FALCONSTOR SOFTWARE INC - 10-K Annual Report

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2001.

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

Commission file number 0-23970

FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 77-0216135
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

125 Baylis Road 11747
Melville, New York (Zip code)
(Address of principal executive offices)

Registrant's telephone number, including area code: 631-777-5188

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001
par value

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 /X/ No / /

Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. /X/

Aggregate market value of Common Stock held by non-affiliates of the
Registrant as of March 8, 2002 was $172,549,972, which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers,
directors, 5% shareholders and their affiliates. Such exclusion should not be
deemed a determination by Registrant that all such individuals are, in fact,
affiliates of the Registrant. The number of shares of Common Stock issued and
outstanding as of March 8, 2002 was 45,430,294 and 45,240,294, respectively.

Documents Incorporated by Reference:

The information required by Part III of Form 10-K will be incorporated
by reference to certain portions of a definitive proxy statement which is
expected to be filed by the Company pursuant to Regulation 14A within 120 days
after the close of its fiscal year.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

2001 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

Page

PART I.

Item 1. Business...................................................... 3
Item 2. Properties.................................................... 10
Item 3. Legal Proceedings............................................. 10
Item 4. Submission of Matters to a Vote of Security Holders........... 10

PART II.

Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters........................................... 11
Item 6. Selected Consolidated Financial Data.......................... 11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 13
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.... 20
Item 8. Consolidated Financial Statements and Supplementary Data...... 21
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure........................... 41

PART III.

Item 10. Directors and Executive Officers of the Registrant............ 41
Item 11. Executive Compensation........................................ 41
Item 12. Security Ownership of Certain Beneficial Owners and Management 41
Item 13. Certain Relationships and Related Transactions................ 41

PART IV.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 41

SIGNATURES................................................................... 43

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PART I

Item 1. Business

OVERVIEW

FalconStor Software, Inc. ("FalconStor") is a provider of Storage Networking
Infrastructure Software and related maintenance, implementation and engineering
services. FalconStor's software has a network-centric architecture that enables
enterprises and Internet Data Centers to reduce the Total Cost of Ownership
(TCO) by consolidating the management of storage capacity and related services.
FalconStor's software technology can embrace various I/O interface,
communications standards and mission-critical storage services as they are
introduced. FalconStor's architecture has been recognized and licensed by
partners in Gigabit Ethernet Switch, Disk-Subsystem and Appliances spaces. The
Company believes FalconStor's flagship IPStor(TM) product, which began shipping
in the second quarter of 2001, is currently the only available all-software
solution that combines industry-standard connectivity with next-generation
network storage services, offering large, distributed enterprises a complete
storage management solution that includes all four of the key service
categories: universal connectivity supporting both Fibre Channel and
IP/iSCSI-based storage provisioning; virtualization; storage services such as
fail-over, mirroring, replication and snapshot; and unified SAN (storage area
network) and NAS (network-attached storage). FalconStor's commitment to open
standards and universal connectivity has been endorsed by such industry leaders
as Adaptec, Brocade, Cisco, Emulex, Fujitsu, Gadzoox, IBM, Intel, NEC, Oracle
and QLogic. FalconStor has agreements with original equipment manufacturers
("OEMs") with companies such as NEC, Runtop, Accton, ADTX, AnexTek Global, Inc.,
MTI, Dot Hill and Storage Engine, which incorporates FalconStor's IPStor
technology with such companies' products. FalconStor's strategic partner program
includes such companies as ATTO Technology, Bell Microproducts, Brocade,
Conservor, Hitachi Data Systems, Hitachi Engineering Co., Ltd., NS Solutions
Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, QLogic
and Tivoli.

Network Peripherals Inc. ("NPI") was incorporated in California in March 1989
and reincorporated in Delaware in 1994. FalconStor, Inc. was incorporated in
Delaware in February 2000. On August 22, 2001, FalconStor, Inc. merged with NPI,
a publicly traded company, with NPI as the surviving corporation. Although NPI
acquired FalconStor, as a result of the transaction, FalconStor, Inc.
stockholders held a majority of the voting interests in the combined enterprise
after the merger. Accordingly, for accounting purposes, the acquisition was a
"reverse acquisition" and FalconStor, Inc. was the "accounting acquiror."
Further, as a result of NPI's decision on June 1, 2001 to discontinue its NuWave
and legacy business, at the time of the merger NPI was a non-operating public
shell with no continuing operations, and no intangible assets associated with
NPI were purchased by FalconStor. As a result, the transaction was accounted for
as a recapitalization of FalconStor and recorded based on the fair value of
NPI's net tangible assets acquired by FalconStor, with no goodwill or other
intangible assets being recognized. In connection with the merger, the name of
NPI was changed to FalconStor Software, Inc. For more information relating to
the merger, see Note 2 of Notes to Consolidated Financial Statements.

INDUSTRY BACKGROUND

The rapid growth of data-intensive business applications has increased the
amount of mission-critical enterprise data and consequently, the need for
dedicated storage. Enterprises are frequently discovering that their existing
storage infrastructure has become inefficient and increasingly congested with
data traffic. To address these increased storage needs, enterprises are
deploying large cabinet, or RAID, devices that are capable of handling multiple
terabytes of data (one trillion bytes). According to Gartner Dataquest, an
industry research firm, average desktop consumption of storage space has grown
from 1.4 gigabytes (one billion bytes) in 1997 to 3.5 GB in 1999 and is
projected to reach 14 GB in 2003. For corporate data centers, worldwide RAID
capacity deployment will grow to 1.3 million TB by 2003 at a compounded annual
growth rate of 79%.

Business enterprises historically supported and managed data requirements by
directly attaching storage devices to the individual servers on a local area
network, or LAN. Servers communicate in this environment using the small
computer systems interface, or SCSI. The SCSI protocol, however, has several
drawbacks, including a short transport distance and the ability to support only
a limited number of connections. According to IDC, an industry research firm,
advances in technology increased LAN transmission speeds by 100 times during the
1990's, while storage-to-server data transmission speeds utilizing the SCSI
interface increased less than 20 times during this period. The result has been
significant congestion at the point of communication between storage systems and
servers.

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The storage management challenge led to the development of network attached
storage, or NAS, and storage area network, or SAN, systems, two innovative ways
of addressing the storage problem. These two storage systems do not compete;
both are needed by corporate data centers. NAS represents a quick and simple
solution to add general purpose, shareable, storage space to users and groups
and to some application servers that are not access-intensive. SAN represents a
way to separate the server and storage into two independently managed systems,
thereby simplifying the complexity of the overall information technology, or IT,
infrastructure. Fibre channel, or FC, a high-speed network connection system,
has emerged as a viable means to implement a SAN. However, a pure FC SAN alone
does not address all the problems in the areas of connectivity, storage
virtualization and storage services.

A large market opportunity is emerging for storage software that can
successfully address the shortcomings of current storage solutions. As SANs
continue to grow in popularity and complexity, innovative software products will
be required to improve the management and transport of data within an
enterprise. Until now, no one could provide a single, managed, optimized,
well-integrated, and well-connected network storage solution that leverages both
IP/iSCSI and FC and at the same time, provides storage virtualization and
storage services offering both SAN and NAS access.

PRODUCTS AND TECHNOLOGY

IPStor is a state-of-the-art storage networking infrastructure software capable
of supporting high performance storage I/O while providing a full suite of
storage services. The base software, running on a layer of standard, dedicated
servers (the IPStor Servers), is responsible for aggregating, virtualizing and
provisioning storage capacity and services to application servers via FC,
IP/iSCSI, CIFS and NFS protocol with speed, security, reliability,
interoperability, and scalability. IPStor offers Capacity Management, Data
Availability and Data Recovery services to help enterprise data centers reduce
their operating costs.

Capacity and Data Management Storage Products
- ---------------------------------------------

IPStor's comprehensive Capacity and Data Management Storage Products include a
Capacity-on-Demand Agent for automated space provisioning in a just-in-time
fashion, NAS functionality for general purpose file-level storage sharing, and
the Storage Service Enabler Option for the transparent add-on of storage
services to pre-existing stores of data, without migration.

Capacity-on-Demand Agent

The Capacity-on-Demand (COD) Agent is an automated capacity management solution
for heterogeneous storage environments that prevents systems from running out of
disk space through continuous monitoring of storage consumption and
availability. The COD Agent provides a customizable monitoring and action policy
with user-defined storage capacity thresholds. When thresholds are reached, the
COD Agent provides free disk space by performing one or more of the following
actions: compress infrequently used files, relocate infrequently used files to a
different volume (an overflow storage pool), and/or expand the capacity of the
file system. The three actions are performed in real time, without user
intervention, or interruption to the business application.

NAS Option

The Company believes the IPStor NAS Option is an easy way to add general
purpose, shareable storage space for Windows, Linux, and Unix users. IPStor NAS
provisions storage via industry-standard file sharing protocols (SMB/CIFS and
NFS) to Microsoft Windows, Linux, and Unix clients. This provisioning allows
users to share folders and files regardless of the operating system.
Furthermore, as the number of users and amount of data grow, a NAS resource can
be dynamically expanded once its full capacity has been reached.

Distinctively different from today's typical NAS solution, IPStor allows both
NAS and SAN resources to be created from the same virtualized storage pool. This
innovative architecture simplifies administrative tasks because IPStor's
advanced storage services, such as Active-Active Failover (high availability),
Mirroring, Replication, Snapshot Copy, TimeMark, database-aware Snapshot Agents,
Zero-Impact Backup Enabler, and Serverless Backup Enabler, all work identically
for both SAN and NAS resources.

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Storage Service Enabler Option

The Storage Service Enabler Option allows IPStor to directly provide Data
Availability and Data Recovery storage services to existing storage with
existing data. The Storage Service Enabler allows existing data LUNs to be
enabled by IPStor to make use of all key IPStor services (mirroring, snapshot,
etc.), without any migration/copying, or modification of data, and with minimal
downtime. Using this option, data centers can immediately and transparently take
advantage of IPStor's Storage Services without the need to virtualize their
storage. For Fibre Channel-based storage, this transformation can be done
without any re-cabling, just re-zoning. The Storage Service Enabler option
allows existing storage devices to be zoned or cabled to an IPStor Server and
quickly made available for use by host servers. Existing data is not moved, yet
it can take advantage of all key IPStor storage services.

Data Availability Storage Products
- ----------------------------------

Storage Products for Data Availability include High Availability (Active-Active
Failover), Synchronous Mirroring, Fast Remote Data Synchronization (FRDS),
DynaPath (multi-pathing), and SERvivor. Together, these software products
provide protection against all hardware or even site level failures across
vendor, platform and protocol boundaries.

High Availability (Active-Active Failover) Option

IPStor's Active-Active Failover Option provides enterprises with a highly
redundant storage solution offering 24x7 availability. IPStor can be deployed in
a two-node, active-active cluster configuration, where two IPStor Servers are
configured to monitor each other. Should one fail, the other automatically
assumes the failed server's workload. In this way, IPStor's advanced
virtualization solution supports high availability configurations, enabling full
redundancy throughout the entire data path to ensure no single point of failure.

The Active-Active Failover Option can also be used to facilitate software and
hardware maintenance and upgrades. Using the Java-based IPStor management
console, a forced failover can be triggered to temporarily take the IPStor
Servers off-line for maintenance, one at a time, while having the peace of mind
that another server is there to keep the application servers running without
interruption.

Synchronous Mirroring Option

IPStor's Synchronous Mirroring Option protects against the consequences of
storage failure by providing fault-tolerance for virtual storage volumes. At the
same time, data throughput is improved. Data redundancy is provided by creating
a synchronous mirror of a virtual storage volume. If a primary volume fails, the
IPStor Server continues to function using its mirrored copy. Mirroring is done
at the block level and can cross drive, vendor/brand, and interface (SCSI, FC,
etc.) boundaries. Furthermore, the failure protection of RAID storage systems is
greatly enhanced by IPStor's ability to mirror across cabinets, even if they are
from different vendors.

Once set up, mirrored virtual drives are active at all times, both for reading
and writing. During read operations, IPStor takes full advantage of the extra
drive to improve read performance. Data is read from the primary and the
mirrored drive to maximize throughput. During write operations, data is sent to
both the primary and the mirror drives simultaneously without any added latency.
If any read or write failure is detected, the failed virtual drive is
temporarily disabled, and the surviving virtual drive becomes the primary drive.
Throughout this process, the application servers continue to run without
interruption.

Fast Remote Data Synchronization (FRDS) Option

Specifically designed to defend against site failure by providing automated
off-site data protection, the FRDS Option provides fast remote data
synchronization of storage volumes (SAN and/or NAS) from one IPStor Server to
another-across the street, across town, or across the globe. Administrators can
specify a variety of policies to control the replication process, giving them a
very granular policy-driven mechanism for keeping an extra set of data off-site
for disaster protection. The atomic merge feature further protects data from
long-distance transmission problems and guarantees the integrity and usability
of replicated data by writing all replicated data to a reserved area and only
committing the data to the replica disk after all of the data from the primary
server has been received.

While replicating data, IPStor automatically engages the built-in snapshot
engine to ensure full point-in-time consistency. A delta-sync feature is also
included to calculate the block-level difference for replication. This allows
for tape or other mass storage media to be used to transfer the bulk of the data
to the replica site to minimize the amount of data that needs to be initially
transferred over the wire.

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With the Replication Option, data is replicated over any existing LAN, MAN, or
WAN network infrastructure without the need for extra FC-to-IP converter boxes.
IPStor Replication is done at each IPStor Server and is independent of
application servers and operating system platforms. The source storage and
target storage hardware need not be the same, allowing for low cost Disaster
Recovery planning by using low cost JBODs at the DR center. In case of a
catastrophic failure at the primary site, the systems administrator can quickly
redirect application servers to access data from replicas located in the backup
data center.

To ensure full transactional integrity, this option integrates with IPStor's
Snapshot Agents and the Group Snapshot feature.

DynaPath Agent

IPStor's DynaPath Agent ensures constant data availability across the SAN by
creating parallel active storage paths that transparently reroute application
server traffic to a redundant storage path without interruption in the event of
a storage network problem. Load balancing enhances peak performance of the SAN
by automatically distributing server traffic among the server's multiple storage
paths for higher throughput and to eliminate bottlenecks so that enterprises can
meet today's demands for 24x7 business continuity.

SERVivor Agent

Taking full advantage of IPStor's Fibre Channel Target Mode support, along with
its ability to support diskless servers, this agent makes it possible to have a
hot-spare application server (diskless, and identical to the other servers)
protecting a group of identical servers. When any one of the application servers
fails, IPStor re-assigns its boot image, along with all of its associated data
drives, from the failed server to a hot spare server, thereby achieving
high-availability at the application server level.

Data Recovery Storage Products
- ------------------------------

Storage Products for Data Recovery include Snapshot FastCopy, TimeMark,
Serverless Backup Enabler, Zero-Impact Backup Enabler, and a full suite of
database-aware Snapshot Agents. Together, these software products allow fast
backup and recovery of lost data due to hardware, software, human, or virus
problems. A key differentiator of FalconStor's Data Recovery Storage Services is
the ability to backup/replicate databases and applications without requiring any
backup window, and without forcing the database/application into 'quiet' mode
for an extensive period of time. The resulting copy or replica has full
point-in-time consistency and transaction integrity.

Snapshot FastCopy Option

The Snapshot Copy Option allows administrators to create an independent,
point-in-time copy of a storage volume on demand, which can serve as a backup
for mission-critical data. The IPStor snapshot engine is automatically triggered
to ensure that the resulting drive's contents are identical to the source as of
a single instance in time, giving administrators an easy and reliable way to
take a "snapshot" of a data set that is actively being accessed. When completed,
the new drive can be assigned to application servers with full read/write
access.

If a forced copy were made without the Snapshot option, the resulting data set
would have contents that represent a spectrum of time. Such a data set would not
have point-in-time consistency and would be essentially useless for
applications.

To ensure full transactional integrity, this option integrates with IPStor's
Snapshot Agents and the Group Snapshot feature.

TimeMark Option

IPStor's TimeMark Option guards against "soft errors," data loss caused by data
corruption or user error, such as the accidental deletion of files. TimeMark
protects where high availability (HA) configurations cannot, since in creating a
redundant set of data, HA configurations also create a duplicate set of soft
errors by default. TimeMark protects data from slip-ups, the butter fingers of
employees, unforeseen glitches during backup, and viruses.

The TimeMark Option also serves as an "undo button" for data processing.
Traditionally, when an administrator performed operations on a data set, a full
backup was required before each "dangerous" step, as a safety net. If the step
resulted in undesirable effects, the administrator needed to restore the data

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set and start the entire process again. Now, with IPStor's TimeMark Option,
administrators can create TimeMarks, point-in-time images of any SAN or NAS
virtual drive. Each TimeMark represents the block-level changes, and therefore
does not require 100% redundant capacity. Restoring a drive back to its original
state can be easily achieved with a few clicks in the IPStor management console.
To ensure full transactional integrity, TimeMark integrates with IPStor's
Snapshot Agents and the Group Snapshot feature.

IPStor's TimeView feature is an extension of the TimeMark option that provides
administrators with the tools to freely create multiple and instantaneous
virtual copies of an active data set. The data set copies can then be assigned
to multiple application servers for concurrent, independent processing, while
the original data set is still actively being accessed/updated by the primary
application server. Multiple TimeViews can be created for each SAN or NAS
virtual drive. IPStor's Snapshot Copy option enables the user to create a real,
permanent, independent drive from any TimeView.

Serverless Backup Enabler Option

The Serverless Backup Enabler Option adds support for the Extended Copy Protocol
that enables data to be moved directly from disk to tape. In essence, the IPStor
Server acts as the data mover, thereby effectively eliminating data traffic from
the LAN and greatly reducing the processing cycle imposed on the application
servers. This support allows certified third-party applications to use IPStor as
the facilitator for the extended copy.

By utilizing the Serverless Backup Enabler Option, the constraints associated
with traditional backups are dramatically decreased. The backup server issues
the command to IPStor and then removes itself from the data path. In this way
only IPStor and the source and destination devices are involved in handling data
traffic. However, the application servers still must run some components of the
backup software (called backup agents or client agents) that submit the backup
request and obtain periodic updates on progress. This issue is eliminated by
IPStor's Zero-Impact Backup Enabler Option.

Zero-Impact Backup Enabler Option

The Zero-Impact Backup Enabler Option further extends the concept of serverless
backup by completely eliminating the need for the application server to play any
role in backup and restore operations. By utilizing IPStor's Zero-Impact Backup
Enabler Option, application servers on the SAN benefit from performance
increases and the elimination of overhead associated with backup/restore
operations because the command and data paths are rendered exclusively local to
the IPStor Server. This results in the most optimal data transfer between the
disks and the tape, and is the only way to achieve net transfer rates that are
limited only by the disk's or tape's engine. The backup process automatically
leverages IPStor's snapshot engine to guarantee point-in-time consistency.

To ensure full transactional integrity, this option integrates with IPStor's
Snapshot Agents and the Group Snapshot feature.

Snapshot Agents for Oracle, Exchange, Sybase, DB2, SQL, and Lotus Notes

The IPStor Snapshot Agents ensure that active databases are protected in an
enterprise database environment with a shrinking backup-window. Complete data
and transactional integrity is attained through a robust and automated process
that safely and reliably takes snapshots of databases for point-in-time copy
purposes, third-party backup applications, and disaster recovery planning. These
Agents work seamlessly with the Replication Option, TimeMark Option, Snapshot
Copy Option, and the Zero-Impact Backup Enabler Option, all of which are based
on IPStor's built-in snapshot engine. The Snapshot Agents ensure that the
resulting copy of data not only has "point-in-time consistency," but also
transactional integrity. This means the database copy can be brought on-line
without going through any lengthy database rebuild process to roll-back partial
transactions. This can save many hours of valuable time in the case of a
disaster.

Maintenance, Implementation and Engineering Services
- ----------------------------------------------------

FalconStor offers customers a variety of annual maintenance services, which
entitles the customer to periodic software updates and various levels of
technical support. Although the implementation of IPStor does not generally
require the assistance of FalconStor, the Company offers software implementation

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services if requested from customers. FalconStor also offers customers software
engineering services if required.

BUSINESS STRATEGY

FalconStor intends to solidify its position as a leading network storage
software provider to enterprises and Internet Data Centers worldwide. FalconStor
intends to achieve this objective through the following strategies:

o Maintain a Leadership Position in Network Storage Software. FalconStor
intends to leverage its protocol-agnostic architecture to maintain a
leadership position in the Network Storage Software market. The network
storage software market is defined by rapid change, and FalconStor plans
to continue to focus its research and development efforts to invent
innovative solutions.

o Increase Market Penetration and Brand Recognition. FalconStor plans to
promote its product and corporate awareness by

o forming strategic partnerships with leading industry players;

o participating in industry events, conferences and trade shows; and

o initiating targeted promotions and public relations campaigns.

FalconStor believes that establishing a strong brand identity as a network
storage solution provider is important to its future success.

o Establish Global Presence. FalconStor believes that significant market
share can be achieved in Europe and Asia. FalconStor recently opened its
European headquarters, and plans to build rapidly its operations
capabilities in Europe. FalconStor also opened headquarters in Asia and
believes that it is developing a strong business presence in the
Asia/Pacific Rim.

o Expand Technologies and Capabilities Through Strategic Acquisitions and
Alliances. FalconStor believes that opportunities exist to expand its
technological capabilities, product offerings and services through
acquisitions. When evaluating potential acquisitions, FalconStor will
focus on transactions that enable it to acquire:

o important enabling technology;

o complementary applications;

o marketing, sales, customer and technological synergies; or

o key personnel.

To date, FalconStor has no agreements, commitments or understanding with
respect to any such acquisitions.

o Seek OEM Relationships With Industry Leaders. FalconStor intends to
continue to enter into original equipment manufacturer ("OEM") agreements
with strategic switch, storage, appliance and operating system vendors.
Besides accelerating the overall marketing growth, the OEM relationships
should bolster FalconStor's product recognition, corporate credibility and
revenue stream.

SALES, MARKETING AND CUSTOMER SERVICE

FalconStor plans to sell its products primarily through relationships with OEMs,
value-added resellers and distributors.

o Original Equipment Manufacturer Relationships. OEMs collaborate with
FalconStor to integrate FalconStor's products into their own product
offerings or resell FalconStor's products under their own label.

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o Value-added Reseller and Distributor Relationships. FalconStor has
entered into value-added reseller and distributor agreements to help
sell its product in various geographic areas. FalconStor's
value-added resellers and distributors market the entire IPStor
product suite and receive a discount off list price on products
sold.

FalconStor's marketing department consists of marketing professionals dedicated
to advertising, public relations, marketing communications, events and channel
partner programs. FalconStor's marketing efforts focus on building brand
recognition and developing leads for the sales force.

A dedicated team of FalconStor Professional Services personnel is also available
to assist customers and partners throughout the product life cycle of IPStor
deployments. The Professional Services team includes seasoned "Storage
Architects" who can assist in the assessment, planning/design, deployment, and
testing phases of an IPStor deployment project, and a Technical Support group
for post-deployment assistance and on-going trouble-shooting.

RESEARCH AND DEVELOPMENT

The network storage services industry is subject to rapid technological
advancements, changes in customer requirements, developing industry standards,
and regular new product introductions and enhancements. As a result,
FalconStor's success, in part, depends upon its ability to continue to improve
its existing solutions and to develop and introduce new products on a
cost-effective and timely basis. There can be no assurance that FalconStor will
be able to successfully develop new products to address new customer
requirements and technological changes, or that such products will achieve
market acceptance.

FalconStor believes that its continued investment in research and development is
critical to its ability to continue to develop and introduce new and enhanced
products addressing emerging market needs.

FalconStor's research and development staff consisted of 59 employees as of
December 31, 2001. Research and development expenses, primarily consisting of
personnel expenses were approximately $1.4 million and $5.3 million in 2000 and
2001, respectively. FalconStor anticipates that research and development
expenses will increase in 2002.

COMPETITION

As the demand for network-based storage products and services increases, more
competitors will enter this high-growth market segment. Although there are
several companies attempting to fill specific needs for SCSI-IP connectivity,
Fibre Channel-IP connectivity and FC-SAN storage virtualization, FalconStor is
the only software-based solution capable of accommodating storage device with
industry-standard interface and provisioning the virtualized resource over FS,
IP/iSCSI, NFS and CIFS with comprehensive storage services and end-to-end
manageability. However, some of FalconStor's product capabilities compete with a
number of significant companies with substantially greater financial resources,
such as Network Appliance and Veritas Software. There is currently no other
known software company providing all of FC/IP-based connectivity,
virtualization, and storage services. FalconStor believes that the principal
competitive factors affecting its market include product features such as
scalability, data availability, ease of use, price, reliability,
hardware/platform neutrality, customer service and support.

FalconStor's success will depend largely on its ability to generate market
demand and awareness of IPStor software suite and develop additional or enhanced
products in a timely manner. FalconStor's success will also depend on its
ability to convince potential partners of the benefits of licensing its software
rather than competing technologies. FalconStor's future and existing competitors
could introduce products with superior features, scalability and functionality
at lower prices than its products and could also bundle existing or new products
with other more established products in order to compete with FalconStor.
Increased competition could result in price reductions and reduced gross
margins, which could harm its business.

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INTELLECTUAL PROPERTY

FalconStor's success is dependent upon its proprietary technology. Currently,
the IPStor software suite is the core of its proprietary technology. FalconStor
currently has four pending patent applications and seventeen pending trademark
applications related to its IPStor product.

FalconStor seeks to protect its proprietary rights and other intellectual
property through a combination of copyright, trademark and trade secret
protection, as well as through contractual protections such as proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position.

FalconStor generally enters into confidentiality or license agreements with its
employees, consultants and corporate partners, and generally controls access to
and distribution of its software, documentation and other proprietary
information. Despite FalconStor's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use its
products or technology. Monitoring unauthorized use of its products is
difficult, and there can be no assurance that the steps taken by FalconStor will
prevent misappropriation of its technology, particularly in foreign countries
whose laws may not protect its proprietary rights as fully as do the laws of the
United States.

MAJOR CUSTOMER

For the year ended December 31, 2001, FalconStor had one customer account for
13% of revenues. While the Company expects to derive future revenues from such
customer, the Company believes that the revenues it will receive from such
customer in 2002 will be less than the revenues it received from such customer
in 2001.

EMPLOYEES

As of December 31, 2001, FalconStor had 113 full-time employees, including 28 in
sales and marketing, 18 in service, 59 in research and development and 8 in
general administration. FalconStor is not subject to any collective bargaining
agreements and believes its employee relations are good.

Item 2. Properties

FalconStor's headquarters are located in an approximately 11,800 square foot
facility located in Melville, New York. Offices were also leased for
development, sales and marketing personnel which total an aggregate of
approximately 8,625 square feet in California, Le Chesnay, France; Taichung,
Taiwan; and Tokyo, Japan. Initial lease terms range from one to six years, with
multiple renewal options. The Company believes that there are adequate
facilities available for lease as required to facilitate the Company's growth.

Item 3. Legal Proceedings

There were no material legal proceedings pending or, to our
knowledge, threatened against us.

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

None

-10-

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

Market Information

Since the merger with NPI on August 22, 2001, our Common Stock has
traded on The Nasdaq National Market ("Nasdaq") under the symbol
"FALC". Prior to August 22, 2001, the Common Stock of NPI traded on
Nasdaq under the symbol "NPIX". The following table sets forth the
range of high and low closing sales prices of our Common Stock for
the periods indicated as reported by Nasdaq:

2001 2000
----------------- -----------------

High Low High Low
---- --- ---- -----
Fourth Quarter $ 9.50 $ 5.85 $16.44 $ 6.00
Third Quarter $11.46 $ 7.34 $19.63 $11.56
Second Quarter $13.70 $ 6.00 $30.75 $14.06
First Quarter $ 9.25 $ 6.19 $78.50 $35.50

Holders of Common Stock

We had approximately 222 holders of record of Common Stock as of
February 21, 2002. This does not reflect persons or entities whom
hold Common Stock in nominee or "street" name through various
brokerage firms.

Dividends

We have not paid any cash dividends on our Common Stock since
inception. We expect to reinvest any future earnings to finance
growth, and therefore do not intend to pay cash dividends in the
foreseeable future. Our board of directors will determine if we pay
any future cash dividends.

Item 6. Selected Financial Data

The selected consolidated financial data with respect to our
consolidated balance sheets as of December 31, 2001 and 2000 and the related
consolidated statements of operations for the year ended December 31, 2001 and
the period from inception (February 10, 2000) through December 31, 2000 have
been derived from our audited consolidated financial statements which are
included herein. The following selected consolidated financial data should be
read in conjunction with the consolidated financial statements and the notes
thereto and the information contained in Item 7, "Management's Discussion and
Analysis of Financial Condition and Results of Operations."

-11-

Period from
inception
(February 10, 2000)
Year Ended through
December 31, December 31,
2001 2000
------------ -------------------
(In thousands, except per share data)

Consolidated Statement of Operations Data:

Revenues ............................................................... $ 5,592 $ 143

Operating expenses:

Cost of revenues ............................................... 1,647 224
Software development costs ..................................... 5,254 1,379
Selling and marketing .......................................... 7,358 327
General and administrative ..................................... 2,732 534
-------- --------

Total operating expenses ............................................... 16,991 2,464
-------- --------

Operating loss ......................................................... (11,399) (2,321)
-------- ---------
Interest and other income .............................................. 1,365 225
-------- ---------

Loss before income taxes ............................................... (10,034) (2,096)

Provision for income taxes ............................................. 22 --
-------- ---------

Net loss ............................................................... $(10,056) $ (2,096)
-------- ---------

Beneficial conversion feature attributable to
convertible preferred stock ....................................... 3,896 --
-------- ---------

Net loss attributable to common shareholders............................ $(13,952) $ (2,096)
======== ---------

Basic and diluted net loss per share.................................... $ (0.40) $ (0.09)
======== =========

Weighted average basic and diluted common shares outstanding (1) ....... 35,264 24,383
======== =========

December 31, December 31,
2001 2000
------------ ------------
(In thousands)

Consolidated Balance Sheet Data:

Cash and cash equivalents and marketable securities.................... $ 64,527 $7,727
Working capital ........................................................ 57,518 7,254
Total assets ........................................................... 74,471 8,594
Long-term obligations .................................................. 283 --
Total stockholders' equity ............................................. 63,562 8,057

(1) Weighted average shares do not include any common stock equivalents because
inclusion of common stock equivalents would have been anti-dilutive.

-12-

ITEM 7. 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" within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These forward-looking statements can be identified by the
use of predictive, future-tense or forward-looking terminology, such as
"believes," "anticipates," "expects," "estimates," "plans," "may," "intends,"
"will," or similar terms. Investors are cautioned that any forward-looking
statements are not guarantees of future performance and involve significant
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements. The following discussion
should be read together with the consolidated financial statements and notes to
those financial statements included elsewhere in this report.

OVERVIEW

FalconStor was incorporated in Delaware for the purpose of developing,
manufacturing and selling storage networking infrastructure software and
providing the related maintenance, implementation and engineering services. Our
unique open software approach to storage networking enables companies to better
capture and manipulate the expanding volume of enterprise data than existing
storage solutions, without rendering those solutions obsolete. By moving the
intelligence of storage management from hardware to software, we allow companies
to adopt the state-of-the-art Fibre Channel technology while at the same time,
leveraging their prior investments in Ethernet information technology (IT)
infrastructure, taking full advantage of the ubiquitous connectivity of the
industry-standard Internet Protocol (IP). Our software technology can embrace
various input/output (I/O) interface, communications standards and innovative
storage services as they are introduced. Our architecture has been recognized
and licensed by partners in Gigabit Ethernet Switch, SCSI-to-Fibre Channel
Router, Disk-Subsystem and Appliances spaces. We believe our flagship IPStor(TM)
product, which began shipping in the second quarter of 2001, is currently the
only available all-software solution that combines industry-standard
connectivity with next-generation network storage services, offering large,
distributed enterprises a complete storage management solution that includes all
four of the key service categories: universal connectivity supporting both Fibre
Channel and IP/iSCSI-based storage provisioning; virtualization; storage
services such as fail-over, mirroring, replication and snapshot; and unified SAN
(storage area network) and NAS (network-attached storage).

From March 2000 through May 2001, we received net proceeds of
approximately $17.9 million from the sale of our preferred stock which converted
into approximately 20.2 million shares of our common stock. Our operations from
inception through the second quarter of 2001 were mainly comprised of the
development of our core storage networking infrastructure software product.
During 2000 and the first two quarters of 2001, we were in the development stage
of operations, as a result there were no significant revenues generated from our
planned principal operations. During the second quarter of 2001, we completed
the development of our principal product and released our software. We began to
earn our first significant revenues from software licenses in the third quarter
of 2001.

On August 22, 2001, we merged with NPI, a publicly traded company. For
more information relating to the merger with NPI, including the accounting
treatment, see note 2 to the audited consolidated financial statements.

Our critical accounting policies are those related to revenue
recognition. As described in note 1 to our consolidated financial statements, we
recognize revenue in accordance with the provisions of Statement of Position
97-2, Software Revenue Recognition, as amended. Software license revenue is
recognized when pervasive evidence of an arrangement exists and the fee is fixed
and determinable, among other criteria. An arrangement is evidenced by a signed
customer contract for nonrefundable royalty advances received from OEMs and, in
addition to a signed agreement with OEMs, distributors, and solution providers
(or resellers) a signed customer purchase order for each software license resold
by an OEM or distributor to an end user. The software license fees are fixed and
determinable as our standard payment terms range from 30 to 90 days, depending
on the regional billing practice, and we have not provided any of our customers
extended payment terms. When a customer licenses software together with the
purchase of maintenance, we allocate a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate.

-13-

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2001 COMPARED TO THE
PERIOD FROM INCEPTION (FEBRUARY 10, 2000) THROUGH DECEMBER 31, 2000.

Revenues

Revenues for the year ended December 31, 2001 were $5.6 million
compared to approximately $143,000 for the period from inception (February 10,
2000) through December 31, 2000. The increase of approximately $5.4 million is
due to the release of our principal product at the end of the second quarter of
2001. As a result of the release of our product, we recognized approximately
$5.5 million in revenue from software licenses. Additionally, for the year ended
December 31, 2001 we recognized $84,120 from maintenance fees and services. For
the period from inception (February 10, 2000) through December 31, 2000, we did
not generate any revenues from software licenses since our software was still in
the process of being developed and had not yet been released. All revenues in
2000 were related to network consulting services. Future revenues are expected
to be derived substantially from software licenses and maintenance fees related
to our software.

Cost of Revenues

Cost of revenues consists primarily of personnel costs associated with
providing system implementations, technical support under maintenance contracts
and training. Cost of revenues for the year ended December 31, 2001 were $1.6
million compared to approximately $224,000 for the period from inception
(February 10, 2000) through December 31, 2000. The increase in cost of revenues
from the prior year is mainly due to an increase in personnel costs. As a result
of the release of our software in the second quarter of 2001, we hired
additional employees to help implement and support our software.

Gross profit for the year ended December 31, 2001 was $3.9 million or
71% compared to ($80,000) or (56%) for the period from inception (February 10,
2000) through December 31, 2000. The increase in gross margin was due to the
increase in software license revenues, which have a higher gross margin than
network consulting fees. In 2000, the cost of employee compensation exceeded the
revenues earned.

Software Development Costs

Software development costs consist primarily of personnel costs for
product development personnel and other related costs associated with the
development of new products, enhancements to existing products, quality
assurance and testing. Software development costs were $5.3 million for the year
ended December 31, 2001 compared to $1.4 million for the period from inception
(February 10, 2000) through December 31, 2000. The $3.9 million increase from
the prior year is mainly due to an increase in development personnel. The
increase in employees was required to develop our initial core storage
networking infrastructure software product, as well as, to develop new
innovative features and options.

Selling and Marketing

Selling and marketing expenses consist primarily of sales and marketing
personnel costs, travel, public relations expense, marketing literature and
promotions, commissions, trade show expenses, and the costs associated with our
foreign sales offices. Selling and marketing expenses increased from
approximately $327,000 for the period from inception (February 10, 2000) through
December 31, 2000 to $7.4 million for the year ended December 31, 2001. This
increase in selling and marketing expenses was due to our product being released
during the end of the second quarter of 2001. As a result of this release, we
expanded our sales force to accommodate our revenue growth and we initiated our
marketing efforts to promote our product and create brand awareness. Selling and
marketing expenses were limited in 2000 since our product had not yet been
released.

General and Administrative

General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related fees,
directors and officers insurance, legal and professional fees and other general
corporate overhead costs. General and administrative expenses were $2.7 million
for the year ended December 31, 2001, an increase of approximately $2.2 million
from the period from inception (February 10, 2000) through December 31, 2000.
The increase in general and administrative expenses was due to increased

-14-

salaries as a result of increased personnel associated with building our basic
corporate infrastructure. Additionally, as a public company, we now incur
additional legal and professional fees and corporate directors and officers
insurance expense.

Interest and Other Income

Interest and other income was $1.4 million for the year ended December
30, 2001 compared to approximately $226,000 for the period from inception
(February 10, 2000) through December 31, 2000. The $1.2 million increase in
interest income was due to higher average cash, cash equivalent and marketable
securities balances as a result of the merger with NPI, as well as the cash we
raised from the issuance of Series C convertible preferred stock.

Income Taxes

We did not record a tax benefit associated with the pre-tax loss
incurred from the period from inception (February 10, 2000) through December 30,
2001, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our development and now early stage operations,
and accordingly, we provided a full valuation allowance against the deferred tax
asset.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2001, we had $38.4 million in cash and cash
equivalents and $26.2 million in marketable securities. Net cash used in
operating activities for the year ended December 31, 2001 was $10.1 million
compared to $1.4 million for the period from inception (February 10, 2000)
through December 31, 2000. The increase in net cash used in operating activities
was mainly attributable to our net loss of $10.1 million partially offset by
non-cash expenses of $1.5 million and increases in accounts payable, accrued
expenses and deferred revenue of $2.0 million. The increase in net cash used was
also attributable to increases in accounts receivable and prepaid expenses and
other current assets totaling $3.6 million. For the period from inception
(February 10, 2000) through December 31, 2000 the net cash used was mainly
attributable to our net loss of $2.1 million partially offset by non-cash
expenses of $0.2 million and increases in accounts payable, accrued expenses and
deferred revenue of $0.5 million.

Net cash provided by investing activities was $33.9 million for the
year ended December 31, 2001 compared to net cash used of $0.9 million for the
period from inception (February 10, 2000) through December 31, 2000. The
increase in net cash provided by investing activities is mainly due to the $48.2
million of net cash acquired from the merger with NPI, less $0.8 million in
payments of liabilities of discontinued operations. These amounts were partially
offset by net purchases of marketable securities of $7.4 million, $1.3 million
in purchases of property and equipment, $2.2 million related to the purchase of
software licenses and a $2.3 million investment in preferred stock of another
entity. See Note 9 of Notes to Consolidated Financial Statements. For the period
from inception (February 10, 2000) through December 31, 2000 the net cash used
was attributable to purchases of property and equipment of $0.6 million and
approximately $0.2 million in security deposits.

Net cash provided by financing activities was $7.0 million for the year
ended December 31, 2001 which was comprised of $7.9 million raised from our
Series C preferred stock financing and approximately $0.3 million from the
exercise of stock options. These amounts were partially offset by the repurchase
of treasury stock totaling $1.2 million. For the period from inception (February
10, 2000) through December 31, 2000, cash provided by financing activities was
$10.0 million primarily from the issuance of Series A and B preferred stock.

As of December 31, 2001, we had $8.4 million of liabilities related to
the discontinued operations of NPI. In October 2001, we announced that our Board
of Directors authorized the repurchase of up to two million shares of our
outstanding common stock, of which 190,000 shares were repurchased through
December 31, 2001. Our principal sources of liquidity are cash, cash equivalents
and marketable securities, which are expected to be used for general corporate
purposes, including expansion of operations and capital expenditures.

We believe that our current balance of cash, cash equivalents and
marketable securities and expected cash flows from operations will be sufficient
to meet our cash requirements for at least the next twelve months.

-15-

Impact of Recently Issued Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 142 "Goodwill And Other
Intangible Assets" ("SFAS No. 142"), which is effective for fiscal years
beginning after June 15, 2001. SFAS No. 142 establishes accounting and reporting
standards for goodwill and other intangible assets. In accordance with SFAS No.
142, an entity will no longer amortize goodwill over its estimated useful life.
Rather goodwill will be subject to assessments for impairment by applying a
fair-value-based test. Intangible assets, except work force in place, must be
separately recognized and amortized over their useful life. FalconStor expects
that its adoption of SFAS No. 142 on January 1, 2002 will not have a material
impact on its consolidated results of operations or financial position.

The FASB also recently issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," that is applicable to financial
statements issued for fiscal years beginning after December 15, 2001. The FASB's
new rules on asset impairment supersede FASB Statement 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,"
and portions of APB Opinion 30, "Reporting the Results of Operations." This
Standard provides a single accounting model for long-lived assets to be disposed
of and significantly changes the criteria that would have to be met to classify
an asset as held-for-sale. Classification as held-for-sale is an important
distinction since such assets are not depreciated and are stated at the lower of
fair value and carrying amount. This Standard also requires expected future
operating losses from discontinued operations to be displayed in the period(s)
in which the losses are incurred, rather than as of the measurement date as
presently required. FalconStor expects the adoption of SFAS No. 144 will not
have a material impact on its consolidated results of operations or financial
position.

RISK FACTORS

Failure to achieve anticipated growth could harm our business and operating
results.

Achieving our anticipated growth will depend on a number of factors,
some of which include:

o retention of key management, marketing and technical personnel;

o our ability to increase our customer base and to increase the sales
of our products; and

o competitive conditions in the storage networking infrastructure
software market.

We cannot assure you that the anticipated growth will be achieved. The
failure to achieve anticipated growth could harm our business, financial
condition and operating results.

We have had limited revenues and a history of losses, and we may not achieve or
maintain profitability.

Due to the early stage of our product, we have had limited revenues and
a history of losses. For the period from inception (February 10, 2000) through
December 31, 2001, we had a net loss of $12,151,469. We have signed contracts
with resellers and original equipment manufacturers, or OEMs, and expect that as
a result of these contracts, our revenues will increase in the future. Our
business model depends upon signing agreements with additional OEM customers,
further developing our reseller sales channel, and expanding our direct sales
force. Any difficulty in obtaining these OEM and reseller customers or in
attracting qualified sales personnel will negatively impact our financial
performance.

The market for IP-based storage solutions is new and uncertain, and our business
will suffer if it does not develop as we expect.

The rapid adoption of Internet protocol (IP)-based storage solutions is
critical to our future success. The market for IP-based solutions is still
unproven, making it difficult to predict its potential size or future growth
rate, and there are currently only a handful of companies with IP-based storage
products that are commercially available. Most potential customers have made

-16-

substantial investments in their current storage networking infrastructure, and
they may elect to remain with current network architectures or to adopt new
architecture, in limited stages or over extended periods of time. We will need
to convince these potential customers of the benefits of our IP-based storage
products for future storage network infrastructure upgrades or expansions. We
cannot be certain that a viable market for our products will develop or be
sustainable. If this market does not develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
seriously harmed.

If we are unable to develop and manufacture new products that address additional
storage networking infrastructure software market segments, our operating
results may suffer.

Although our current products are designed for one of the most
significant segments of the storage networking infrastructure software market,
demand may shift to other market segments. Accordingly, we may need to develop
and manufacture new products that address additional storage networking
infrastructure software market segments and emerging technologies to remain
competitive in the data storage software industry. We cannot assure you that we
will successfully qualify new storage networking infrastructure software
products with our customers by meeting customer performance and quality
specifications or quickly achieve high volume production of storage networking
infrastructure software products. Any failure to address additional market
segments could harm our business, financial condition and operating results.

Our complex products may have errors or defects that could result in reduced
demand for our products or costly litigation.

Our IPStor platform is complex and designed to be deployed in large and
complex networks. Many of our customers have unique infrastructures which may
require additional professional services in order for our software to work
within their infrastructure. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
defects in our product within our customers' networks could result in lost
profits or damage to our customers. These problems could cause us to incur
significant service and warranty costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.

Our future quarterly results may fluctuate significantly, which could cause our
stock price to decline.

Our future performance will depend on many factors, including:

o the timing of securing software license contracts and the
delivery of software and related revenue recognition;

o the average unit selling price of our products;

o existing or new competitors introducing better products at
competitive prices before we do;

o our ability to manage successfully the complex and difficult
process of qualifying our products with our customers;

o our customers canceling, rescheduling or deferring significant
orders for our products, particularly in anticipation of new
products or enhancements from us or our competitors;

o import or export restrictions on our proprietary technology;
and

o personnel changes.

Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.

-17-

The storage networking infrastructure software market is highly competitive and
intense competition could negatively impact our business.

The storage networking infrastructure software market is intensely
competitive even during periods when demand is stable. Our management believes
that we compete primarily with Network Appliance and Veritas. Those competitors
and other potential competitors may be able to establish rapidly or expand
storage networking infrastructure software offerings more quickly, adapt to new
technologies and customer requirements faster and take advantage of acquisition
and other opportunities more readily.

Our competitors also may:

o consolidate or establish strategic relationships among
themselves to lower their product costs or to otherwise compete
more effectively against us; or

o bundle their products with other products to increase demand
for their products.

In addition, some OEMs with whom we do business, or hope to do
business, may enter the market directly and rapidly capture market share. If we
fail to compete successfully against current or future competitors, our
business, financial condition and operating results may suffer.

The loss of any of our key personnel could harm our business.

Our success depends upon the continued contributions of our key
employees, many of whom would be extremely difficult to replace. We do not have
key person life insurance on any of our personnel. Many of our senior management
and a significant number of our other employees have been with us for a short
period of time. Worldwide competition for skilled employees in the storage
networking infrastructure software industry is extremely intense. If we are
unable to retain existing employees or to hire and integrate new employees, our
business, financial condition and operating results could suffer. In addition,
companies whose employees accept positions with competitors often claim that the
competitors have engaged in unfair hiring practices. We may be the subject of
such claims in the future as we seek to hire qualified personnel and could incur
substantial costs defending ourselves against those claims.

Our board of directors may selectively release shares of our common stock from
lock-up restrictions.

Currently, approximately 28.6 million shares of our common stock are
subject to lock-up restrictions expiring on April 30, 2003, and approximately
0.9 million shares of our common stock are subject to lock-up restrictions
expiring on August 22, 2002. Our board of directors may, in its sole discretion,
release any or all of the shares of our common stock from lock-up restrictions
at any time with or without notice. Any release of such shares from lock-up
restrictions may be applied on a proportionate or selective basis. If the
release is selectively applied, the stockholders whose shares are not released
will be forced to hold such shares while other stockholders may sell. In
addition, the release of any of such shares could depress our stock price.

If we are unable to protect our intellectual property, our business will suffer.

Our success is dependent upon our proprietary technology. Currently,
the IPStor software suite is the core of our proprietary technology. We have
four pending patent applications and seventeen pending trademark applications
related to our IPStor product. We cannot predict whether we will receive patents
for our pending or future patent applications, and any patents that we own or
that are issued to us may be invalidated, circumvented or challenged. In
addition, the laws of certain countries in which we sell and manufacture our
products, including various countries in Asia, may not protect our products and
intellectual property rights to the same extent as the laws of the United
States.

We also rely on trade secret, copyright and trademark laws, as well as
the confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.

-18-

Our technology may be subject to infringement claims that could harm our
business.

We may become subject to litigation regarding infringement claims
alleged by third parties. If an action is commenced against us, our management
may have to devote substantial attention and resources to defend these claims.
An unfavorable result for the Company could have a material adverse effect on
our business, financial condition and operating results and could limit our
ability to use our intellectual property.

Our efforts to protect our intellectual property may cause us to become involved
in costly and lengthy litigation which could seriously harm our business.

In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights. Legal
proceedings could subject us to significant liability for damages or invalidate
our intellectual property rights. Any litigation, regardless of its outcome,
would likely be time consuming and expensive to resolve and would divert
management's time and attention. Any potential intellectual property litigation
against us could force us to take specific actions, including:

o cease selling our products that use the challenged intellectual
property;

o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology or
trademark, which license may not be available on reasonable
terms, or at all; or

o redesign those products that use infringing intellectual
property or cease to use an infringing trademark.

We have a significant amount of authorized but unissued preferred stock, which
may affect the likelihood of a change of control in our company.

Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control.

We have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders' percentage ownership of our common stock.

As of December 31, 2001, we have outstanding options to purchase an
aggregate of 7,274,717 shares of our common stock at a weighted average exercise
price of $3.28 per share.

The exercise of all of the outstanding options would dilute the
then-existing stockholders' percentage ownership of common stock, and any sales
in the public market of the common stock issuable upon such exercise could
adversely affect prevailing market prices for the common stock. In addition, the
existence of a significant amount of outstanding options may encourage short
selling by the option holders since the exercise of the outstanding options
could depress the price of our common stock. Moreover, the terms upon which we
would be able to obtain additional equity capital could be adversely affected
because the holders of such securities can be expected to exercise or convert
them at a time when we would, in all likelihood, be able to obtain any needed
capital on terms more favorable than those provided by such securities.

Network Peripherals Inc. has liabilities and ongoing obligations to certain
customers and suppliers as a result of the winding down of its business.

-19-

Network Peripherals Inc. had existing agreements with certain
suppliers and customers. NPI may have liabilities to certain existing customers
and suppliers as a result of the termination of these agreements. While we are
taking steps to minimize any such potential liability, we cannot be sure that
our efforts to remove all such liability will be successful.

Item 7A. Qualitative and Quantitative Disclosures About Market Risk

Interest Rate Risks. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities.

Foreign Currency Risk. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. We do not use
derivative financial instruments to limit our foreign currency risk exposure.

-20-

Item 8. Consolidated Financial Statements and Supplementary Data

Index to Consolidated Financial Statements Page

Independent Auditors' Report............................................ 22

Consolidated Balance Sheets as of December 31, 2001 and 2000............ 23

Consolidated Statements of Operations for the year ended December 31, 2001
and for the period from inception (February 10, 2000) through
December 31, 2000............................................... 24

Consolidated Statements of Stockholders' Equity and Comprehensive Loss for
the year ended December 31, 2001 and for the period from inception
(February 10, 2000) through December 31, 2000................... 25

Consolidated Statements of Cash Flows for the year ended December 31, 2001
and for the period from inception (February 10, 2000) through
December 31, 2000.............................................. 26

Notes to Consolidated Financial Statements............................. 28

-21-

Independent Auditors' Report

The Board of Directors and Stockholders
FalconStor Software, Inc.:

We have audited the accompanying consolidated balance sheets of
FalconStor Software, Inc. and subsidiaries as of December 31, 2001 and 2000, and
the related consolidated statements of operations, stockholders' equity and
comprehensive loss, and cash flows for the year ended December 31, 2001 and the
period from inception (February 10, 2000) through December 31, 2000. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of FalconStor
Software, Inc. and subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for the year ended December 31,
2001 and the period from inception (February 10, 2000) through December 31,
2000, in conformity with accounting principles generally accepted in the United
States of America.

/s/ KPMG LLP

Melville, New York
January 28, 2002

-22-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

December 31,
-----------------------------

2001 2000
---- ----
Assets
Current assets:
Cash and cash equivalents ................................................ $ 38,370,937 $ 7,727,182
Marketable securities .................................................... 26,156,180 --
Accounts receivable, net ................................................. 2,539,987 15,814
Prepaid expenses and other current assets ................................ 1,077,017 47,995
------------ ------------

Total current assets ............................................ 68,144,121 7,790,991

Property and equipment, net ................................................. 1,605,396 583,201
Investments ................................................................. 2,300,062 --
Other assets ................................................................ 2,421,376 220,099
------------ ------------

Total assets .................................................... $ 74,470,955 $ 8,594,291
============ ============

Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 544,998 $ 137,365
Accrued expenses ......................................................... 1,588,723 266,949
Deferred revenue ......................................................... 357,912 133,000
Net liabilities of discontinued operations ............................... 8,134,322 --
------------ ------------

Total current liabilities ....................................... 10,625,955 537,314
------------ ------------

Long-term liabilities of discontinued operations ........................ 283,428 --
------------ ------------

Commitments

Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 and 10,000,000
shares authorized, respectively
Series A, -0- and 3,000,000 shares issued and outstanding, respectively -- 3,000
Series B, -0- and 4,900,000 shares issued and outstanding, respectively -- 4,900
Series C, none issued ................................................. -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
45,049,379 and 10,900,016 shares issued, respectively 45,049 10,900
Additional paid-in capital ............................................... 77,991,996 10,625,252
Deferred compensation .................................................... (1,026,674) (469,351)
Accumulated deficit ...................................................... (12,151,469) (2,095,719)
Common stock held in treasury, at cost (190,000 shares in 2001) .......... (1,220,730) --
Accumulated other comprehensive loss ..................................... (76,600) (22,005)
------------ ------------

Total stockholders' equity ...................................... 63,561,572 8,056,977
------------ ------------
Total liabilities and stockholders' equity ...................... $ 74,470,955 $ 8,594,291
============ ============

See accompanying notes to consolidated financial statements.

-23-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

Period from
Inception
(February 10,
Year Ended 2000) through
December 31, December 31,
2001 2000
---- ----

Revenues ................................................................ $ 5,591,729 $ 143,294

Operating expenses:
Cost of revenues ..................................................... 1,646,950 223,689
Software development costs ........................................... 5,253,842 1,379,260
Selling and marketing ................................................ 7,358,426 327,142
General and administrative ........................................... 2,731,551 534,473
------------ ------------
16,990,769 2,464,564
------------ ------------
Operating loss ............................................... (11,399,040) (2,321,270)
------------ ------------

Interest and other income ............................................... 1,364,780 225,551
------------ ------------

Loss before income taxes ....................................... (10,034,260) (2,095,719)

Provision for income taxes ............................................. 21,490 --
------------ ------------

Net loss ....................................................... $(10,055,750) $ (2,095,719)
------------ ------------

Beneficial conversion feature attributable
to convertible preferred stock........................................ 3,896,287 --
------------ ------------

Net loss attributable to common
shareholders ......................................................... $(13,952,037) $ (2,095,719)
============ ============

Basic and diluted net loss per share attributable to common shareholders $ (0.40) $ (0.09)
============ ============

Basic and diluted weighted average shares
outstanding .......................................................... 35,264,277 24,383,166
============ ============

See accompanying notes to consolidated financial statements.

-24-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS

Series A Series B Series C
convertible convertible convertible Additional
preferred preferred preferred Common paid-in Deferred
stock stock stock stock capital compensation
----------------------------------------------------------------------------------------

Balance at inception
(February 10, 2000) $ - $ - $ - $ - $ - $ -

Issuance of 10,900,016 shares
of common stock - - - 10,900 44,100 -

Issuance of 3,000,000 shares of
Series A preferred stock 3,000 - - - 2,973,329 -

Issuance of 4,900,000 shares of
Series B preferred stock - 4,900 - - 6,992,216 -

Increase of stock options and
common stock to
non-employees - - - - 118,647 -

Deferred compensation - - - - 496,960 (496,960)

Amortization of deferred
compensation - - - - - 27,609

Net loss - - - - - -

Foreign currency translation
adjustment - - - - - -
-------------------------------------------------------------------------------------------

Balance, December 31, 2000 $ 3,000 $ 4,900 $ - $ 10,900 $ 10,625,252 $ (469,351)

Issuance of 3,193,678 shares of
Series C preferred stock - - 3,194 - 7,929,141 -

Issuance of stock options and
common stock to
non-employees - - - - 450,802 -

Exercise of stock options - - - 593 254,273 -

Deferred compensation - - - - 1,028,640 (1,028,640)

Amortization of deferred
compensation - - - - - 471,317

Net loss - - - - - -

Conversion of preferred stock
into common stock (3,000) (4,900) (3,194) 20,207 (9,113) -

Issuance of common stock in
connection with NPI merger - - - 13,349 57,713,001 -

Acquisition of treasury stock - - - - - -

Net unrealized gain on
marketable securities - - - - - -

Foreign currency translation
adjustment - - - - - -
------------------------------------ ------------------------------------------------------

Balance, December 31, 2001 $ - $ - $ - $45,049 $ 77,991,996 $ (1,026,674)
===========================================================================================

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS

Accumulated
other
compre- Total Compre-
Accumulated Treasury hensive stockholders' hensive
Deficit stock loss equity loss
------------------------------------------------------------------------------------------------

Balance at inception
(February 10, 2000) $ - $ - $ - $ - $ -

Issuance of 10,900,016 shares
of common stock - - - 55,000 -

Issuance of 3,000,000 shares of
Series A preferred stock - - - 2,976,329 -

Issuance of 4,900,000 shares of
Series B preferred stock - - - 6,997,116 -

Increase of stock options and
common stock to
non-employees - - - 118,647 -

Deferred compensation - - - - -

Amortization of deferred
compensation - - - 27,609 -

Net loss (2,095,719) - - (2,095,719) (2,095,719)

Foreign currency translation
adjustment - (22,005) (22,005) (22,005)
---------------------------------------------------------------------------------------------

Balance, December 31, 2000 (2,095,719) $ - $ (22,005) $ 8,056,977 $ (2,117,724)
====================

Issuance of 3,193,678 shares of
Series C preferred stock - - - 7,932,335 -

Issuance of stock options and
common stock to
non-employees - - - 450,802 -

Exercise of stock options - - - 254,866 -

Deferred compensation - - - - -

Amortization of deferred
compensation - - - 471,317 -

Net loss (10,055,750) - - (10,055,750) (10,055,750)

Conversion of preferred stock
into common stock - - - - -

Issuance of common stock in
connection with NPI merger - - - 57,726,350 -

Acquisition of treasury stock - (1,220,730) - (1,220,730) -

Net unrealized gain on
marketable securities - 4,533 4,533 4,533

Foreign currency translation
adjustment - (59,128) (59,128) (59,128)
---------------------------------------------------------------------------------------------

Balance, December 31, 2001 $ (12,151,469) $ (1,220,730) $ (76,600) $ 63,561,572 $ (10,110,345)
=============================================================================================

See accompanying notes to consolidated financial statements.

-25-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Period from
Inception (February
Year Ended 10, 2000) through
December 31, 2001 December 31, 2000
----------------- -----------------

Cash flows from operating activities:
Net loss ............................................. $(10,055,750) $ (2,095,719)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization .................. 617,277 50,905
Non-cash professional services expenses ........ 450,802 118,647
Equity-based compensation ...................... 471,317 27,609
Changes in operating assets and liabilities:
Accounts receivable, net ....................... (2,524,173) (15,814)
Prepaid expenses and other current assets ...... (1,029,022) (47,995)
Accounts payable ............................... 407,633 137,365
Accrued expenses ............................... 1,321,774 266,949
Deferred revenue ............................... 224,912 133,000
------------ ------------

Net cash used in operating activities ....... (10,115,230) (1,425,053)
------------ ------------

Cash flows from investing activities:
Purchase of marketable securities .................... (9,312,973) --
Sale of marketable securities ........................ 1,868,430 --
Purchase of investment ............................... (2,300,062) --
Purchase of property and equipment ................... (1,340,583) (634,106)
Purchase of software licenses ........................ (2,240,000) --
Net cash acquired from acquisition of NPI ............ 48,208,649 --
Payments of liabilities of discontinued operations ... (821,653) --
Security deposits .................................... (210,166) (220,099)
------------ ------------

Net cash provided by (used in) investing activities 33,851,642 (854,205)
------------ ------------

Cash flows from financing activities:
Net proceeds from issuance of preferred stock ........ 7,932,335 9,973,445
Proceeds from exercise of stock options .............. 254,866 --
Proceeds from issuance of common stock ............... -- 55,000
Payments to acquire treasury stock ................... (1,220,730) --
------------ ------------

Net cash provided by financing activities ......... 6,966,471 10,028,445
------------ ------------

Effect of exchange rate changes on cash ................. (59,128) (22,005)
------------ ------------

Net increase in cash and cash equivalents .............. 30,643,755 7,727,182

Cash and cash equivalents, beginning of period .......... 7,727,182 --
------------ ------------

Cash and cash equivalents, end of period ............... $ 38,370,937 $ 7,727,182
============ ============

-26-

Supplemental disclosures of cash flow information:

In connection with the merger with NPI (note 2), additional paid-in capital
increased as follows:

Cash acquired ................................ 57,091,647
Marketable securities acquired ............... 18,707,104
Merger related costs ......................... (8,882,998)
Fair value of property and equipment acquired 50,000
Fair value of accounts receivable acquired ... 92,000
Liabilities of discontinued operations assumed (9,331,403)
------------

Increase in additional paid-in capital ....... $ 57,726,350
============

The Company did not pay any interest expense or income taxes from the period
from inception (February 10, 2000) through December 31, 2001.

See accompanying notes to consolidated financial statements.

-27-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(1) Summary of Significant Accounting Policies

(a) Nature of Operations

FalconStor Software, Inc., a Delaware corporation (the "Company"),
develops, manufactures and sells storage networking infrastructure software and
provides the related maintenance, implementation and engineering services. The
Company also provides network consulting services.

(b) Principles of Consolidation

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

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$38.3 million and $7.5 million at December 31, 2001 and 2000, respectively.
Marketable securities at December 31, 2001 consist of corporate bonds and
government securities, which are classified as available for sale, and
accordingly, unrealized gains and losses on marketable securities are reflected
as a component of stockholders' equity.

(d) Revenue Recognition

The Company recognizes revenue from software licenses in accordance
with Statement of Position ("SOP") 97-2, Software Revenue Recognition, as
amended. Accordingly, revenue for software licenses is recognized when
persuasive evidence of an arrangement exists, the fee is fixed and determinable
and the software is delivered, provided no significant obligations remain and
collection of the resulting receivable is deemed probable. Software delivered to
a customer on a trial basis is not recognized as revenue until a permanent key
is delivered to the customer. When a customer licenses software together with
the purchase of maintenance, the Company allocates a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate. Software maintenance fees are deferred and recognized as revenue ratably
over the term of the contract. The cost of providing technical support is
included in cost of revenues.

Revenues associated with software implementation and software
engineering services are recognized as the services are performed. Network
consulting fees, which are billed on a time and material basis and have not been
provided to end user software license customers, are also recognized as revenue
when the services are performed. Costs of providing services are included in
cost of revenues.

The Company has entered into various distribution, licensing and joint
promotion agreements with OEM's and distributors, whereby the Company has
provided the reseller a non-exclusive software license to install the Company's
software on certain hardware or to resell the Company's software in exchange for
royalty payments based on the number of products distributed by the OEM or
distributor. Nonrefundable advances received by the Company from an OEM for
royalties are recorded as deferred revenue and recognized as revenue when any
related software engineering services are complete, if any, and the software
product master is delivered and accepted.

Revenues from maintenance fees and services were $84,120 for the year
ended December 31, 2001 and $143,294 for the period from inception (February 10,
2000) through December 31, 2000. All other revenues were derived from software
licenses.

-28-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(e) Property and Equipment

Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years).

(f) Software Development Costs

Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility in
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $23,643 was amortized in 2001.
Amortization of software development costs is recorded at the greater of
straight line over three years or the ratio of current revenue of the related
products to total current and anticipated future revenue of these products.

(g) Income Taxes

Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.

(h) Long-Lived Assets

The Company reviews its long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount of the
asset may not be recoverable. If the sum of the expected future cash flows,
undiscounted and without interest, is less than the carrying amount of the
asset, an impairment loss is recognized as the amount by which the carrying
amount of the asset exceeds its fair value.

(i) Accounting for Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with
SFAS No. 123, Accounting for Stock-Based Compensation. The Company has elected
to record compensation expense for stock options and warrants granted to
employees and directors only if the then current market price of the underlying
stock exceeds the exercise price on the date of grant, in accordance with the
provisions of Accounting Principles Board ("APB") Opinion No. 25, Accounting for
Stock Issued to Employees, rather than the fair value based method of measuring
compensation cost under SFAS No. 123. Accordingly, the Company has disclosed the
pro forma net loss as if the fair value method of SFAS No. 123 had been used to
measure compensation cost. Transactions in which options and warrants are
granted to other than employees and directors are accounted for at fair value.

(j) Financial Instruments

As of December 31, 2001 and 2000, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.

-29-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(k) Stock Split

In July 2000, the Company's Board of Directors declared a five-for-one
stock split to be effected in the form of a common stock dividend. For purposes
of the accompanying consolidated financial statements, all share and per share
information have been adjusted for the stock split.

(l) Foreign Currency

Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.

(m) Earnings Per Share (EPS)

Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the periods presented, all common stock
equivalents were excluded from diluted net loss per share. As of December 31,
2001, potentially dilutive common stock equivalents included 7,274,717 stock
options outstanding. As of December 31, 2000, potentially dilutive common stock
equivalents included 4,735,027 stock options outstanding and 17,902,078 shares
issuable upon the conversion of convertible preferred stock.

(n) Comprehensive Income (Loss)

Comprehensive income (loss) includes the Company's net loss, foreign
currency translation adjustments, and unrealized gains on marketable securities.

(o) Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that effect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

(p) New Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142 "Goodwill And Other
Intangible Assets" ("SFAS No. 142"), which is effective for fiscal years
beginning after June 15, 2001. SFAS No. 142 establishes accounting and reporting
standards for goodwill and other intangible assets. In accordance with SFAS No.
142, an entity will no longer amortize goodwill over its estimated useful life.
Rather goodwill will be subject to assessments for impairment by applying a
fair-value-based test. Intangible assets, except work force in place, must be
separately recognized and amortized over their useful life. FalconStor expects
that its adoption of SFAS No. 142 on January 1, 2002 will not have a material
impact on its consolidated results of operations or financial position.

-30-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

and portions of APB Opinion 30, "Reporting the Results of Operations." This
Standard provides a single accounting model for long-lived assets to be disposed
of and significantly changes the criteria that would have to be met to classify
an asset as held-for-sale. Classification as held-for-sale is an important
distinction since such assets are not depreciated and are stated at the lower of
fair value and carrying amount. This Standard also requires expected future
operating losses from discontinued operations to be displayed in the period(s)
in which the losses are incurred, rather than as of the measurement date as
presently required. FalconStor expects the adoption of SFAS No. 144 will not
have a material impact on its consolidated results of operations or financial
position.

(2) Merger with Network Peripherals Inc.

On August 22, 2001, pursuant to an Agreement and Plan of Merger and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor") merged
with Network Peripherals Inc. ("NPI"), with NPI as the surviving corporation.
Under the terms of the Merger Agreement, all of FalconStor's preferred shares
were converted into common shares and the stockholders of FalconStor received
0.721858 shares of NPI common stock for each share of FalconStor common stock
that they held. Although NPI acquired FalconStor, as a result of the
transaction, FalconStor stockholders held a majority of the voting interests in
the combined enterprise after the merger. Accordingly, for accounting purposes,
the acquisition was a "reverse acquisition" and FalconStor was the "accounting
acquiror." Further, as a result of NPI's decision on June 1, 2001 to discontinue
its NuWave and legacy business, at the time of the merger NPI was a
non-operating public shell with no continuing operations, and no intangible
assets associated with NPI were purchased by FalconStor. As a result, the
transaction was accounted for as a recapitalization of FalconStor and recorded
based on the fair value of NPI's net tangible assets acquired by FalconStor,
with no goodwill or other intangible assets being recognized. Costs incurred by
FalconStor directly related to the transaction, amounting to $8,882,998, were
charged to additional paid-in capital. The conversion of all of FalconStor's
preferred stock into common stock resulted in an additional 20,207,460 shares of
common stock outstanding and, for accounting purposes, the merger resulted in
the issuance of 13,348,605 common shares to NPI's pre-merger shareholders. In
connection with the merger, the name of NPI was changed to FalconStor Software,
Inc.

The following unaudited pro forma consolidated financial information reflects
NPI as a discontinued operation and gives effect to the above described merger
as if the merger had occurred at the beginning of the respective periods by
consolidating the continuing results of operations of the Company and NPI for
the year ended December 31, 2001 and the period from inception (February 10,
2000) through December 31, 2000.

Period from Inception
Year Ended (February 10, 2000) through
December 31, 2000 December 31, 2001
----------------- -----------------

Revenues ........................................ $ 5,341,729 $ 143,294
Net Loss from continuing operations ............. (10,305,750) (2,095,719)
Basic and diluted net
loss from continuing operations per share $ (0.24) $ (0.06)
Weighted average basic and
diluted shares outstanding ............... 43,822,013 37,731,771

The pro forma statements are provided for illustrative purposes only
and do not represent what the actual consolidated results of operations would
have been had the merger occurred on the dates assumed, nor are they necessarily
indicative of future results of operations.

-31-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Property and Equipment

Property and equipment consist of the following:

December 31, December 31, Useful
2001 2000 lives
---- ---- -----

Computer hardware and software $ 1,641,975 $ 516,261 3 years
Furniture and equipment 321,391 117,845 5-7 years
Leasehold improvements 61,323 --
----------- ---------
2,024,689 634,106
Less accumulated depreciation (419,293) (50,905)
----------- ----------
$ 1,605,396 $ 583,201
=========== ==========

(4) Marketable securities

The Company accounts for its short-term investments in accordance with
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 establishes
the accounting and reporting requirements for all debt securities and for
investments in equity securities that have a readily determinable fair market
value. All short-term marketable securities must be classified as one of the
following: held-to-maturity, available-for-sale or trading securities. The
Company's short-term investments consist of available-for-sale securities. The
Company's available-for-sale securities are carried at fair value, with
unrealized gains and losses reported as a separate component of stockholders'
equity. Unrealized gains and losses are computed on the basis of the specific
identification method. Realized gains, realized losses and declines in value
judged to be other-than-temporary, are included in other income. The cost of
available-for-sale securities sold are based on the specific identification
method and interest earned is included in net income.

The carrying value and fair values of the Company's marketable
securities as of December 31, 2001 are as follows:

Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
---------- ----- ----- ------

Available-for-sales securities $ 26,156,180 $ 26,151,647 $ 4,533 $ -

Marketable securities at December 31, 2001 consist of corporate bonds
and government securities.

(5) Accrued Expenses

Accrued expenses are comprised of the following:

2001 2000
---------- -----------

Accrued compensation $ 532,060 $ 153,943

-32-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

Accrued consulting and professional fees 395,491 80,000
Accrued marketing and promotion 304,631 --
Other accrued expenses 356,541 33,006
---------- ----------

$1,588,723 $ 266,949
========== ==========

(6) Income Taxes

The provision for income taxes for the year ended December 31, 2001 is
comprised solely of foreign income taxes. There was no provision for income
taxes for the period from inception (February 10, 2000) through December 31,
2000. The tax effects of temporary differences that give rise to the Company's
deferred tax assets (liabilities) as of December 31, 2001 and 2000 are as
follows:

2001 2000
-------------- ------------

U.S. net operating loss carryforwards $ 4,750,000 $ 485,500
U.S. net operating loss carryforwards (NPI) 31,756,000 --
Start-up costs not currently deductible for taxes 708,600 230,200
Depreciation (53,000) 21,400
Compensation 580,700 --
Reserves and development credit carryforwards 345,600 --
Liabilities of discontinued operations 3,535,400 --
Other 307,800 69,600
------------ ------------
41,931,100 806,700

Valuation allowance (41,931,100) (806,700)
------------ ------------

$ - $ -
============ ============

The difference between the provision for income taxes computed at the
Federal statutory rate and the reported amount of tax expense attributable to
loss before income taxes for the year ended December 31, 2001 and for the period
from inception (February 10, 2000) through December 31, 2000 is as follows:

2001 2000
------------ ------------

Tax recovery at Federal statutory rate $(3,411,700) $ (712,500)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit (819,400) (147,300)
Non-deductible expenses 34,600 34,700
Foreign tax credit (21,490) 18,400
Foreign tax rate differential (610) --
Research and development credit (345,600) --
Increase in valuation allowance 4,585,690 806,700
----------- -----------

$ 21,490 $ --
=========== ===========

-33-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

For the year ended December 31, 2001 and the period from inception
(February 10, 2000) through December 31, 2000, the Company had pre-tax losses of
$10,100,000 and $2,044,000, respectively in the U.S. and a pre-tax profit (loss)
from foreign operations of $65,000 and ($52,000), respectively. As of December
31, 2001, the Company has U.S. net operating loss carryforwards of approximately
$11,309,500, which expire in 2020 and 2021. As of the date of the merger, NPI
had U.S. net operating losses of $93,400,000 that start to expire in December,
2012. At December 31, 2001 and 2000, the Company has established a valuation
allowance against its net deferred tax assets due to the Company's pre-tax
losses and the resulting likelihood that the deferred tax asset is not
realizable. The utilization of certain tax loss carryforwards may be subject to
annual limitations imposed by the Internal Revenue Code Section 382 due to the
Company's various equity transactions which may result in a change of control.
NPI experienced such ownership change as a result of the merger. As such, the
Company's ability to use its NOL carryforward to offset taxable income in the
future may be significantly limited. The Company is in the process of
determining the amount of such limitation. If the entire deferred tax asset were
realized, $4,816,100 would be allocated to paid-in capital with the remainder
reducing income tax expense. Of the amount allocable to paid in capital,
$3,880,500 related to the tax effect of the deductions that will result from
payments of the liabilities of discontinued operations and the balance, $935,600
related to the effect of compensation deductions from exercises of employee and
consultants stock options.

(7) Stockholders' Equity

Upon the incorporation of the Company on February 10, 2000, the Company
issued 10,827,831 shares of its common stock for proceeds of $30,000.

In November 2000, in connection with a consulting agreement, the
Company, in addition to agreeing to pay a monthly consulting fee, sold 72,185
shares of common stock to a consultant for $25,000 ($0.35 per share). The
consultant's rights to such shares will vest for 23,821 on each of November 1,
2001 and 2002 and 24,543 on November 1, 2003. As of March 31, 2001, the services
related to this consulting agreement were fully performed. The excess of the
fair value of the common stock over $0.35 of $122,000 and $32,000 in 2001 and
2000, respectively was recorded as cumulative consulting expense each period up
until the services were fully performed.

In March 2000, the Company issued 3,000,000 shares of its Series A
convertible preferred stock ("Series A") at $1.00 per share for net proceeds of
$2,976,329. While outstanding, each share of Series A was convertible, at the
option of the holder, into five shares of common stock. The holders of Series A
were entitled to receive cumulative cash dividends at the same rate as dividends
are paid with respect to the common stock. The Series A was not redeemable at
the option of the holder and had a liquidation preference equal to the greater
of $1.00 per share plus all accumulated unpaid dividends, or the amount that the
Series A holders would have received had they converted all Series A into shares
of common stock.

In September 2000, the Company issued 4,900,000 shares of its Series B
convertible preferred stock ("Series B") at $1.43 per share for net proceeds of
$6,997,116. While outstanding each share of Series B was convertible, at the
option of the holder, into two shares of common stock. The holders of Series B
were entitled to receive cumulative cash dividends at the same rate as dividends
are paid with respect to the common stock. The Series B was not redeemable at
the option of the holder and had a liquidation preference equal to the greater
of the amount that the Series B holders would have received had they converted
all Series B into shares of common stock, or the aggregate purchase price paid
for the Series B plus all accumulated unpaid dividends.

On May 4, 2001, the Company issued 3,193,678 shares of its Series C
preferred stock ("Series C") at 2.55 per share for net proceeds of $7,932,335.
While outstanding, each share of Series C was convertible, at the option of the
holder, into one share of common stock. The Series C automatically converted
into common stock upon the consummation of a merger or consolidation of the
Company with or into another company. The holders of Series C were entitled to
receive cumulative cash dividends at the same rate as dividends are paid with
respect to the common stock. The Series C was not redeemable at the option of
the holder and had a liquidation

-34-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

preference equal to the greater of $2.55 per share plus all accumulated unpaid
dividends, or the amount that the Series C holders would have received had they
converted all Series C into shares of common stock.

The issuance of the Series C preferred stock resulted in a beneficial
conversion feature, which was recorded as a preferred stock dividend in the
second quarter of 2001, since the Series C preferred stock was convertible at
issuance. The beneficial conversion feature of $3,896,287 was calculated on the
date of issuance, based on the difference between the fair value of the
Company's common stock which would be issued upon conversion of the preferred
stock and the amount paid for the preferred stock.

In connection with the Company's merger with NPI in August 2001, all of
FalconStor's preferred stock was converted into common stock which resulted in
an additional 20,207,460 shares of common stock outstanding and, for accounting
purposes, the merger resulted in the issuance of 13,348,605 common shares to
NPI's pre-merger shareholders.

(8) Stock Option Plans

As of May 1, 2000, the Company adopted the FalconStor, Inc. 2000 Stock
Option Plan (the "Plan"). The Plan is administered by the Board of Directors and
provides for the issuance of up to 8,662,296 options, as amended, to employees,
consultants and non-employee directors. Options may be incentive ("ISO") or
non-qualified. Exercise prices of ISOs granted must be at least equal to the
fair value of the common stock on the date of grant, and have terms not greater
than ten years, except those to an employee who owns stock greater than 10% of
the voting power of all classes of stock of the Company, in which case they must
have an option price at least 110% of the fair value of the stock, and expire
after five years from the date of grant.

Certain of the options granted to employees had exercise prices less
than the fair value of the common stock on the date of grant, which resulted in
deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively.
The amortization of deferred compensation amounted to $471,317 and $27,609 in
2001 and 2000, respectively.

The Company granted options to certain non-employee consultants to
purchase an aggregate of 25,546 and 203,563 shares of common stock in exchange
for professional services received during 2001 and 2000, respectively. The
aggregate fair value of these options as determined using the fair value method
under SFAS No. 123, amounted to $328,802 and $86,647 in 2001 and 2000,
respectively.

As of December 31, 2001, there were outstanding options to purchase
1,066,759 common shares under several of the former NPI stock option plans. All
of these outstanding options expire within one year and the Company does not
intend to grant any additional options under these plans except for the 1994
Outside Directors Stock Option Plan which has 150,000 shares authorized for
issuance upon the exercise of options, of which options to purchase 125,000
shares are outstanding as of December 31, 2001. The Company will seek
stockholder approval to increase the number of shares issuable upon the exercise
of options under this plan from 150,000 to 500,000.

-35-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

Stock option activity for the periods indicated is as follows:

Weighted
average
Number of exercise
Options price
------------ ---------

Outstanding at February 10, 2000 (inception) ... --
Granted ........................................ 4,735,027 $ 0.35
Exercised ...................................... --
Canceled ....................................... --
--------

Outstanding at December 31, 2000 ............... 4,735,027 $ 0.35
Granted ........................................ 2,591,451 $ 5.37
Assumed in connection with NPI acquisition .... 1,717,040 $ 10.78
Exercised ...................................... (593,297) $ 0.43
Canceled ....................................... (1,175,504) $ 8.46
----------

Outstanding at December 31, 2001 ............... 7,274,717 $ 3.28
=========

Vested at December 31, 2001 .................... 2,177,265 $ 4.49
==========

Options available for grant at December 31, 2001 2,019,385
==========

The following table summarizes information about stock options
outstanding at December 31, 2001:

Options Outstanding Options Exercisable
------------------------------------------------------- --------------------------------------

Weighted Average Weighted Weighted
Range of Number Remaining Contractual Average Exercise Number Average Exercise
Exercise Price Outstanding Life (Years) Price Outstanding Price
-------------- ----------- ------------ ----- ----------- -----

$ 0.35 4,534,393 8.5 $ 0.35 1,179,214 $ 0.35
$ 1.01 57,749 9.0 $ 1.01 - -
$ 2.63 - $ 5.94 421,414 6.0 $ 4.71 403,020 $ 4.88
$ 6.20 1,088,612 9.5 $ 6.20 - -
$ 7.63 - $ 9.13 160,000 9.0 $ 7.67 130,000 $ 7.68
$ 9.60 - $10.95 527,204 9.5 $10.37 - -
$11.88 - $17.63 445,367 8.5 $13.11 432,970 $13.00
$23.88 - $25.69 39,978 8.0 $24.57 32,061 $24.29
--------- ---------
7,274,717 2,177,265
========= =========

-36-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

The per share weighted average fair value of stock options granted
during 2001 and 2000 was $4.08 and $0.32, respectively, on the date of grant
using the Black-Scholes option-pricing method with the following weighted
average assumptions: 2001 - expected dividend yield of 0%, risk free interest
rate of 3%, expected stock volatility of 118% and an expected option life of
three years for options granted to employees of the Company, and an option life
of ten years for options granted to non-employees; 2000 - expected dividend
yield of 0%, risk free interest rate of 6%, expected stock volatility of 60% and
an expected option life of five years for options granted to employees of the
Company, and an option life of ten years for options granted to non-employees.

The Company applies the provisions of APB Opinion No. 25 in accounting
for stock-based employee compensation. Had the Company determined stock-based
compensation cost based upon the fair value method under SFAS No. 123, the
Company's pro forma net loss and diluted net loss per share would have been
adjusted to the pro forma amounts indicated below:

2001 2000
---- ----

Net loss attributable to common shareholders- as reported .................$ (13,952,037) $ (2,095,719)

Net loss - pro forma ......................................................$ (16,875,614) $ (2,256,180)

Basic net loss per common share - as reported..............................$ (0.40) $ (0.09)

Basic net loss per common share - pro forma................................$ (0.48) $ (0.09)

(9) Investments

On October 5, 2001, the Company invested $2,300,062 in Network-1
Security Solutions, Inc. ("Network-1"), a publicly traded corporation that
develops next generation distributed firewalls and other network security
software products. As part of a private placement, for its investment the
Company received Network-1's preferred stock, which if converted into common
stock, would represent an approximate 16.5% ownership of Network-1. This
investment is accounted for under the cost method.

Simultaneously with this investment, the Company entered into a
multi-year Technology License Agreement with Network-1, in which the Company
will have the right to distribute Network-1's product offerings in its indirect
and OEM channels.

(10) Other Assets

In 2001, the Company purchased two software licenses for $2,240,000.
The Company is further developing the acquired software, which is included in
other assets and is being amortized over three years.

(11) Net Liabilities of Discontinued Operations

-37-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

As of December 31, 2001, the Company consummated the wind down of NPI's
discontinued operations, including the termination of all of NPI's former
employees. Liabilities of NPI's discontinued operations at December 31, 2001
consisted of $3.0 million in future lease obligations, $0.9 million in warranty
related liabilities, $0.4 million in severance related payments, $0.4 million in
professional fees and $3.7 million in other related liabilities, including
estimated settlement costs for disputes.

(12) Commitments

The Company has an operating lease covering its primary office facility
that expires in July, 2007. The Company also has a sales office in California
and several operating leases related to offices in foreign countries. The
expiration date for these leases ranges from 2002 through 2004. The following is
a schedule of future minimum lease payments for these operating leases as of
December 31, 2001:

Year ending December 31,
------------------------

2002 ..... $ 499,144
2003 ..... 399,824
2004 ..... 293,556
2005 ..... 269,968
2006 ..... 303,919
Thereafter 150,429
----------

$1,916,840
==========

These leases require the Company to pay its proportionate share of
real estate taxes and other common charges. Total rent expense for operating
leases was $381,260 and $68,571 for the year ended December 31, 2001 and the
period from inception (February 10, 2000) through December 31, 2000,
respectively.

(13) Stock Repurchase Program

On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases will be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. As of December 31, 2001, the Company
repurchased a total of 190,000 shares for $1,220,730.

(14) Segment Reporting

The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the year ended
December 31, 2001 and the period from inception (February 10, 2000) to December
31, 2000 and the location of long-lived assets as of December 31, 2001 and 2000
are summarized as follows:

-38-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

2001 2000
---------- -----------

Revenues:
United States $1,755,823 $ 143,294
Asia $3,581,791 $ --
Other international $ 254,115 $ --
---------- ----------

Total revenues $5,591,729 $ 143,294
========== ==========

Long-lived assets (includes all non-current assets):
United States $5,963,235 $ 764,056
Asia $ 301,923 $ 39,244
Other international $ 61,676 $ --
---------- ----------

Total long-lived assets $6,326,834 $ 803,300
========== ==========

For the year ended December 31, 2001, the Company had one customer that
accounted for 13% of revenues and for the period from inception (February 10,
2000) through December 31, 2000, the Company had one customer that accounted for
64% of revenues.

(15) Valuation and Qualifying Accounts - Allowance for Doubtful Accounts

Balance at Balance at
Beginning of Additions charged End of
Period Ended, Period to Expense Deductions Period
------------- ------ ---------- ---------- ------

December 31, 2000 $ - $ - $ - $ -

December 31, 2001 $ - $ 128,138 $ - $ 128,138

(16) Quarterly Financial Data (Unaudited)

The following is a summary of selected quarterly financial data for the
year ended December 31, 2001 and the period from inception (February 10, 2000)
through December 31, 2000:

2001 2000
--------------------------------------------------------- ------------------------------------------------------
Fourth Third Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
------- ------- ------- ------- ------- ------- ------- -------

Revenue $ 3,026,442 $ 2,521,887 $ 43,400 $ -- $ 74,944 $ 68,350 $ -- $ --
=========== =========== =========== ============= =========== =========== ========= ===========

Net loss $(1,251,501) $(1,443,657) $(4,448,424) $ (2,912,168) $(1,399,113) $ (489,388) $(155,744) $ (51,474)
=========== =========== =========== ============= =========== =========== ========= ===========

-39-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

Basic and diluted
net loss per share $ (0.03) $ (0.04) $ (0.15) $ (0.10) $ (0.05) $ (0.02) $ (0.01) $ (0.004)
========== ============ ============ =========== =========== ========== =========== ==========

Basic and
and diluted weighted
average common
shares outstanding 44,723,121 37,004,055 30,333,760 28,802,095 28,700,094 21,655,701 21,655,701 13,037,600
========== ============ ============ =========== =========== ========== =========== ===========

The sum of the quarterly net loss per share amounts do not always equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each such period.

-40-

Item 9. Changes in and disagreements with Accountants on Accounting and
Financial Disclosure

For information relating to the change in the Company's independent
public accountants, please see the Form 8-K filed by the Company on
September 6, 2001 which is incorporated herein by reference.

Item 10. Directors and Executive Officers of the Registrant

Information called for by Part III, Item 10, regarding the
Registrant's directors will be included in our Proxy Statement
relating to our annual meeting of stockholders to be held in May
2002, and is incorporated herein by reference. The information
appears in the Proxy Statement under the caption "Election of
Directors." The Proxy Statement will be filed within 120 days of
December 31, 2001, our year end.

Item 11. Executive Compensation

Information called for by Part III, Item 11, will be included in our
Proxy Statement relating to our annual meeting of stockholders to be
held in May 2002, and is incorporated herein by reference. The
information appears in the Proxy Statement under the caption
"Executive Compensation." The Proxy Statement will be filed within
120 days of December 31, 2001, our year end.

Item 12. Security Ownership of Certain Beneficial Owners and Management

Information called for by Part III, Item 12, will be included in our
Proxy Statement relating to our annual meeting of stockholders to be
held in May 2002, and is incorporated herein by reference. The
information appears in the Proxy Statement under the caption
"Beneficial Ownership of Shares." The Proxy Statement will be filed
within 120 days of December 31, 2001, our year end.

Item 13. Certain Relationships and Related Transactions

Information regarding our relationships and related transactions is
available under "Certain Transactions" in our Proxy Statement
relating to our annual meeting of stockholders to be held in May
2002, and is incorporated by reference. The Proxy Statement will be
filed within 120 days of December 31, 2001, our year end.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K

The information required by subsections (a)(1) and (a)(2) of this
item are included in the response to Item 8 of Part II of this annual report on
Form 10-K.

(b) Reports on Form 8-K

None.

(c) 2.1 Agreement and Plan of Merger and Reorganization,
dated as of May 4, 2001, among FalconStor, Inc.,
Network Peripherals Inc. and Empire Acquisition Corp,
incorporated herein by reference to Annex A to the
Registrant's joint proxy/prospectus on Form S-4,
filed on May 11, 2001.

3.1 Restated Certificate of Incorporation, incorporated
herein by reference to Exhibit 3.1 to the
Registrant's registration statement on Form S-1 (File
no. 33-79350), filed on April 28, 1994.

-41-

3.2 Bylaws, incorporated herein by reference to Exhibit
3.2 to the Registrant's quarterly report on Form 10-Q
for the period ended March 31, 2000, filed on May 10,
2000.

3.3 Certificate of Amendment to the Certificate of
Incorporation, incorporated herein by reference to
Exhibit 3.3 to the Registrant's annual report on Form
10-K for the year ended December 31, 1998, filed on
March 22, 1999.

3.4 *Certificate of Amendment to the Certificate of
Incorporation.

4.1 2000 Stock Option Plan, incorporated herein by
reference to Exhibit 4.1 to the Registrant's
registration statement on Form S-8, filed on
September 21, 2001.

4.2 1994 Outside Directors Stock Plan, incorporated
herein by reference to Exhibit 10.4 to the
Registrant's registration statement on Form S-1 (File
no. 33-79350), filed on April 28, 1994.

10.1 *Agreement of Lease between Reckson Operating
Partnership, L.P. and FalconStor.net, Inc. dated
July, 2000.

10.2 *First Lease Modification and Extension Agreement
between Reckson Operating Partnership, L.P. and
FalconStor, Inc. dated May 25, 2001.

10.3 *ReiJane Huai Employment Agreement, dated September
1, 2001 between the Registrant and ReiJane Huai.

10.4 *Change of Control Agreement dated December 10, 2001
between the Registrant and ReiJane Huai.

10.5 *Change of Control Agreement dated December 7, 2001
between the Registrant and Wayne Lam.

10.6 *Change of Control Agreement dated December 10, 2001
between Registrant and Jacob Ferng.

16.1 Letter of PricewaterhouseCoopers LLP regarding
termination as certifying accountant, incorporated
herein by reference to Exhibit 16.1 to the
Registrant's current report on Form 8-K, filed on
September 6, 2001.

21.1 Subsidiaries of Registrant -- FalconStor, Inc.

23.1 *Consent of KPMG LLP.

* - filed herewith.

-42-

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has signed this report by the
undersigned, thereunto duly authorized in the City of New York, State of New
York on March 26, 2002.

FALCONSTOR SOFTWARE, INC.

By: /s/ ReiJane Huai Date: March 27, 2002
-----------------------------------------
ReiJane Huai, President, Chief Executive
Officer of FalconStor Software, Inc.

POWER OF ATTORNEY

FalconStor Software, Inc. and each of the undersigned do hereby
appoint ReiJane Huai and Jacob Ferng, and each of them severally, its or his
true and lawful attorney to execute on behalf of FalconStor Software, Inc. and
the undersigned any and all amendments to this Annual Report on Form 10-K and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission; each of such attorneys
shall have the power to act hereunder with or without the other.

Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.

By: /s/ ReiJane Huai March 27, 2002
-------------------------------------------------------- ------------------
ReiJane Huai, President, Chief Executive Officer and Date
Chairman of the Board
(Principal Executive Officer)

By: /s/ Jacob Ferng March 27, 2002
-------------------------------------------------------- ------------------
Jacob Ferng, Chief Financial Officer, Vice President Date
and Secretary
(Principal Accounting Officer)

By: /s/ Lawrence S. Dolin March 27, 2002
-------------------------------------------------------- ------------------
Lawrence S. Dolin, Director Date

By: /s/ Steven R. Fischer March 27, 2002
-------------------------------------------------------- ------------------
Steven R. Fischer, Director Date

By: /s/ Steven H. Owings March 27, 2002
-------------------------------------------------------- -----------------
Steven H. Owings, Director Date

-43-