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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 March 31, 2003
--------------------------------------
/ / 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 / /
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act). Yes /X/ No / /
The number of shares of Common Stock issued and outstanding as of May 7, 2003
was 45,613,814, which includes redeemable common shares.
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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 March 31, 2003
(unaudited) and December 31, 2002 3
Unaudited Consolidated Statements of Operations for the
three months ended March 31, 2003 and 2002 4
Unaudited Consolidated Statements of Cash Flows for the three
months ended March 31, 2003 and 2002 5
Notes to the Unaudited Condensed Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Qualitative and Quantitative Disclosures about Market Risk 21
Item 4. Controls and Procedures 21
PART II. Other Information 22
Item 6. Exhibits and Reports on Form 8-K 22
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PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, 2003 December 31, 2002
-------------- -----------------
Assets (unaudited)
Current assets:
Cash and cash equivalents ................................................ $ 15,600,619 $ 14,191,075
Marketable securities .................................................... 30,731,311 36,910,448
Accounts receivable, net ................................................. 3,941,408 4,285,892
Prepaid expenses and other current assets ................................ 733,498 1,167,174
------------ ------------
Total current assets ............................................ 51,006,836 56,554,589
Property and equipment, net ................................................. 2,476,644 2,068,001
Goodwill .................................................................... 3,301,599 3,301,599
Other intangible assets, net ................................................ 319,722 309,491
Other assets ................................................................ 3,061,987 2,476,306
------------ ------------
Total assets .................................................... $ 60,166,788 $ 64,709,986
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 450,770 $ 437,088
Accrued expenses ......................................................... 1,942,677 1,987,651
Deferred revenue ......................................................... 2,225,983 2,182,729
Net liabilities of discontinued operations ............................... 1,291,398 4,201,465
------------ ------------
Total current liabilities ....................................... 5,910,828 8,808,933
------------ ------------
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
45,824,882 and 45,527,590 shares issued, respectively 45,825 45,528
Additional paid-in capital ............................................... 81,536,321 81,423,661
Deferred compensation .................................................... (355,576) (471,445)
Accumulated deficit ...................................................... (25,433,487) (23,694,634)
Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,435,130)
Accumulated other comprehensive (loss) gain .............................. (101,993) 33,073
------------ ------------
Total stockholders' equity ...................................... 54,255,960 55,901,053
------------ ------------
Total liabilities and stockholders' equity ...................... $ 60,166,788 $ 64,709,986
============ ============
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
March 31,
2003 2002
---- ----
Revenues:
Software license revenue ............................ $ 2,686,818 $ 1,634,944
Software services and other revenue ................. 992,089 345,898
------------ ------------
3,678,907 1,980,842
------------ ------------
Operating expenses:
Amortization of purchased and capitalized software 261,213 7,881
Cost of software services and other revenue ...... 592,001 311,339
Software development costs ....................... 1,634,792 1,694,756
Selling and marketing ............................ 2,548,930 2,311,822
General and administrative ....................... 692,320 617,488
------------ ------------
5,729,256 4,943,286
------------ ------------
Operating loss ........................... (2,050,349) (2,962,444)
------------ ------------
Interest and other income ........................... 318,311 381,059
------------ ------------
Loss before income taxes ................... (1,732,038) (2,581,385)
Provision for income taxes .......................... 6,815 --
------------ ------------
Net loss ................................... $ (1,738,853) $ (2,581,385)
------------ ------------
Basic and diluted net loss per share ................ $ (0.04) $ (0.06)
============ ============
Weighted average basic and diluted shares
outstanding ...................................... 45,499,862 45,184,257
============ ============
See accompanying notes to unaudited consolidated financial statements.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
2003 2002
---- ----
Cash flows from operating activities:
Net loss ............................................. $ (1,738,853) $ (2,581,385)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization .................. 588,938 352,618
Non-cash professional services expenses ........ 10,901 12,600
Equity-based compensation expense .............. 115,869 358,546
Changes in operating assets and liabilities:
Accounts receivable, net ....................... 344,484 141,316
Prepaid expenses and other current assets ...... 433,676 (150,294)
Other assets ................................... (50,541) (6,788)
Accounts payable ............................... 13,682 113,821
Accrued expenses ............................... (44,974) (173,700)
Deferred revenue ............................... 43,254 342,194
------------ ------------
Net cash used in operating activities ....... (283,564) (1,591,072)
------------ ------------
Cash flows from investing activities:
Sale of marketable securities ........................ 8,349,508 --
Purchase of marketable securities .................... (2,300,000) (9,973,296)
Purchase of property and equipment ................... (690,047) (481,271)
Purchase of software licenses ........................ (811,000) --
Purchase of intangibles .............................. (41,905) --
------------ ------------
Net cash provided by (used in) investing activities 4,506,556 (10,454,567)
------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options .............. 102,056 1,076,538
------------ ------------
Net cash provided by financing activities ......... 102,056 1,076,538
------------ ------------
Cash flows from discontinued operations:
Payments of liabilities of discontinued operations ... (2,910,067) (1,460,101)
------------ ------------
Effect of exchange rate changes on cash ................. (5,437) (14,149)
------------ ------------
Net increase (decrease) in cash and cash equivalents .... 1,409,544 (12,443,351)
Cash and cash equivalents, beginning of period .......... 14,191,075 38,370,937
------------ ------------
Cash and cash equivalents, end of period ................ $ 15,600,619 $ 25,927,586
============ ============
The Company did not pay any interest expense or income taxes for the three
months ended March 31, 2003 and 2002. 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 network storage infrastructure software solutions 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.
(c) UNAUDITED INTERIM FINANCIAL INFORMATION
The unaudited interim consolidated financial statements of the Company as of
and for the three months ended March 31, 2003 and 2002, included herein have
been prepared, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission ("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 March 31, 2003 and the results of its operations for the three
months ended March 31, 2003 and 2002.
(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
$15.0 million at March 31, 2003. Marketable securities at March 31, 2003
amounted to $30.7 million and consisted 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 accumulated other comprehensive (loss) gain in stockholders'
equity.
(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 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.
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
payments based on the products distributed by the OEM or distributor.
-6-
Nonrefundable advances and engineering fees received by the Company from an OEM
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.
For the quarter ended March 31, 2003, the Company had a limited number of
transactions in which it purchased hardware and bundled this hardware with the
Company's software and sold the bundled solution to its customer. The associated
revenue was recognized when the hardware and the software were delivered to the
customer.
(f) 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).
(g) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and identifiable intangible assets acquired in business
combinations. Consistent with Statement of Financial Accounting Standards
("SFAS") 142, Goodwill and Other Intangible Assets, the Company has not
amortized goodwill related to its acquisitions, but instead tested the balance
for impairment. Identifiable intangible assets are amortized over a three-year
period using the straight-line method. Amortization expense was $31,674 and $432
for the three months ended March 31, 2003 and 2002, respectively. The gross
carrying amount and accumulated amortization of other intangible assets as of
March 31, 2003 and December 31, 2002 are as follows:
March 31, December 31,
2003 2002
--------- ------------
Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization $ (54,213) $ (36,142)
--------- ---------
Net carrying amount $ 162,637 $ 180,708
========= =========
Patents and trademarks:
Gross carrying amount $ 187,439 $ 145,534
Accumulated amortization $ (30,354) $ (16,751)
--------- ---------
Net carrying amount $ 157,085 $ 128,783
========= =========
(h) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
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 $7,881 was amortized for the
three months ended March 31, 2003 and 2002. 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.
-7-
Purchased software technology of $2,458,750 and $1,923,611, net of
accumulated amortization of $1,392,249 and $1,116,389, is included in other
assets in the balance sheets as of March 31, 2003 and December 31, 2002,
respectively. Amortization expense was $275,860 and $186,667 for the three
months ended March 31, 2003 and 2002, respectively.
(i) 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.
(j) 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.
(k) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44, ACCOUNTING FOR
CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB
OPINION No. 25, issued in March 2000, to account for its fixed-plan stock
options. Under this method, compensation expense is recorded on the date of
grant only if the current market price of the underlying stock exceeded the
exercise price. SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION,
established accounting and disclosure requirements using a fair-value-based
method of accounting for stock-based employee compensation plans. As allowed by
SFAS No. 123, the Company has elected to continue to apply the
intrinsic-value-based method of accounting described above, and has adopted only
the disclosure requirements of SFAS No. 123.
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:
For the Three Months Ended March 31,
2003 2002
----------- -----------
Net loss as reported $(1,738,853) $(2,581,385)
Add stock-based employee compensation expense included
in reported net income, net of tax $ 115,869 $ 358,546
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax $(1,317,042) $ (877,116)
----------- -----------
Net loss - pro forma $(2,940,026) $(3,099,955)
=========== ===========
Basic net loss per common share-as reported $ (0.04) $ (0.06)
Basic net loss per common share- pro forma $ (0.06) $ (0.07)
-8-
(l) FINANCIAL INSTRUMENTS
As of March 31, 2003 and December 31, 2002, 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.
(m) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated from the
functional currency to the U.S. dollar 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 component of accumulated
other (loss) gain in stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.
(n) 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 March 31, 2003,
potentially dilutive common stock equivalents included 9,047,115 stock options
outstanding.
(o) COMPREHENSIVE LOSS
Comprehensive loss amounted to $1,873,919 and $2,848,111 for the three
months ended March 31, 2003 and 2002, respectively and includes the Company's
net loss, foreign currency translation adjustments of $(5,437) and $(14,149) for
the three months ended March 31, 2003 and 2002, respectively and unrealized
losses on marketable securities of $(129,629) and $(252,577) for the three
months ended March 31, 2003 and 2002, respectively.
(p) 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.
(q) NEW ACCOUNTING PRONOUNCEMENTS
In November 2002, the Emerging Issue Task Force ("EITF") reached a consensus
on EITF Issue No. 00-21, "ACCOUNTING FOR REVENUE ARRANGEMENTS WITH MULTIPLE
DELIVERABLES". The Issue addresses the accounting for arrangements that may
involve the delivery or performance of multiple revenue-generating activities
and how to determine whether such an arrangement involving multiple deliverables
contains more than one unit of accounting for purposes of revenue recognition.
The guidance in this issue is effective for revenue arrangements entered into in
quarters beginning after June 15, 2003. Accordingly, the Company will adopt EITF
Issue No. 00-21 effective July 1, 2003. We are currently evaluating the impact
of this Issue but do not expect adoption to have a material impact on our
results of operations, financial position or cash flows.
In December 2002, the FASB issued SFAS No. 148, ACCOUNTING FOR STOCK-BASED
COMPENSATION--TRANSITION AND DISCLOSURE ("SFAS No. 148"). SFAS No. 148 amends
SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, to provide alternative
methods of transition for a voluntary change to the fair value-based method of
accounting for stock-based employee compensation ("transition provisions"). In
addition, SFAS No. 148 amends the disclosure requirements of APB Opinion No. 28,
INTERIM FINANCIAL REPORTING, to require proforma disclosure in interim financial
statements by companies that elect to account for stock-based compensation using
the intrinsic value method prescribed in APB Opinion No. 25 ("disclosure
provisions"). The transition methods of SFAS No. 148 are effective for financial
statements for fiscal years ending after December 15, 2002. The Company
-9-
continues to use the intrinsic value method of accounting for stock-based
compensation. As a result, the transition provisions do not have an effect on
the Company's consolidated financial statements. The Company has adopted the
disclosure requirements of SFAS No. 148. The FASB recently indicated that they
will require stock-based employee compensation to be recorded as a charge to
earnings beginning in 2004. The Company will continue to monitor the progress of
the FASB on the issuance of this standard as well as evaluate its position with
respect to current guidance.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an interpretation of Accounting Research Bulletin
No. 51. Interpretation 46 establishes accounting guidance for consolidation of
variable interest entities that function to support the activities of the
primary beneficiary. Interpretation 46 applies to any business enterprise, both
public and private, that has a controlling interest, contractual relationship or
other business relationship with a variable interest entity. The Company
currently has no contractual relationship or other business relationship with a
variable interest entity and therefore the adoption did not have an effect on
its consolidated financial position or results of operations. However, if the
Company enters into any such arrangement with a variable interest entity in the
future, its consolidated financial position or results of operations may be
adversely impacted.
(r) RECLASSIFICATIONS
Certain reclassifications have been made to prior year's consolidated
financial statements to conform to the current year's presentation.
(2) ACQUISITIONS
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 for
mission-critical networks, for $2,432,419 in cash plus payments contingent on
the level of revenues from IP Metrics' products and services for a period of
twenty-four months. As of March 31, 2003, the Company has accrued $281,469 of
additional purchase consideration related to these contingent payments. The
acquisition was accounted for under the purchase method and the results of IP
Metrics are included with those of the Company from the date of acquisition.
The fair value of the net tangible liabilities of IP Metrics assumed was
$898,306. The Company purchased certain intangible assets, including customer
relationships and purchased technology with a fair value of $216,851. These
intangible assets are being amortized under the straight-line method over an
estimated useful life of 3 years, the expected period of benefit. The purchase
price in excess of the fair value of the net tangible and intangible assets
acquired and liabilities assumed by the Company amounted to $3,113,874 and has
been recorded as goodwill.
On November 12, 2002, FalconStor AC, Inc., acquired all of the common
stock of FarmStor, a software sales organization in the Republic of Korea for
$180,000 in cash. The fair value of the net tangible liabilities of FarmStor
assumed was $7,725. The purchase price in excess of the fair value of the net
tangible assets acquired and liabilities assumed by the Company amounted to
$187,725 and has been recorded as goodwill.
The following unaudited pro forma consolidated financial information gives
effect to the above described acquisitions of IP Metrics and FarmStor, as if
they had occurred at the beginning of the period by consolidating the continuing
results of operations of the Company, IP Metrics and FarmStor for the three
months ended March 31, 2002.
Three Months Ended
March 31, 2002
------------------
Revenues ................................................ $ 2,208,976
Net Loss from continuing operations ..................... (2,500,264)
Basic and diluted net loss from continuing operations per
share .............................................. --
$ (0.06)
Weighted average basic and diluted shares
outstanding......................................... 45,184,257
-10-
The pro forma statement is provided for illustrative purposes only and
does not represent what the actual consolidated results of operations would have
been had the acquisitions occurred on the date assumed, nor is it 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 months
ended March 31, 2003 and March 31, 2002 and the location of long-lived assets as
of March 31, 2003 and December 31, 2002 are summarized as follows:
Three Months Ended March 31,
2003 2002
---------- ----------
United States $2,301,566 $1,168,697
Asia and other international $1,377,341 $ 812,145
-------------------------
Total revenues $3,678,907 $1,980,842
========== ==========
March 31, December 31,
2003 2002
---------- ------------
Long-lived assets (includes all non-current assets):
United States $8,411,049 $7,655,900
Asia and other international $ 748,903 $ 499,497
---------- ----------
Total long-lived assets $9,159,952 $8,155,397
========== ==========
(4) LIABILITIES OF DISCONTINUED OPERATIONS
On February 14, 2003, the Company reached a settlement related to a claim
associated with the liabilities of discontinued operations. The Company paid
$2,850,000 in settlement of this claim.
(5) 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 March 31, 2003, the Company
repurchased a total of 235,000 shares for $1,435,130.
-11-
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
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 network storage infrastructure software
solutions and providing related maintenance, implementation and engineering
services. Our unique approach to storage networking enables companies to embrace
state-of-art equipment (based on SCSI, Fibre Channel or iSCSI) from any storage
manufacturer without rendering their existing or legacy solutions obsolete.
Several strategic partners have recognized the industrial strength of our
flagship IPStor(R) software and utilized it to power their special purpose
storage appliances to perform Real Time Data Migration, Data Replication, and
other advanced storage services. IPStor leverages high performance IP or FC
based networks to help corporate IT aggregate storage capacity and contain the
run-away cost of administering mission-critical storage services such as
snapshot, backup, data replication, and other storage services, in a distributed
environment. Over 300 customers around the world have deployed IPStor in the
production environment to manage storage infrastructure with minimal TCO (Total
Cost of Ownership) and optimal ROI (Return on Investment).
On July 3, 2002, we acquired IP Metrics, a provider of intelligent
trunking software for mission-critical networks. For more information relating
to the acquisition of IP Metrics, including the accounting treatment, see note 2
to the accompanying consolidated financial statements.
Our critical accounting policies are those related to revenue
recognition. As described in note 1 to our unaudited condensed 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, among other criteria. An
arrangement is evidenced by a signed customer contract for nonrefundable
payments received from OEMs, or a customer purchase order for each software
license 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 regional billing practices, 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.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2003 COMPARED TO
THE THREE MONTHS ENDED MARCH 31, 2002.
REVENUES
Overall, revenues increased 86% from $2.0 million for the three months ended
March 31, 2002 to $3.7 million for the three months ended March 31, 2003.
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold
through our OEM's, value-added resellers and distributors to end users and, to a
lesser extent, directly to end users. These revenues are recognized when, among
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other requirements, we receive a customer purchase order and the software and
permanent key codes are delivered to the customer. We also receive nonrefundable
advances and engineering fees from some of our OEM partners. These arrangements
are evidenced by a signed customer contract, and the revenue is recognized when
the software product master is delivered and accepted, and the engineering
services, if any, have been performed.
Software license revenue increased 64% from $1.6 million for the
three months ended March 31, 2002 to $2.7 million for the three months ended
March 31, 2003. The increase in software license revenues was due to increased
market acceptance of our product as well as an increase in the number of our
channel partners. As a result of these increases, the number of our transactions
nearly doubled compared to the same period a year ago.
SOFTWARE SERVICES AND OTHER REVENUE
Software services and other revenues are comprised of software
maintenance and technical support, professional services primarily related to
the implementation of our software, engineering services, and, to a lesser
extent, sales of computer hardware. Revenue derived from maintenance and
technical support contracts is recognized ratably over the contractual
maintenance term. Professional services revenue is recognized in the period that
the related services are performed. Engineering services are primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In the first three months of 2003, we had a limited number of
transactions in which we purchased hardware and bundled this hardware with our
software and sold the bundled solution to our customer. The associated revenue
was recognized when the hardware and software were delivered to the customer.
Software services and other revenue increased 187% to $1.0 million for the three
months ended March 31, 2003 compared to $0.3 million for the three months ended
March 31, 2002. The primary reason for the increase in software services and
other revenue was an increase in the number of our maintenance and technical
support contracts. This increase in maintenance and support contracts is
directly related to the increase in our software license customers that have
elected to purchase maintenance. Additionally, for the three months ended March
31, 2003, we earned revenue from maintenance renewals related to software
licenses from the prior year. For the three months ended March 31, 2002, we did
not earn any revenue from maintenance renewals since our software was only
released at the end of the second quarter of 2001. The sale of approximately
$0.4 million of hardware in the three months ended March 31, 2003 also
contributed to the increase in software services and other revenue. For the
three months ended March 31, 2002, we did not have any sales of hardware.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
Amortization of purchased and capitalized software increased from
$7,881 for the three months ended March 31, 2002 to $0.3 million for the three
months ended March 31, 2003. The Company did not capitalize any software
development costs until our initial product reached technological feasibility in
March 2001. At that point, we capitalized $0.1 million of software development
costs, which are being amortized 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. Amortization of capitalized
software was $7,881 for the three months ended March 31, 2002 and 2003. The
amortization of purchased software licenses is recorded as software development
expense until the modified product is available for resale and then the expenses
are recorded in cost of revenues. For the three months ended March 31, 2002, the
amortization of purchased software licenses was recorded as software development
expense since the product was not yet available for resale. For the three months
ended March 31, 2003, a much higher portion of our purchased software licenses
were available for resale. As a result, amortization of $253,332 related to the
purchased software licenses available for resale was recorded in cost of
revenues for the three months ended March 31, 2003.
COST OF SOFTWARE SERVICES AND OTHER REVENUE
Cost of software services and other revenues consists primarily of
personnel and other costs associated with providing software implementations,
technical support under maintenance contracts, and training. Cost of software
services and other revenues also includes the cost of hardware purchased for
resale. Cost of software services and other revenues for the three months ended
March 31, 2003 increased by 90% to $0.6 million compared to $0.3 million for the
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three months ended March 31, 2002. The increase in cost of software services and
other revenues is primarily related to $0.3 million of hardware costs associated
with hardware revenue. For the three months ended March 31, 2002, we did not
have any sales of hardware.
Gross profit for the three months ended March 31, 2003 was $2.8
million or 77% compared to $1.7 million or 84% for the three months ended March
31, 2002. The increase in gross profit was directly related to the increase in
revenues. The decrease in gross margins was primarily due to the increase in
amortization of purchased software licenses and lower margins on hardware sales.
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 decreased 4% to $1.6 million
for the three months ended March 31, 2003 from $1.7 million for the three months
ended March 31, 2002. The decrease in software development costs was mainly due
to recording a portion of amortization expense from purchased software licenses
in amortization of purchased and capitalized software in 2003. The amortization
of these licenses is recorded as software development expense until the modified
product is available for resale and then the expenses are recorded in cost of
revenues.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and
marketing personnel and related 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 10% to $2.5 million for the three months ended March 31, 2003 from
$2.3 million for the three months ended March 31, 2002. This increase in selling
and marketing expenses was partially due to increased commission expense, which
is directly related to our increase in revenues. Additionally, salary related
expenses increased as we increased our headcount to support our revenue growth.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related costs,
directors and officers insurance, legal and professional fees, and other general
corporate overhead costs. General and administrative expenses increased 12% to
$0.7 million for the three months ended March 31, 2003 from $0.6 million for the
three months ended March 31, 2002. The increase in general and administrative
expenses was primarily due to significantly increased premiums for our directors
and officers insurance.
INTEREST AND OTHER INCOME
Interest and other income decreased 16% to $0.3 million for the
three months ended March 31, 2003 from $0.4 million for the three months ended
March 31, 2002. This decrease in interest income was due to lower interest rates
and lower average cash, cash equivalent and marketable securities balances.
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 March 31,
2003, 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.
Accordingly, we provided a full valuation allowance against our net deferred tax
assets. Our income tax provision consists of tax liabilities related to our
foreign subsidiaries.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents totaled $15.6 million and marketable
securities totaled $30.7 million at March 31, 2003. As of March 31, 2002, we had
approximately $25.9 million in cash and cash equivalents and $35.9 million in
marketable securities. Net cash used in operating activities totaled $0.3
million for the three months ended March 31, 2003. This was primarily a result
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of our net loss of $1.7 million, an increase in other assets and a decrease in
accrued expenses. These amounts were partially offset by non-cash charges of
$0.7 million consisting of depreciation and amortization, non-cash professional
services expenses, and equity-based compensation. Additional offsetting amounts
include decreases in accounts receivable, prepaid expenses and other current
assets, and increases in accounts payable and deferred revenue. Net cash used in
operating activities for the three months ended March 31, 2002 was $1.6 million.
The cash used in operating activities for the three months ended March 31, 2002
was mainly comprised of the Company's net loss of $2.6 million, a decrease in
accrued expenses and an increase in prepaid expenses and other current assets.
These amounts were partially offset by non-cash expenses of $0.7 million, a
decrease in accounts receivable and an increase in accounts payable and deferred
revenue.
Net cash provided by investing activities was $4.5 million for the
three months ended March 31, 2003, due primarily to net sales of marketable
securities of $6.0 million. This amount was partially offset by purchases of
property and equipment of $0.7 million and purchases of software licenses of
$0.8 million. Net cash used in investing activities was $10.5 million for the
three months ended March 31, 2002, due to $10.0 million in purchases of
marketable securities and $0.5 million in purchases of property and equipment.
Net cash provided by financing activities was $0.1 million and $1.1
million for the three months ended March 31, 2003 and 2002, respectively. These
amounts were related to the exercise of stock options.
For the three months ended March 31, 2003 and 2002, we paid $2.9
million and $1.5 million, respectively, related to liabilities of discontinued
operations.
As of March 31, 2003, we had $1.3 million of liabilities related to
the discontinued operations of Network Peripherals Inc.
In October 2001, our Board of Directors authorized the repurchase of
up to two million shares of our outstanding common stock, of which 235,000
shares were repurchased through March 31, 2003, at an aggregate purchase price
of $1.4 million.
In connection with our acquisition of IP Metrics in July 2002, we
are required to make cash payments to the former shareholders of IP Metrics,
which are contingent on the level of revenues from IP Metrics products for a
period of twenty-four months subsequent to the acquisition. As of March 31,
2003, the Company has accrued $0.3 million of additional purchase consideration
related to sales of IP Metrics products.
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.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In November 2002, the Emerging Issue Task Force ("EITF") reached a
consensus on EITF Issue No. 00-21, "ACCOUNTING FOR REVENUE ARRANGEMENTS WITH
MULTIPLE DELIVERABLES". The Issue addresses the accounting for arrangements that
may involve the delivery or performance of multiple revenue-generating
activities and how to determine whether such an arrangement involving multiple
deliverables contains more than one unit of accounting for purposes of revenue
recognition. The guidance in this issue is effective for revenue arrangements
entered into in quarters beginning after June 15, 2003. Accordingly, we will
adopt EITF Issue No. 00-21 effective July 1, 2003. We are currently evaluating
the impact of this Issue but do not expect adoption to have a material impact on
our results of operations, financial position or cash flows.
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In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, ACCOUNTING FOR
STOCK-BASED COMPENSATION--TRANSITION AND DISCLOSURE ("SFAS No. 148"). SFAS
No.148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide
alternative methods of transition for a voluntary change to the fair value-based
method of accounting for stock-based employee compensation ("transition
provisions"). In addition, SFAS No. 148 amends the disclosure requirements of
Accounting Principals Board ("APB") Opinion No. 28, INTERIM FINANCIAL REPORTING,
to require proforma disclosure in interim financial statements by companies that
elect to account for stock-based compensation using the intrinsic value method
prescribed in APB Opinion No. 25 ("disclosure provisions"). The transition
methods of SFAS No. 148 are effective for financial statements for fiscal years
ending after December 15, 2002. We continue to use the intrinsic value method of
accounting for stock-based compensation. As a result, the transition provisions
do not have an effect on our consolidated financial statements. We have adopted
the disclosure requirements of SFAS No. 148. The FASB recently indicated that
they will require stock-based employee compensation to be recorded as a charge
to earnings beginning in 2004. We will continue to monitor the progress of the
FASB on the issuance of this standard as well as evaluate our position with
respect to current guidance.
In January 2003, the FASB issued Interpretation No. 46,
CONSOLIDATION OF VARIABLE INTEREST ENTITIES, AN INTERPRETATION OF ACCOUNTING
RESEARCH BULLETIN NO. 51. Interpretation 46 establishes accounting guidance for
consolidation of variable interest entities that function to support the
activities of the primary beneficiary. Interpretation 46 applies to any business
enterprise, both public and private, that has a controlling interest,
contractual relationship or other business relationship with a variable interest
entity. We currently have no contractual relationship or other business
relationship with a variable interest entity and therefore the adoption did not
have an effect on our consolidated financial position or results of operations.
However, if we enter into any such arrangement with a variable interest entity
in the future, our consolidated financial position or results of operations may
be adversely impacted.
RISK FACTORS
WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR
MAINTAIN PROFITABILITY.
We have had limited revenues and a history of losses. For the year
ended December 31, 2002 and the three months ended March 31, 2003, we had
revenues of $10.6 million and $3.7 million, respectively. For the period from
inception (February 10, 2000) through March 31, 2003 and for the three months
ended March 31, 2003, we had a net loss of $25.4 million and $1.7 million,
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, although we are unable to predict
whether we will be profitable. 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
hinder our ability to generate additional revenues and achieve or maintain
profitability.
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.
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DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE
INFRASTRUCTURE SOFTWARE MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING
REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
We have only a limited history from which to predict our revenue.
This limited operating experience, combined with the rapidly evolving nature of
the network storage infrastructure software market in which we sell our products
and other factors that are beyond our control, reduces our ability to accurately
forecast our quarterly and annual revenue. However, we use our forecasted
revenue to establish our expense budget. Most of our expenses are fixed in the
short term or incurred in advance of anticipated revenue. As a result, we may
not be able to decrease our expenses in a timely manner to offset any shortfall
in revenue.
GLOBAL ECONOMIC CONDITIONS MAY CONTINUE TO ERODE, WHICH COULD RESULT IN
DECREASED REVENUES.
The macroeconomic environment and capital spending on information
technology have continued to erode, resulting in continued uncertainty in our
revenue expectations. The operating results of our business depend on the
overall demand for network storage infrastructure software. Because our sales
are primarily to major corporate customers whose businesses fluctuate with
general economic and business conditions, continued soft demand for network
storage infrastructure software caused by a weakening economy and budgetary
constraints may result in decreased revenues. Customers may continue to defer or
to reconsider purchasing our software if they continue to experience a lack of
growth in their business or if the general economy fails to significantly
improve, resulting in a lack of demand for our product.
THE MARKETS FOR STORAGE AREA NETWORKS, NETWORK ATTACHED STORAGE, AND DIRECT
ATTACHED STORAGE ARE NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO
NOT DEVELOP AS WE EXPECT.
The rapid adoption of Storage Area Networks (SAN), Network Attached
Storage (NAS), and Direct Attached Storage (DAS) storage solutions is critical
to our future success. The markets for SAN, NAS and DAS solutions are still
unproven, making it difficult to predict their potential sizes or future growth
rates. 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 are uncertain whether a viable market for our
products will develop or be sustainable. If these markets fail to develop, or
develop more slowly than we expect, our business, financial condition and
results of operations would be adversely affected.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, OUR OPERATING RESULTS MAY
SUFFER.
The network storage infrastructure software market continues to
evolve and as a result there is continuing demand for new products. Accordingly,
we may need to develop and manufacture new products that address additional
network storage infrastructure software market segments and emerging
technologies to remain competitive in the data storage software industry. We are
uncertain whether we will successfully qualify new network storage
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 PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN, NAS or DAS storage
system. All components of these systems must comply with the same industry
standards in order to operate together efficiently. We depend on companies that
provide other components of these systems to conform to industry standards. Some
industry standards may not be widely adopted or implemented uniformly, and
competing standards may emerge that may be preferred by OEM customers or end
users. If other providers of components do not support the same industry
standards as we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.
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 is 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
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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 OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require
that each of our products undergo an extensive qualification process, which
involves interoperability testing of our product in the OEM's system as well as
rigorous reliability testing. This qualification of a product by an OEM does not
assure any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including sales, marketing and management efforts, toward
qualifying our products with OEMs in anticipation of sales to them. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND
INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage infrastructure software market is intensely
competitive even during periods when demand is stable. Some of our current and
potential competitors have longer operating histories, significantly greater
resources, broader name recognition and a larger installed base of customers
than we have. Those competitors and other potential competitors may be able to
establish or to expand network storage 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.
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.
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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.
OUR BOARD OF DIRECTORS MAY SELECTIVELY RELEASE SHARES OF OUR COMMON STOCK FROM
LOCK-UP RESTRICTIONS.
Currently, approximately 26.2 million shares of our common stock are
subject to contractual lock-up restrictions expiring on April 30, 2004. 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. Our board of directors has agreed to a
phased release of up to approximately 2.0 million shares between November 1,
2002 and April 1, 2004, from the shares that are subject to contractual lock-up
restrictions expiring on April 30, 2004.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past
and may be volatile in the future. For example, during the past twelve months
ended March 31, 2003, the market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $3.43 and $7.60. The market
price of our common stock may be significantly affected by the following
factors:
o actual or anticipated fluctuations in our operating results;
o failure to meet financial estimates;
o changes in market valuations of other technology companies,
particularly those in the storage networking infrastructure
software market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint
ventures or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
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 March 31, 2003, we have outstanding options to purchase an
aggregate of 9,047,115 shares of our common stock at a weighted average exercise
price of $3.67 per share.
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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. 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.
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 multiple 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.
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 product or trademark.
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. Worldwide competition for
skilled employees in the network storage 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.
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WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other
companies or their assets. Integration of the acquired products, technologies
and businesses, could divert management's time and resources. Further, we may
not be able to properly integrate the acquired products, technologies or
businesses, with our existing products and operations, train, retain and
motivate personnel from the acquired businesses, or combine potentially
different corporate cultures. If we are unable to fully integrate the acquired
products, technologies or businesses, or train, retain and motivate personnel
from the acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
LONG TERM CHARACTER OF INVESTMENTS.
Our present and future equity investments may never appreciate in
value, and are subject to normal risks associated with equity investments in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
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.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures within 90 days of the filing date of this quarterly
report, and, based on their evaluation, our principal executive officer and
principal financial officer have concluded that these controls and procedures
are effective. There were no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation.
Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the Securities and Exchange Commission's
rules and forms. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by us in the reports that we file under the Exchange Act is
accumulated and communicated to our management, including our principal
executive officer and principal financial officer, as appropriate to allow
timely decisions regarding required disclosure.
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PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
99.1 Certification of the Chief Executive Officer
99.2 Certification of the Chief Financial Officer
(b) Reports on Form 8-K
On January 29, 2003, we filed a Form 8-K under Item 5.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ Jacob Ferng
----------------------------------
Jacob Ferng
Chief Financial Officer and Vice President
(Principal Accounting Officer)
May 15, 2003
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I, ReiJane Huai, certify that:
1. I have reviewed this quarterly report on Form 10-Q of
FalconStor Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries, is
made known to us by others within those entities,
particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date within
90 days prior to the filing date of this quarterly
report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusion about
the effectiveness of the disclosure controls and
procedures based on our evaluation as of the Evaluation
Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation
of internal controls which would adversely affect the
registrants ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weakness in internal
controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weakness.
Date: May 15, 2003 /s/ ReiJane Huai
--------------------------------
ReiJane Huai
Chief Executive Officer
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I, Jacob Ferng, certify that:
1. I have reviewed this quarterly report on Form 10-Q of
FalconStor Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light
of the circumstances under which such statements were made,
not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries, is
made known to us by others within those entities,
particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date within
90 days prior to the filing date of this quarterly
report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusion about
the effectiveness of the disclosure controls and
procedures based on our evaluation as of the Evaluation
Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation
of internal controls which would adversely affect the
registrants ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weakness in internal
controls; and
b) any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and
material weakness.
Date: May 15, 2003 /s/ Jacob Ferng
--------------------------------
Jacob Ferng
Chief Financial Officer
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