presented. The unaudited pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented. In addition, they are not
intended to be a projection and do not reflect any synergies that might be achieved from combined operations.

Nine Months Ended
September 30,2002

2001(unaudited)Revenue

$
65,809

$
65,155Net loss


(8,464
)

(9,277
)Net loss per share-basic and diluted

$
(0.49
)
$
(0.56
)


9.    Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143,Accounting for Asset Retirement
Obligations. SFAS No. 143 requires that the fair value of the liability for an asset retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and amortized over the useful
life of the asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We are currently evaluating the requirements and impact of this standard, but its adoption is
not expected to have a material impact on our results of operations and financial position.

In
April, 2002, the FASB issued SFAS No. 145,Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and
Technical Corrections. SFAS No. 145 rescinds SFAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS No., 145, companies will be required to apply the criteria in Accounting Principles Board ("APB") Opinion
No. 30,Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events
and Transactions, in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13
to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback
transactions. SFAS No. 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS No. 4
encouraged. We are currently evaluating the requirements and impact of this standard, but its adoption is not expected to have a material impact on our results of operations and financial position.

In
July 2002, the FASB issued SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities,which changes
the way a company will report the expenses related to restructuring. SFAS No. 146 is required to be adopted for exit or disposal activities initiated after December 31, 2002. We
are currently evaluating the requirements and impact of this standard, but its adoption is not expected to have a material impact on our results of operations and financial position.

9

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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. The words "expect," "anticipate," "intend," "plan" and similar expressions identify forward-looking statements.
Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Risks Related to our Business"
and "Risks Related to our Industry," and those risks described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 1, 2002. This
discussion and analysis should also be read in conjunction with our interim unaudited Condensed Consolidated Financial Statements and related notes included in this quarterly report on
Form 10-Q.

Overview

Digimarc is a leading provider of digital watermarking technologies that allow imperceptible digital code to be embedded in the printed or digital versions of
media content, such as identification documents, commercial and consumer photographs, movies, music, magazine advertisements, catalogs, product packages, identification cards, financial instruments,
passports, and event tickets. In addition to a code that can be embedded within various types of media content, our technologies include reader software that, as a resident application on personal
computers and other devices, enables the recognition of these embedded codes. Digimarc also is a leading provider of identification card systems to government agencies, which include driver's
licenses, voter identification cards and similar systems. We believe our technologies have many potential applications. We are developing products and services and licensing our intellectual property
to address what we believe are our four largest near-term market opportunities: the deterrence of digital counterfeiting and piracy; the enhancement of Internet access and navigation; the
enhancement and protection of audio and video digital files; and the enhancement of information capture and analysis technology for the defense and intelligence communities.

Critical Accounting Policies and Estimates

The preparation of condensed consolidated financial statements requires Digimarc to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts,
inventories, intangible assets, income taxes, restructuring, long-term service contracts, warranties, investments, contingencies and litigation. We base our estimates on historical
experience and on various other assumptions we believe 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.

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



10

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11

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Results of Operations

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

|                                       |                                       | Three Months Ended
September 30, |    | Nine Months Ended
September 30, |    
|-------------------------------------- | ------------------------------------- | -------------------------------- | -- | ------------------------------- | ---
|
|Revenue:                               |                                       |                                  |    |                                 |    
|                                       | Product and subscription              |                                  | 31 | %                               | 13 
|                                       | Service                               |                                  | 69 | %                               | 87 
|                                       |                                       |                                  |    |                                 |    
|                                       |                                       | Total revenue                    |    | 100                             | %  
|Cost of revenue:                       |                                       |                                  |    |                                 |    
|                                       | Product and subscription              |                                  | 24 | %                               | 1  
|                                       | Service                               |                                  | 41 | %                               | 51 
|                                       |                                       |                                  |    |                                 |    
|                                       |                                       | Total cost of revenue            |    | 65                              | %  
|Gross profit                           |                                       | 35                               | %  | 48                              | %  
|Operating expenses:                    |                                       |                                  |    |                                 |    
|                                       | Sales and marketing                   |                                  | 13 | %                               | 84 
|                                       | Research, development and engineering |                                  | 9  | %                               | 51 
|                                       | General and administrative            |                                  | 18 | %                               | 103
|                                       | Restructuring charges, net            |                                  | 0  | %                               | 0  
|                                       |                                       |                                  |    |                                 |    
|                                       |                                       | Total operating expenses         |    | 40                              | %  
|                                       |                                       |                                  |    |                                 |    
|                                       |                                       | Operating loss                   |    | (5                              | )% 
|                                       |                                       | Total other income, net          |    | 1                               | %  
|                                       |                                       |                                  |    |                                 |    
|Loss before provision for income taxes |                                       | (4                               | )% | (150                            | )% 
|Provision for income taxes             |                                       | 0                                | %  | 0                               | %  
|                                       |                                       |                                  |    |                                 |    
|                                       |                                       | Net loss                         |    | (4                              | )% 
|                                       |                                       |                                  |    |                                 |    

Revenue

Total revenue was $26.5 million and $65.8 million for the three and nine months ended September 30, 2002, respectively, compared to total
revenue of $3.1 million and $11.0 million for the three and nine
months ended September 30, 2001. The increase in total revenue related predominately to revenue recognized from the acquired assets of DIDS. This revenue is primarily derived from
long-term contracts with sovereign governments, and is relatively consistent and predictable over time, although there may be some quarter to quarter variations. The Company has an
agreement with a consortium of central banks that accounted for less than 10% of our revenue for the three and nine months ended September 30, 2002 compared to approximately 70% and 62% of our
total revenue for the three and nine months ended September 30, 2001, respectively. The consortium has the right to terminate this agreement before the end of its term. Unless the consortium
exercises this right, we expect to earn revenue under the agreement through the end of 2003. We intend to pursue further business with the consortium and may be able to achieve other sources of
revenue in future periods by providing additional products and services to them and other related institutions. We also expect to develop new products and services, which we anticipate selling to
other customers through a variety of pricing plans, including license fees per document from issuers of documents other than banknotes and from identification document issuers, magazine advertisers
and publishers, commercial printers, and other producers of print and digital media. We also expect to develop new products and services for the defense and intelligence sectors. Successful
introduction and implementation of these new products and services, if achieved, would significantly change the mix and concentration of our future revenue.

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Product and subscription.Product and subscription revenue was $8.1 million and $15.2 million for the three and
nine months ended September 30, 2002, respectively, compared to $0.4 million and $2.0 million for the three and nine months ended September 30, 2001, respectively. The
$7.7 million or 1,997% increase and $13.2 million or 666% increase for the three and nine months ended September 30, 2002, respectively, were primarily related to increased sales
to international customers of products related to identification card production. An event-driven sale to an international customer during the quarter accounted for approximately 63% and 33% of
product and subscription revenue for the three and nine months ended September 30, 2002, respectively. We also signed new license agreements that accounted for approximately 10% and less than
10% of product and subscription revenue for the three and nine months ended September 30, 2002, respectively. We did not have any sales of such products to international customers in the three
and nine months ended September 30, 2001.

Service.Service revenue was $18.4 million and $50.6 million for the three and nine months ended
September 30, 2002, respectively, compared to $2.7 million and $9.0 million for the three and nine months ended September 30, 2001, respectively. The $15.7 million
or 587% increase and the $41.6 million or 461% increase for the three and nine months ended September 30, 2002, respectively, were primarily related to increased revenue related to state
identification card and drivers' license contracts. These contracts were acquired in December 2001 with the purchase of DIDS.

Cost of Revenue

Product and subscription.Cost of product and subscription revenue primarily includes compensation for operations personnel,
costs related to goods sold to end-users, Internet service provider connectivity charges, and image search data fees to support the services offered to our subscription customers. Cost of
product and subscription revenue was $6.4 million and $10.0 million for the three and nine months ended September 30, 2002, respectively, compared to less than $0.1 million
and $0.1 million for the three and nine months ended September 30, 2001, respectively. Cost of product and subscription revenue increased sequentially due to a low margin, event-driven
sales transaction that occurred during the quarter. The changes relate primarily to increased costs of goods related to event-driven identification card products sold to international customers. Costs
and margins associated with product and subscription sales vary from period to period due to product and customer mix.

Service.Cost of service revenue primarily includes compensation for field operations personnel, software engineers, quality
assurance personnel, product managers and business development personnel, cost of materials used, outside contractors, and travel costs directly attributable to service and development contracts. Cost
of service revenue was $10.9 million and $30.0 million for the three and nine months ended September 30, 2002, respectively, compared to $1.6 million and
$5.2 million for the three and nine months ended September 30, 2001, respectively. The $9.3 million or 601% increase and $24.8 million or 480% increase for the three and
nine months ended September 30, 2002, respectively, were primarily the result of the increased costs related to the support of long-term service contracts with various government
agencies to produce identification cards and drivers' licenses. The increased costs include the addition of field operations personnel and materials used to deliver the services. Field operations
employees totaled 163 and zero as of September 30, 2002 and 2001, respectively.

Operating Expenses

Sales and marketing.Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and
marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research and costs associated with marketing programs, such as trade shows, public relations, new
product launches, and bid costs for new contracts. Sales and marketing expenses were $3.4 million and $11.2 million for the three and nine months ended September 30, 2002,

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respectively, compared to $2.6 million and $8.2 million for the three and nine months ended September 30, 2001, respectively. The $0.8 million or 31% increase for the
three month period resulted from increased costs of $0.6 million for salaries and employee related costs, $0.1 million for additional administrative costs associated with sales and
marketing, and $0.2 million related to decreased use of sales and marketing personnel to provide services for our revenue generating contracts that would have been allocated to cost of service
revenue or capitalized to fixed assets, partially offset by decreased marketing and advertising costs of $0.1 million. The $3.0 million or 35% increase for the nine month period resulted
from increased costs of $1.2 million for salaries and employee related costs, $0.3 million in additional contractor and temporary help fees, $0.2 million in additional
administrative costs associated with sales and marketing, and $1.8 million related to decreased use of sales and marketing personnel to provide services for our revenue generating contracts
that would have been allocated to cost of service revenue or capitalized to fixed assets, partially offset by decreased marketing and
advertising costs of $0.5 million. Sales and marketing employees totaled 64 and 71 as of September 30, 2002 and 2001, respectively.

Research, development and engineering.Research, development and engineering expenses consist primarily of compensation,
benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $2.3 million and
$7.3 million for the three and nine months ended September 30, 2002, respectively, compared to $1.6 million and $4.9 million for the three and nine months ended
September 30, 2001, respectively. The $0.7 million or 44% increase for the three month period resulted from increased costs of $1.7 million related to salaries and employee
related costs, $0.8 million related to outside consultants and temporary help, and $0.1 million related to administrative costs associated with research, development, and engineering
activities, partially offset by a decrease of $1.9 million related to increased use of research, development, and engineering personnel to provide services for our revenue generating contracts
that were allocated to cost of service revenue or capitalized to fixed assets. The $2.4 million or 49% increase for the nine month period resulted from increased costs of $3.9 million
related to salaries and employee related costs, $3.0 million related to outside consultants and temporary help, and $0.1 million related to administrative costs associated with research,
development, and engineering activities, partially offset by a decrease of $4.6 million related to increased use of research, development, and engineering personnel to provide services for our
revenue generating contracts that were allocated to cost of service revenue or capitalized to fixed assets. Research, development and engineering personnel totaled 150 and 83 as of
September 30, 2002 and 2001, respectively.

General and administrative.General and administrative expenses consist primarily of compensation, benefits and related costs
of executive, finance, information technology and administrative personnel, facilities costs, legal, accounting and other professional fees and depreciation and amortization expense. General and
administrative expenses were $4.7 million and $16.2 million for the three and nine months ended September 30, 2002, respectively, compared to $3.2 million and
$9.6 million for the three and nine months ended September 30, 2001, respectively. The $1.6 million or 50% increase for the three months ended September 30, 2002 resulted
from increased costs of $0.6 million related to salaries and other employee related costs, including travel expenses and $1.3 million related to administrative costs, including
depreciation of non-program assets and amortization of intangibles, partially offset by $0.2 million related to the decreased use of contractors and outside consultants and
$0.1 million in increased use of general and administrative personnel to provide services for our revenue generating contracts that were allocated to cost of service revenue or capitalized to
fixed assets. The $6.6 million or 69% increase for the nine month period resulted from increased costs of $3.0 million related to salaries and other employee related costs, including
travel expenses, $0.4 million related to outside contractors and temporary help, and $4.9 million related to administrative costs, including depreciation of non-program
assets and amortization of intangibles, partially offset by $1.7 million in increased use of general and administrative personnel to provide services for our revenue generating contracts that
were allocated to cost of service revenue or

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capitalized to fixed assets. General and administrative employees totaled 49 and 31 as of September 30, 2002 and 2001, respectively.

Restructuring charges.Restructuring charges include employee severance costs associated with the June 2002 reduction
of 30 positions and the cost of abandoned space. Net restructuring charges were
zero and $0.5 million for the three and nine months ended September 30, 2002, respectively, compared to zero for the three and nine months ended September 30, 2001. Gross
restructuring charges recorded in the three and nine months ended September 30, 2002 were $0.6 million, which were partially offset by a $0.1 million reduction to the
restructuring accrual remaining on the books from charges taken in the fourth quarter of 2001. The reduction related to a change in estimate for excess leased facility charges.

Stock-based compensation.Stock-based compensation expense is based on the difference between the fair market value of the
Company's common stock and the exercise price of options to purchase that stock on the date of grant, and is being recognized over the vesting period of the related options, usually four years.
Stock-based compensation expense of $0.4 million and $1.4 million was recorded for the three and nine months ended September 30, 2002, respectively, compared to
$0.5 million and $1.5 million for the three and nine months ended September 30, 2001, respectively, and is included in the respective statements of operations expense categories
for the employees to which it applies. At September 30, 2002, $1.8 million of stock-based compensation remains deferred and we expect approximately $0.5 million and
$1.3 million to be amortized to expense in each of the remainder of 2002 and all of 2003, respectively.

Other Income (Expense).Other income (expense) consists primarily of interest received and paid. Other income (expense) was
$0.2 million and $0.9 million for the three and nine months ended September 30, 2002, respectively, compared to $1.2 million and $4.8 million for the three and nine
months ended September 30, 2001, respectively. The $1.0 million or 80% decrease and $3.9 million or 82% decrease for the three and nine months ended September 30, 2002,
respectively, resulted from significantly lower cash and cash equivalent balance earning interest due to the funds used in purchasing DIDS as well as lower interest rates in 2002.

Provision for Income Taxes.We have recognized operating losses since inception and as such have not incurred income tax
expense.

Liquidity and Capital Resources

As of September 30, 2002, we had cash and cash equivalents and short-term investments of $53.0 million, representing a decrease of
$8.6 million from $61.6 million at December 31, 2001. Working capital at September 30, 2002 was $66.0 million, compared to working capital of $79.2 million at
December 31, 2001. The decrease in working capital is attributable primarily to the cash used for the purchase of property and equipment of $14.0 million.

The
$4.6 million of cash provided by operations in the first nine months of 2002 was positively impacted by depreciation and amortization of $6.7 million, an increase in
deferred revenue of $2.5 million, an increase in accounts payable of $2.0 million, non-cash charges related to stock-based compensation of $1.4 million, a decrease in
inventory (net) of $0.7 million, and an increase in payroll-related accruals of $0.6 million. Cash provided by operations in the first nine months of 2002 was negatively impacted by a
net loss of $8.5 million and an increase in trade and unbilled accounts receivable (net) of $0.6 million.
The $10.5 million of cash used in operations in the first nine months of 2001 was positively impacted by depreciation and amortization of $1.8 million and non-cash charges
related to stock-based compensation of $1.5 million. Cash used in operations in the first nine months of 2001 was negatively impacted by a net loss of $12.2 million and an increase in
trade and unbilled accounts receivable (net) of $0.8 million.

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The $11.1 million of cash provided by investing activities for the nine months ended September 30, 2002 related primarily to the sale or maturity of $38.0 million in
short-term investments, offset by the purchase of $12.6 million in short-term investments and the addition of $14.0 million of property and equipment. Investing
activities provided cash of $29.8 million for the nine months ended September 30, 2001 related primarily to $74.8 million of sales or maturities in short-term
investments offset by $44.2 million of purchases of short-term investments.

The
$1.1 million of cash provided by financing activities related primarily to proceeds from the issuance of stock for $1.6 million related to the employee stock option and
employee stock purchase plans, partially offset by $0.5 million of principal payments under capital leases. Financing activities provided cash of $1.1 million for the nine months ended
September 30, 2001 primarily as a result of the issuance of stock for $1.2 million related to the employee stock option and employee stock purchase plans, partially offset by
$0.1 million of principal payments under capital leases.

We
have computers and office equipment financed under long-term capital leases that expire over the next 23 months. As of September 30, 2002, we had an
outstanding balance of approximately $0.1 million of capital lease obligations. Other significant commitments consist of obligations under non-cancelable operating leases, which
totaled $8.5 million as of September 30, 2002, and are payable in monthly installments through October 2010.

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

We
believe that our current cash, cash equivalents, and short-term investment balances will satisfy our projected working capital and capital expenditure requirements for at
least the next 12 months. Thereafter, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities. We may not be able to obtain additional financings or
credit facilities, or if these funds are available, they may not be available on satisfactory terms.

Recent Accounting Pronouncements.

In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143,Accounting for Asset Retirement
Obligations. SFAS No. 143 requires that the fair value of the liability for an asset retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and amortized over the useful
life of the asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We are currently evaluating the requirements and impact of this standard, but its adoption is
not expected to have a material impact on our results of operations and financial position.

In
April, 2002, the FASB issued SFAS No. 145,Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and
Technical Corrections. SFAS No. 145 rescinds SFAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS No. 145, companies will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to
require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions.
SFAS No. 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS No. 4 encouraged. We are
currently evaluating the requirements and impact of this standard,

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but its adoption is not expected to have a material impact on our results of operations and financial position.

In
July 2002, the FASB issued SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities,which changes
the way a company will report the expenses related to restructuring. SFAS No. 146 is required to be adopted for exit or disposal activities initiated after December 31, 2002. We are
currently evaluating the requirements and impact of this standard, but its adoption is not expected to have a material impact on our results of operations and financial position.

Risks Related to Our Business

Uncertainties associated with the integration of the Digimarc ID Systems business into our existing business could cause an interruption or loss in momentum in our existing
business and operating activities and the business and operating activities of the business acquired and, if material, might harm us

The integration of the operations of Digimarc ID Systems, LLC (collectively referred to as "DIDS") and its subsidiaries into our business involves a number of
risks, including:



The
process of integrating DIDS' operations could cause an interruption or loss in momentum in our business and operating activities and, if material, could harm our business. Moreover,
in the course of the integration and transition effort, we may discover facts or circumstances that were not known or apparent prior to the date we acquired the assets from Polaroid Corporation,
Polaroid ID Systems, Inc. and some other affiliated entities of Polaroid Corporation or during our due diligence review of these assets prior to the acquisition. These facts and circumstances
could result in delays or interruptions in the integration and transition and may have other negative effects which, if material, could adversely affect our business.

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We may incur additional charges related to the integration of the Digimarc ID Systems business into Digimarc which might exceed our expectations and materially affect our
business, financial condition and results of operations

In connection with the acquisition of DIDS, we may incur charges or capital expenditures associated with integrating the acquired business with our existing one.
These charges may include:



While
we have completed three quarters of transition activities, these activities and the risks associated with them will continue through the fourth quarter. We believe that most
activities associated with the transition of the business and its integration into the Company will be completed by the end of the year, and that any lingering issues will be reflected in the 2003
expected results.

While
many of the transition activities are nearing completion, the aggregate amount of additional expenses, if any, is not yet determinable, but could be significant. In addition, we
cannot assure you that we will not incur additional charges in subsequent quarters to reflect costs associated with the integration of DIDS' operations. Adverse developments could include employee
turnover, problems in integrating new financial and information systems, problems associated with the relocation to new office space, and remaining film and other dependencies involving Polaroid.
While we are not aware of specific problems or associated risks at this time, any remaining costs that exceed our expectations could materially affect our business, financial condition, and results of
operations.

We may not realize the synergistic, strategic, and financial benefits expected from the acquisition of DIDS

We cannot assure you that we will realize the synergistic, strategic and financial benefits sought through the acquisition of DIDS. Although we view this
acquisition as an opportunity to significantly enhance the security and usefulness of drivers' licenses and other DIDS products, we cannot assure you that we will be successful in combining our
current technological applications and product offerings with those of DIDS or that the combined product offerings will be acceptable in the marketplace. Factors that could affect acceptance of these
combined product offerings are changes in government regulations and industry standards, and increased competition from DIDS' primary competitors who may develop superior or alternative technology
that is more widely acceptable in the marketplace. We cannot assure you that, if we fail to realize the synergistic, strategic and financial benefits sought through the acquisition of DIDS, the
resulting effect will not harm our business, operating results and financial condition.

We have a history of losses and expect future losses and we cannot assure you that we will achieve profitability

We have incurred significant net losses since inception and we expect to incur a loss for the 2002 fiscal year in light of our planned operating expenditures. We
incurred net losses of $19.2 million in 2001. We have not been profitable and cannot assure you that we will realize sufficient revenue to achieve profitability. Our accumulated deficit as of
September 30, 2002 was approximately $55.8 million. In order to achieve profitability, we will need to generate significantly higher revenue than we have in prior years. Even if we
ultimately achieve profitability, we may not be able to sustain

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or increase our profitability. If our revenue grows more slowly than we anticipate, or if our operating expenses exceed our expectations, our operating results will be harmed and we may not be
profitable.

Because some of our revenue models relating to anticipated products and services are under development and the corresponding anticipated products and services may fail to
attract or retain customers, we cannot assure you that anticipated products and services will generate or sustain revenues

Our business involves embedding digital watermarks in traditional and digital media, including identification documents, secure documents, and images distributed
on the Internet. Through 2001, our revenue stream was based primarily on a combination of development, consulting, subscription and license fees from copyright communication, from Secure Document
applications and from Media Commerce applications. Beginning in 2002 and into the future, we have seen, and we anticipate, that an increasing share of our revenue will be from security related
applications in the government and commercial market areas (including identification systems) and from sales of other applications of our digital watermarking technologies (including to the defense
and intelligence communities). We have not fully developed revenue models for our future applications. In addition, because these products are not yet fully established in the marketplace and because
these products will be sold in new and undeveloped markets, we cannot be certain that the pricing structure and product marketing that have been developed and that are being developed currently for
these products will be accepted. We cannot assure you that our anticipated products and services will be able to compete effectively against other alternative technologies in our target markets or
that we will be able to compete effectively against current or future digital watermarking companies in terms of price, performance, applications or other features of their technologies. In addition,
as we develop models for generating revenue, they may not be sustainable over time, and as a result, our business, operating results and financial condition may seriously be harmed.

The loss of any large contract may seriously harm our business, operating results and financial condition

We have historically derived a substantial portion of our revenue from a consortium of leading central banks with which we have a development and license
agreement related to banknote counterfeit deterrence. Revenue from products and services provided to this significant customer accounted for 56% of our total revenue in 2001. With the acquisition of
DIDS, revenue generated from the consortium is expected to significantly decrease as a percentage of our total revenue and, in fact, has dropped below 10% for the current fiscal year to date; however,
the loss of this consortium as a customer could harm our business, operating results and financial condition. The consortium has the right to terminate the agreement prior to the expiration of its
term. Unless the consortium exercises this right, we expect to earn revenue under the agreement through at least 2003, which concludes the current agreement with the consortium of banks. While we are
optimistic that the agreement will be renewed for future periods, we cannot guarantee that this will happen.

Under
the terms of our agreement with the consortium, we are obliged to keep the identity of the participating banks, design of the system and timetable for deployment confidential. Any
change in our relationship with the consortium, including any actual or alleged breach of the contract by either party or the early termination of, or any other material change in, the agreement would
seriously harm our business, operating results and financial condition.

Separately,
contracts between state government agencies and DIDS generally have a three to five year term, after which the government agency can re-open the contract for
bidding. To the extent that some of these contracts generate significant revenue for us, the loss of any one or more of them may seriously harm our business, operating results and financial condition.

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Our future growth will depend on the successful implementation of our product solutions by third-party partners

The Digimarc MediaBridge system, personal identification systems products and other applications and services that we intend to provide in the future will rely on
the successful implementation of our product solutions, including our reader technology, by third-party software developers and original equipment manufacturers. We anticipate maintaining and entering
into agreements with third-party vendors to create and promote products that incorporate, embed, integrate or bundle our technologies. If we fail to obtain partners that will incorporate, embed,
integrate or bundle our technologies, or these partners are unsuccessful in their efforts, our business, operating results and financial condition could be seriously harmed. In addition, if our
technologies do not perform according to market expectations, our business will be seriously harmed.

We have a limited operating history and are subject to the risks encountered by early-stage companies

We incorporated in January 1995. Accordingly, we have a limited operating history, and our business and prospects must be considered in light of the risks
and uncertainties to which early-stage companies in new and rapidly evolving markets, such as digital watermarking, are exposed. These risks include the following:



We
cannot assure you that our business strategy will be successful or that we will successfully address these risks and the other risks described elsewhere in this report.

Our new revenue sources are tied largely to the government procurement process that is subject to potential delay and unpredictability

Both our government programs business and personal identification systems business derive substantial portions of their revenue from government contract awards.
Moreover, in our personal identification systems business, aggregate revenue amounts often are subject to significant swings resulting from large, event-driven activities which occur from time to
time, such as voter registration programs. Additionally, many contracts in our government programs business and personal identification systems business are awarded based on a bid or request for
proposal process. Consequently, large components of new revenue are tied to procurement schedules, which could shift as the needs of the related government procurement agencies change. Such a shift,
which is outside of our control, could result in bookings sliding out of the forecasted quarter. Furthermore, these government contracts result from purchasing decisions made by public sector agencies
that are often subject to political influence, onerous procurement procedures, budget changes, appropriations cycles and award protests. Any change in purchasing decisions would have an impact on the
predictability of our quarterly results and may potentially have a material negative effect on our financial position, results of operation or cash flows.

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

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

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



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

The markets for digital watermark applications are new and developing

Digital watermarking is a new and developing technology. Our success depends on the acceptance of this technology and the adoption of applications in areas such
as digital media commerce, counterfeiting and piracy deterrence, self-authentication of documents, and security and intelligence applications. The markets for products and services using
digital watermarks are rapidly evolving and are characterized by an increasing number of market entrants who have introduced or developed products and services using digital watermarking or
alternative technologies. As is typical in a new and rapidly evolving industry, demand and market acceptance of recently introduced products and services

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are subject to a high level of uncertainty. Our products and services relating to digital watermarking are currently used by only a limited number of customers. It is difficult to predict the future
growth rate, if any, and ultimate size of these markets or our anticipated future markets. We cannot assure you that new markets for our products and services will develop or that our existing markets
will grow.

We may not be able to adequately protect our intellectual property, and we may be subject to infringement claims

Our success depends on our proprietary technologies. We rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures
and licensing arrangements to establish and protect our proprietary rights. We face risks associated with our patent position, including the potential need to engage in significant legal proceedings
to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our
patents and the possibility that our products may infringe patent rights of third parties. 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.

As
part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, 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 in foreign countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States.

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

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

We
have registered "DIGIMARC", "MARCSPIDER", "MARCCENTRE", "PICTUREMARC" and the "D" logo as trademarks in the United States and some other countries, and are pursuing registration of
the "DIGIMARC" trademark in additional countries. We also have trademark rights with respect to "MediaBridge" and are pursuing registration of this mark in the United States and other countries.
However, our tradenames or trademarks may be registered by third parties in other countries, impairing our ability to enter and compete in these markets. In the United States, the trademarks
"Digimark" and "Mediabridge" and the domain names "Digimark.com" and "Mediabridge.com" have been registered by unrelated companies. While we have successfully co-existed with these other
companies, we cannot assure you that this situation will continue. If we were forced to

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change our name or were prevented from using our other brand names, we would lose a significant amount of our brand equity, and our business would suffer.

As
more companies enter the digital watermarking marketplace and develop intellectual property rights, it is increasingly likely that claims may arise which assert that some of our
products or services infringe upon other parties' intellectual property rights. These claims could subject us to costly litigation, divert management resources and result in the invalidation of our
intellectual property rights. These claims may require us to pay significant damages, cease production of infringing products, terminate our use of infringing technologies or develop
non-infringing technologies. In these
circumstances, continued use of our technologies may require that we acquire licenses to the intellectual property that is the subject of the alleged infringement, and we might not be able to obtain
these licenses on commercially reasonable terms or at all. Our use of protected technologies may result in liability that threatens our continuing operation.

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

Our products and services involve the embedding of digital code in media content that is imperceptible in normal use but that can be read by digitally-enabled
devices. The success of our products and services depends on the security of our media commerce, anti-counterfeiting and piracy systems, self-authentication solutions, and
supporting infrastructure. Security breaches of these systems and solutions could damage our reputation and expose us to a risk of loss or litigation and possible liability. The security measures that
we use in our products and services may not prevent security breaches, and failure to prevent these security breaches may disrupt our business. A party who is able to circumvent our security measures
could misappropriate proprietary information or cause interruptions or otherwise damage our products, services and reputation and the properties of our customers. If unintended parties obtain
sensitive data and information, or create bugs or viruses in an attempt to sabotage the functionality of our products and services, we may receive negative publicity, incur liability to our customers
or lose the confidence of our customers, any of which may cause the termination or modification of our contracts.

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

Our products could have unknown defects or errors

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

Because
customers rely on our products for critical security applications, defects or errors in our products might discourage customers from purchasing our products. These defects or
errors could also
result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty disclaimers and liability limitation clauses in our sales
agreements,

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these contractual provisions are sometimes not included and may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this insurance coverage may not
adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or
adequately covered by insurance, our business could be materially harmed.

During
the third quarter, DIDS completed efforts in a number of jurisdictions to finish projects or correct defects that had been identified during the acquisition process. Those
projects have proceeded well. Nonetheless, there may be additional issues or defects that we have not yet identified that may require significant efforts and resources to correct.

We may encounter difficulties managing our planned growth and expansion that may harm our business

As of September 30, 2002 we had 426 employees and 93 contract workers, although we carried out reductions in workforce in June 2002 and we
anticipate additional reductions in workforce through the end of the current fiscal year. To manage our operations, management must continue to improve our operational and financial systems and train,
improve and manage our employee base. Additional growth of our product lines or business could significantly strain our managerial and financial resources. If we cannot manage our growth effectively,
we may not be able to coordinate the activities of our technical, accounting and marketing staffs, and our business could be harmed.

We may acquire other businesses or technologies and, if we do, we may be unable to integrate them with our own business, or we may impair our financial performance as a result
of doing so

From time to time we have discussions with third parties about potential acquisitions. If appropriate opportunities present themselves, we may attempt to acquire
other businesses or technologies. We may not be able to identify, negotiate or finance any future acquisition successfully. Despite the acquisition of DIDS, we have limited experience in integrating
an acquired business into our existing business. The process of integration may produce operating difficulties and expenditures and may require significant attention of our management that otherwise
would be available for the ongoing development of our business. In the end, we may be unsuccessful in integrating an acquired business or technology with our existing business. Moreover, if we make
acquisitions, we may issue shares of our stock that would dilute the equity holdings of our existing stockholders, incur debt, assume contingent liabilities or create additional expenses related to
amortizing goodwill and other intangible assets, any of which might negatively affect our financial results and cause our stock price to decline. Any financing that we might need for future
acquisitions may also place restrictions on our business. Furthermore, we may never achieve any of the benefits that we might anticipate from a future acquisition.

We depend on our key employees for our future success

Our success depends to a significant extent on the performance and continued service of our senior management. Most of our senior management do not have an
employment agreement. Although our employees have executed agreements containing non-competition clauses, there is no assurance that a court would enforce all of the terms of these clauses
or the clauses generally. If these clauses were not fully enforced, our employees would be freely able to join our competitors. In addition, we currently have key person life insurance only on Bruce
Davis, our chairman and chief executive officer, and Geoffrey Rhoads, our chief technology officer. The loss of the services of any of our senior management or any of our other key employees could
harm our business.

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If we are not able to retain, hire or integrate qualified personnel, our business may be harmed

Our ability to successfully develop, market and sell our applications and products depends to a significant degree upon the continued contributions of our key
personnel in engineering, sales, marketing and operations, many of whom would be difficult to replace. We believe our future success will also depend in large part upon our ability to retain our
current key employees or our ability to attract, integrate and retain other highly skilled managerial, engineering, sales, marketing and operations personnel in the future. In addition, because our
business is based on our patented technology, which is unique and not generally known, new employees will require substantial training, which will require significant resources and management
attention. Competition for experienced personnel in our market segments can be intense. If we do not succeed in attracting new, qualified personnel or in integrating, retaining and motivating our
current personnel, our business could be harmed. In June 2002 and October 2001, we implemented reductions in our workforce. We do not believe these reductions in our workforce have had a
material adverse affect on our operations. However, these reductions in workforce may make it difficult for us to recruit necessary personnel in the future. In December 2001, as part of our
acquisition of DIDS, we hired 186 people formerly employed by Polaroid Corporation, Polaroid ID Systems, Inc. or some other affiliated entities of Polaroid Corporation. If we are unable to
attract or retain qualified personnel in the future, successfully integrate and retain the DIDS employees, or if we experience delays in hiring required personnel, particularly qualified engineers and
sales personnel, our ability to develop, introduce and sell our products could be harmed.

Our promotion of the Digimarc brand must be successful in order for us to attract users as well as advertisers and other strategic partners

We believe that establishing and maintaining our brand is critical to our success and that the importance of brand recognition will increase due to the growing
number of technologies that compete with our watermarking technologies and the increasing number of competitors offering technologies
similar to ours. If our brand-building strategy is unsuccessful, the effort and expenses spent may never be recovered, we may be unable to increase our future revenue and our business could be
seriously harmed.

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

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

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



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These
provisions could have the effect of discouraging a third party from making a tender offer or otherwise attempting to gain control of us. In addition, these provisions could limit
the price that investors might be willing to pay in the future for shares of our common stock.

Risks Related to Our Industry

If we are unable to respond to regulatory or industry standards effectively, our business could be harmed

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 newly-imposed regulatory or industry standards. Our ability to remain competitive will depend in part on our ability to influence and respond to emerging industry standards, including
any standards that may be adopted for the protection of audio, video, and image content, and for other uses of metadata with such content, in a timely and cost-effective manner. If we are
unable to influence or respond to these standards effectively, our business could be harmed.

If we are unable to integrate new technologies effectively, our business could be harmed

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



We
cannot assure you that we will be successful in responding to these technological and industry challenges in a timely and cost-effective manner. If we are unable to
integrate new technologies effectively or respond to these changing needs, our business could be harmed.

Our markets for digital watermarking applications are highly competitive

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



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In
addition, as we more broadly apply our technologies to the Internet through the Digimarc MediaBridge system and other new commercial solutions applications, we may begin to compete
with a wide range of other types of companies beyond those companies using digital watermarking technologies and alternative technologies. Moreover, many of the companies that currently compete with
us, as well as other companies with whom we may compete in the future, are national or international in scope and may have greater 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 in our target markets. We cannot assure you that digital watermarking technologies, and our products and services
using these technologies, will gain widespread market acceptance.

We
cannot assure you that we will be able to compete successfully against current or future participants in our markets or against alternative technologies, nor can we assure you that
the competitive pressures we face will not harm our business, operating results and financial condition.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

The Company's market risk disclosures set forth in Item 7A of its Annual Report on Form 10-K for the year ended December 31, 2001 have
not changed materially.

Item 4. Controls and Procedures.

Within the 90-days prior to the filing of this report, we carried out an evaluation, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report.

There
have been no significant changes in our internal controls or in other factors which could significantly affect internal controls subsequent to our most recent evaluation of our
internal controls.

It
should be noted that 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.

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Part II. OTHER INFORMATION

Item 1. Legal Proceedings.

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 Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's initial public offering as defendants.
The complaints have since been consolidated into a single action. The complaints allege, among other things, that the underwriters of the Company's initial public offering violated securities laws by
failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company's initial public offering registration statement.
Plaintiffs seek, among other things, damages in an unspecified amount as well as costs and expenses, including attorneys' fees. Similar complaints have been filed against multiple other issuers that
have had initial public offerings since 1998. The Company intends to defend these actions vigorously. During the third quarter, settlement discussions were initiated in connection with this
litigation. 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. Although no assurance can be given that this matter will be resolved favorably, the Company believes that the resolution of these lawsuits will not have a material adverse effect on its
consolidated financial position, results of operations or cash flows.

In
April 2000, Digimarc filed a patent infringement case against Verance Corporation in the United States District Court for the District of Oregon in connection with Digimarc's
patents 5,850,481, 5,636,292, and 5,832,119. In September 2000, Digimarc filed an additional patent infringement case against Verance Corporation in the United States District Court for the
District of Oregon in connection with Digimarc's patent 6,122,392. In September 2001, Digimarc filed a third patent infringement case against Verance Corporation in the United States District
Court for the District of Oregon in connection with Digimarc's patent 6,266,430. In November 2001, Verance Corporation filed counterclaims against Digimarc in the United States District Court
for the District of Oregon alleging patent infringement, fraud, and monopolistic activities. On August 1, 2002, Digimarc and Verance Corporation entered into a settlement agreement pursuant to
which each dismissed its claims against the other. Additionally, Verance Corporation entered into a royalty-bearing license for the use of Digimarc's patent portfolio in media content management
products and services and media information products and services pursuant to which Verance Corporation agreed to pay a license initiation fee and
certain minimum guaranteed amounts during the term of the license, including a minimum guaranteed royalty commitment by Verance Corporation to Digimarc in excess of $2 million.

In
October 2002, Digimarc filed a patent infringement case against Spectra Systems Corporation in the United States District Court for the District of Delaware alleging
infringement of Digimarc's patents 5,636,292, 5,745,604 and 6,385,330. The Company intends to prosecute vigorously its claims against Spectra Systems Corporation.

Item 6. Exhibits and Reports On Form 8-K





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SIGNATURES

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

|                        |  |                      |  |                                                                                                            
|----------------------- |  | -------------------- |  | -----------------------------------------------------------------------------------------------------------
|                        |  | DIGIMARC CORPORATION
|Date: November 14, 2002 |  | By:                  |  | /s/E.K. RANJITE.K. Ranjit Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)

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CERTIFICATION

I, Bruce Davis, certify that:





Date:
November 14, 2002



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CERTIFICATION

I, E.K. Ranjit, certify that:





Date:
November 14, 2002



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