FALCONSTOR SOFTWARE INC - 10-Q Quarterly Report

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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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

For the quarterly period ended June 30, 2002
--------------------------------------

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

For the transition period from _______________ to __________________

Commission File Number 0-23970

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

DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer
Identification No.)

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

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

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 / /

The number of shares of Common Stock issued and outstanding as of August 1, 2002
was 45,224,176, which includes redeemable common shares.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

Page

PART I. Financial Information 3

Item 1. Consolidated Financial Statements 3

Consolidated Balance Sheets at June 30, 2002
(unaudited) and December 31, 2001 3

Unaudited Consolidated Statements of Operations for the
three and six months ended June 30, 2002 and 2001 4

Unaudited Consolidated Statements of Cash Flows for the
six months ended June 30, 2002 and 2001 5

Notes to the Unaudited Condensed Consolidated
Financial Statements 6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 9

Item 3. Qualitative and Quantitative Disclosures about Market Risk 18

PART II. Other Information 19

Item 4. Submission of Matters to a Vote of Security Holders 19

Item 6. Exhibits and Reports on Form 8-K 19

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PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, 2002 December 31, 2001
------------- -----------------
Assets (unaudited)
Current assets:
Cash and cash equivalents ................................................ $ 27,838,015 $ 38,370,937
Marketable securities .................................................... 30,819,875 26,156,180
Accounts receivable, net ................................................. 2,532,878 2,539,987
Prepaid expenses and other current assets ................................ 1,066,955 1,077,017
------------ ------------

Total current assets ............................................ 62,257,723 68,144,121

Property and equipment, net ................................................. 2,067,369 1,605,396
Investments ................................................................. 2,375,062 2,300,062
Other assets ................................................................ 2,422,766 2,421,376
------------ ------------

Total assets .................................................... $ 69,122,920 $ 74,470,955
============ ============

Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 395,590 $ 544,998
Accrued expenses ......................................................... 1,372,416 1,588,723
Deferred revenue ......................................................... 847,415 357,912
Net liabilities of discontinued operations ............................... 6,556,048 8,134,322
------------ ------------

Total current liabilities ....................................... 9,171,469 10,625,955
------------ ------------

Long-term liabilities of discontinued operations ........................ 60,691 283,428
------------ ------------

Commitments

Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
45,456,794 and 45,049,379 shares issued, respectively 45,457 45,049
Additional paid-in capital ............................................... 79,231,785 77,991,996
Deferred compensation .................................................... (703,175) (1,026,674)
Accumulated deficit ...................................................... (17,197,525) (12,151,469)
Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,220,730)
Accumulated other comprehensive loss ..................................... (50,652) (76,600)
------------ ------------

Total stockholders' equity ...................................... 59,890,760 63,561,572
------------ ------------
Total liabilities and stockholders' equity ...................... $ 69,122,920 $ 74,470,955
============ ============

See accompanying notes to unaudited consolidated financial statements.

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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Three Months Ended June 30, Six Months Ended June 30,
---------------------------- -----------------------------

2002 2001 2002 2001
------------ ------------- ------------ ------------
Revenues ................................. $ 2,376,618 $ 43,400 $ 4,357,460 $ 43,400

Operating expenses:
Cost of revenues ...................... 574,557 555,174 1,167,809 555,174
Software development costs ............ 1,822,433 1,323,929 3,517,189 2,285,421
Selling and marketing ................. 2,263,565 2,306,433 4,301,355 3,450,703
General and administrative ............ 637,536 610,431 1,255,024 1,495,489
------------ ------------ ------------ ------------
5,298,091 4,795,967 10,241,377 7,786,787
------------ ------------ ------------ ------------
Operating loss ................ (2,921,473) (4,752,567) (5,883,917) (7,743,387)
------------ ------------ ------------ ------------

Interest and other income ................ 456,802 305,455 837,861 384,107
------------ ------------ ------------ ------------

Loss before income taxes ........ (2,464,671) (4,447,112) (5,046,056) (7,359,280)

Provision for income taxes ............... -- 1,312 -- 1,312
------------ ------------ ------------ ------------

Net loss ........................ $ (2,464,671) $ (4,448,424) $ (5,046,056) $ (7,360,592)
------------ ------------ ------------ ------------

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

Net loss attributable to common
shareholders .......................... $ (2,464,671) $ (8,344,711) $ (5,046,056) $(11,256,879)
============ ============ ============ ============

Basic and diluted net loss per share ..... $ (0.05) $ (0.28) $ (0.11) $ (0.38)
============ ============ ============ ============

Weighted average basic and diluted shares
outstanding ........................... 45,238,657 30,333,760 45,211,607 29,572,159
============ ============ ============ ============

See accompanying notes to unaudited consolidated financial statements.

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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Six Months Ended Six Months Ended
June 30, 2002 June 30, 2001
------------- -------------
Cash flows from operating activities:
Net loss ......................................... $ (5,046,056) $ (7,360,592)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization .............. 769,194 133,476
Non-cash professional services expenses .... 16,353 429,671
Equity-based compensation earned ........... 459,305 217,055
Changes in operating assets and liabilities:
Accounts receivable, net ................... 7,109 (459,814)
Prepaid expenses and other current assets .. 10,062 (118,940)
Other assets ............................... (53,890) (248,197)
Accounts payable ........................... (149,408) 510,279
Accrued expenses ........................... (216,307) 1,016,940
Deferred revenue ........................... 489,503 690,400
------------ ------------

Net cash used in operating activities ... (3,714,135) (5,189,722)
------------ ------------

Cash flows from investing activities:
Purchase of marketable securities ................ (11,990,346) --
Sale of marketable securities .................... 7,326,429 --
Purchase of investment ........................... (75,000) --
Purchase of property and equipment ............... (828,667) (796,267)
Purchase of software licenses .................... (350,000) --
Payments of liabilities of discontinued operations (1,801,011) --
------------ ------------

Net cash used in investing activities ......... (7,718,595) (796,267)
------------ ------------
Cash flows from financing activities:
Net proceeds from issuance of preferred stock .... -- 30,522,086
Payments to acquire treasury stock ............... (214,400) --
Proceeds from exercise of stock options .......... 1,088,038 58,765
------------ ------------

Net cash provided by financing activities ..... 873,638 30,580,851
------------ ------------

Effect of exchange rate changes on cash ............. 26,170 (19,508)
------------ ------------

Net (decrease) increase in cash and cash equivalents (10,532,922) 24,575,354

Cash and cash equivalents, beginning of period ...... 38,370,937 7,727,182
------------ ------------

Cash and cash equivalents, end of period ............ $ 27,838,015 $ 32,302,536
============ ============

The Company did not pay any interest expense or income taxes for the six
months ended June 30, 2002 and 2001.

See accompanying notes to unaudited consolidated financial statements.

-5-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(1) Summary of Significant Accounting Policies

(a) The Company and 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.

(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 unaudited interim consolidated financial statements of the Company as of and
for the three and six months ended June 30, 2002 and 2001, included herein have
been prepared, without audit, pursuant to the rules and regulations of the SEC.
Certain information and note disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to such
rules and regulations relating to interim financial statements.

In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at June 30, 2002 and the results of its operations for the three
and six months ended June 30, 2002 and 2001.

(d) Cash Equivalents and Marketable Securities

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
$27.5 million at June 30, 2002. Cash at June 30, 2002 amounted to $0.3 million.
Marketable securities at June 30, 2002 amounted to $30.8 million and consisted
of corporate bonds and government securities.

(e) Revenue Recognition

The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, Software Revenue Recognition. 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
services, which are billed on a time and material basis, are also recognized as
revenue when the services are performed. Costs of providing these services are
included in cost of revenues.

-6-

The Company has entered into various distribution, licensing and joint promotion
agreements with OEMs 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 related software
engineering services are complete, if any, and the software product master is
delivered and accepted.

Revenue from maintenance fees and services was $278,339 and $624,237 for the
three and six months ended June 30, 2002, respectively. All other revenues were
derived from software licenses. Revenues for the three and six months ended June
30, 2001 were comprised of $23,000 from software licenses and $20,000 from
network consulting fees.

(f) 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 a net loss, all common stock equivalents were excluded from diluted net loss
per share. As of June 30, 2002 potentially dilutive common stock equivalents
included 8,287,118 stock options outstanding.

(g) Comprehensive Loss

Comprehensive loss amounted to $2,171,997 and $4,473,931 for the three months
ended June 30, 2002 and 2001, respectively, and $5,020,108 and $7,380,100 for
the six months ended June 30, 2002 and 2001, respectively. Comprehensive loss
includes the Company's foreign currency translation adjustments of $40,319 and
$(25,507) for the three months ended June 20, 2002 and 2001, respectively, and
$26,170 and $(19,508) for the six months ended June 30, 2002 and 2001,
respectively. Additionally, comprehensive loss includes the Company's unrealized
gains/(losses) on marketable securities of $252,355 and $(222) for the three and
six months ended June 20, 2002, respectively.

(h) Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect 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.

(i) New Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 142 "Goodwill And Other Intangible
Assets" ("SFAS No. 142"), which was effective January 1, 2002. SFAS No. 142
establishes accounting and reporting standards for goodwill and other intangible
assets. In accordance with SFAS No. 142, an entity can 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 must be separately recognized and amortized over their useful life. The
Company adopted SFAS 142 effective January 1, 2002, and such adoption had no
impact on the Company's consolidated financial statements.

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 recorded in the period(s) in
which the losses are incurred, rather than as of the measurement date as
previously required. The Company adopted SFAS 144 effective January 1, 2002, and
such adoption had no impact on the Company's consolidated financial statements.

-7-

(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 three and six months ended June 30, 2002 and 2001.

Three months Ended Six months Ended
June 30, June 30,
2002 2001 2002 2001

Revenues $ 2,376,618 $ 43,400 $ 4,357,460 $ 43,400
Net loss from continuing operations (2,464,671) (4,448,424) (5,046,056) (7,360,592)
Basic and diluted net
loss from continuing operations per share $ (0.05) $ (0.10) $ (0.11) $ (0.17)
Weighted average basic and
diluted shares outstanding 45,238,657 43,682,365 45,211,607 42,920,764

The pro forma information is provided for illustrative purposes only and does
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.

(3) 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 three and six
months ended June 30, 2002 and 2001 and the location of long-lived assets as of
June 30, 2002 and December 31, 2001 are summarized as follows:

-8-

Three Months Ended June 30, Six Months Ended June 30,

2002 2001 2002 2001
---------- ----------- ---------- -----------
Revenues:
United States $1,324,595 $ 43,400 $2,493,292 $ 43,400
Asia and other international 1,052,023 -- 1,864,168 --
---------- ---------- ---------- ----------

Total revenues $2,376,618 $ 43,400 $4,357,460 $ 43,400
========== ========== ========== ==========

June 30, December 31,
2002 2001
---------- ------------

Long-lived assets (includes all non-current assets):
United States $6,433,720 $5,963,235
Asia and other international 431,477 363,599
---------- ----------

Total long-lived assets $6,865,197 $6,326,834
========== ==========

(4) Stockholders' Equity

On May 17, 2002, the shareholders of the Company approved amendments to the
Company's 1994 Outside Directors Stock Option Plan, as amended (the "1994 Plan")
to (i) increase the number of shares issuable upon exercise of options under the
1994 Plan from 150,000 to 500,000, (ii) increase the initial grant of shares
underlying options each non-employee director is entitled to receive on the day
they become a non-employee director from 15,000 to 50,000 shares of common
stock, and (iii) increase the annual grant for shares underlying options for
non-employee directors from 5,000 to 10,000 shares. Shareholders also approved
an amendment to the Company's 2000 Stock Option Plan to increase the number of
shares of common stock reserved for issuance thereunder by 2,000,000 from
8,662,296 to 10,662,296.

(5) Subsequent Events

On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned subsidiary of
the Company, acquired all of the common stock of IP Metrics Software, Inc. ("IP
Metrics"), a provider of intelligent trunking software and high availability
consulting services for mission-critical networks, for $2.5 million in cash plus
payments contingent on the level of revenues from IP Metrics' products for the
next twenty-four months.

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

The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains "forward-looking statements" 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

-9-

those projected in the forward-looking statements. The following discussion
should be read together with the condensed consolidated financial statements and
notes to those 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,
leverage 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
generate significant revenues from software licenses in the third quarter of
2001.

On August 22, 2001, we merged with Network Peripherals Inc. ("NPI"), a publicly
traded company. For more information relating to the merger with NPI, including
the accounting treatment, see note 2 to the unaudited condensed 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
only when pervasive evidence of an arrangement exists and the fee is fixed and
determinable. 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
customer purchase order for each software license to be resold by an OEM,
distributor or solution provider 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.

-10-

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THE
THREE MONTHS ENDED JUNE 30, 2001.

Revenues

Revenues for the three months ended June 30, 2002 were approximately $2.4
million compared to $43,000 for the three months ended June 30, 2001. The
increase in revenues was 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 $2.1 million in revenue from software licenses and
approximately $0.3 million from maintenance, implementation and engineering
services. For the three months ended June 30, 2001, we generated only $23,000 of
revenues from software licenses since our software was not released until the
end of the second quarter of 2001. All other revenue in 2001 related to network
consulting fees.

Cost of Revenues

Cost of revenues for the three months ended June 30, 2002 remained relatively
consistent at $0.6 million compared to the same period a year ago. Cost of
revenues consists primarily of personnel costs associated with providing system
implementations and technical support under maintenance contracts and training.

Gross profit for the three months ended June 30, 2002 was $1.8 million or 76%
compared to $(511,774) for the three months ended June 30, 2001. The increase in
gross profit was due to increased software license revenues associated with the
release of our software.

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 approximately $1.8 million for the three months
ended June 30, 2002 compared to approximately $1.3 million for the three months
ended June 30, 2001. The $0.5 million increase from the prior year is mainly due
to an increase in product development personnel. The increase in employees was
needed to enhance and test our 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, trade show expenses, and the costs associated with our foreign sales
offices. Selling and marketing expenses was $2.3 million for the three months
ended June 30, 2002 and 2001. Personnel related expenses and commission expenses
increased for the three months ended June 30, 2002 compared to June 30, 2001 as
we expanded our sales force to accommodate our revenue growth. This increase was
offset by a non-cash consulting expense for option grants during the three
months ended June 30, 2001. For the three months ended June 30, 2002, we did not
incur any similar expense.

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 $0.6 million for the
three months ended June 30, 2002 and 2001.

-11-

Interest and Other Income

Interest and other income was approximately $0.5 million for the three months
ended June 30, 2002 compared to $0.3 million for the three months ended June 30,
2001. The $0.2 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.

RESULTS OF OPERATIONS - FOR THE SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO THE
SIX MONTHS ENDED JUNE 30, 2001.

Revenues

Revenues for the six months ended June 30, 2002 were approximately $4.4 million
compared to $43,000 for the six months ended June 30, 2001. The increase in
revenues 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 $3.7 million in revenue from software licenses and approximately
$0.7 million from maintenance, implementation and engineering services. For the
six months ended June 30, 2001, we generated only $23,000 in revenues from
software licenses since our software was not released until the end of the
second quarter 2001. All other revenue in 2001 was related to network consulting
fees.

Cost of Revenues

Cost of revenues for the six months ended June 30, 2002 was approximately $1.2
million compared to approximately $0.6 million for the six months ended June 30,
2001. The increase in cost of revenues from the prior year is mainly due to an
increase in employees. 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 six months ended June 30, 2002 was $3.2 million or 73%
compared to $(511,774) for the six months ended June 30, 2001. The increase in
gross profit was due to increased revenues associated with the release of our
software.

Software Development Costs

Software development costs were approximately $3.5 million for the six months
ended June 30, 2002 compared to approximately $2.3 million for the six months
ended June 30, 2001. The $1.2 million increase from the prior year is mainly due
to an increase in product development personnel. The increase in employees was
needed to enhance and test our core storage networking infrastructure software
product, as well as to develop new innovative features and options.

Selling and Marketing

Selling and marketing expenses increased from approximately $3.5 million for the
six months ended June 30, 2001 to approximately $4.3 million for the six months
ended June 30, 2002. 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 increased our marketing efforts to promote our product and to
create brand awareness.

General and Administrative

General and administrative expenses were approximately $1.3 million for the six
months ended June 30, 2002, a decrease of approximately $0.2 million from the
six months ended June 30, 2001. The decrease in general and administrative
expenses was due to a non-cash consulting expense for option grants and higher
legal fees for the six months ended June 30, 2001. These legal expenses related
to our intellectual property. For the six months ended June 30, 2002, we did not
incur any similar expenses.

-12-

Interest and Other Income

Interest and other income was approximately $0.8 million for the six months
ended June 30, 2002 compared to $0.4 million for the six months ended June 30,
2001. The $0.4 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

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 June 30, 2002, 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 June 30, 2002, we had approximately $27.8 million in cash and cash
equivalents and $30.8 million in marketable securities. Subsequent to June 30,
2002, we acquired all of the common stock of IP Metrics for $2.5 million in cash
plus payments contingent on the level of revenues from IP Metrics' products for
the next twenty-four months. Net cash used in operating activities for the six
months ended June 30, 2002 was $3.7 million compared to approximately $5.2
million for the six months ended June 30, 2001. The cash used in operating
activities for the six months ended June 30, 2002 was mainly comprised of the
Company's net loss of $5.0 million and a decrease in accrued expenses and
accounts payable and an increase in other current assets of $0.4 million. These
amounts were partially offset by non-cash expenses of $1.2 million and an
increase in deferred revenue of $0.5 million. Net cash used for the six months
ended June 30, 2001 was mainly comprised of the Company's net loss of $7.4
million and increases in accounts receivable and prepaid expenses and other
current assets totaling $0.8 million. These amounts were partially offset by
non-cash expenses of $0.8 million and increases in accounts payable, accrued
expenses and deferred revenue of $2.2 million.

Net cash used in investing activities for the six months ended June 30, 2002 was
approximately $7.7 million compared to approximately $0.8 million for the six
months ended June 30, 2001. The increase in cash used by investing activities
was mainly due to $4.7 million in net purchases of marketable securities, $1.8
million in payments of liabilities of discontinued operations, $0.8 million in
purchases of property and equipment, and $0.4 million in purchases of software
licenses. For the six months ended June 30, 2001, the net cash used was
attributable to purchases of property and equipment.

Net cash provided by financing activities was approximately $0.9 million for the
six months ended June 30, 2002. This amount was comprised of $1.1 million from
proceeds related to the exercise of stock options partially offset by payments
to acquire treasury stock of $0.2 million. Net cash provided by financing
activities for the six months ended June 30, 2001 was approximately $30.6
million, which was mainly comprised of proceeds from the issuance of preferred
stock.

As of June 30, 2002, we had $6.6 million of liabilities related to the
discontinued operations of NPI.

In October 2001, our Board of Directors authorized the repurchase of up to two
million shares of our outstanding stock, of which 235,000 shares have been
purchased through June 30, 2002.

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.

-13-

Impact of Recently Issued Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 142 "Goodwill And Other Intangible
Assets" ("SFAS No. 142"), which was effective January 1, 2002. SFAS No. 142
establishes accounting and reporting standards for goodwill and other intangible
assets. In accordance with SFAS No. 142, an entity can 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 must be separately recognized and amortized over the useful life. The
Company adopted SFAS 142 effective January 1, 2002, and such adoption had no
impact on the Company's consolidated financial statements.

RISK FACTORS

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 year ended December 31, 2001 and the six months
ended June 30, 2002, we had revenues of $5,591,729 and $4,357,460, respectively.
For the period from inception (February 10, 2000) through June 30, 2002 and for
the three months ended June 30, 2002, we had a net loss of $17,197,525 and
$2,464,671, respectively. We have signed contracts with resellers and original
equipment manufacturers, or OEMs, and believe that as a result of these
contracts, our revenues should 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.

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.

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

-14-

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
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

-15-

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.

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 to 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 contractual lock-up restrictions expiring on April 30, 2003, and
approximately 0.9 million shares of our common stock are subject to contractual
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
nine pending patent applications and twenty pending trademark applications
related to our IPStor product. We cannot predict whether we will receive patents

-16-

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.

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. Finally, we have entered into change of
control agreements with certain executives.

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 June 30, 2002, we have outstanding options to purchase an
aggregate of 8,287,118 shares of our common stock at a weighted average exercise
price of $3.57 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

-17-

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.

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.

We may not successfully integrate the products, technologies or businesses from,
or realize the intended benefits of our recent acquisition.

After the end of the quarter, we purchased IP Metrics Software, Inc., for the
purpose of complementing and expanding our business. Integration of the acquired
products, technologies and business, could divert management's time and
resources. Further, we may not be able to properly integrate the acquired
products, technologies or business, with our existing products and operations,
train, retain and motivate personnel from the acquired business, or combine
potentially different corporate cultures. If we are unable to fully integrate
the acquired products, technologies or business, or train, retain and motivate
personnel from the acquired business, we may not receive the intended benefits
of the acquisition, which could harm our business, operating results and
financial condition.

Item 3. 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.

-18-

PART II. OTHER INFORMATION

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

The Company held its annual meeting of stockholders on May 17, 2002.
38,604,421 shares of Common Stock, 85% of the outstanding shares,
were represented in person or by proxy.

Steven R. Fischer was elected to serve as a director of the Company
for a term expiring in 2005 with 38,288,963 shares voted in favor
and 315,458 shares withheld.

Amendments to the Company's 1994 Outside Directors Stock Option Plan
were approved with 35,536,561 shares voted in favor, 3,005,117
shares voted against, and 62,743 shares abstained.

An amendment to the Company's 2000 Stock Option Plan was approved
with 35,370,325 shares voted in favor, 3,159,389 shares voted
against, and 74,707 shares abstained.

The selection of KPMG LLP as independent accountants for the Company
was approved with 38,389,295 shares voted in favor, 201,508 shares
voted against, and 13,618 shares abstained.

ITEM 6. Exhibits and Reports On Form 8-K

(a) Exhibits

99.1 Stock Purchase Agreement dated July 1, 2002, by
and among IP Metrics Software, Inc., David
Wilbanks, Brett Dolecheck, Mike Reyero, Mark
Coker, FalconStor AC, Inc., and FalconStor
Software, Inc.

99.2 Amendments to the 1994 Outside Directors Stock
Option Plan.

99.3 Amendments to the 2000 Stock Option Plan.

99.4 Certification of the Chief Executive Officer and
the Chief Financial Officer.

(b) Reports on Form 8-K

On July 16, 2002, we filed a Form 8-K under Item 5.

-19-

SIGNATURES

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

FALCONSTOR SOFTWARE, INC.

/s/ ReiJane Huai
----------------
ReiJane Huai
Chairman and Chief Executive Officer

/s/ Jacob Ferng
---------------
Jacob Ferng
Chief Financial Officer and Vice President
(Principal Accounting Officer)

August 13, 2002