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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File Number 000-28317

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

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

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes    ý    No    o

        As of July 31, 2003, there were 17,996,860 shares of the registrant's common stock, par value $0.001 per share, outstanding.

Table of Contents

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

DIGIMARC CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

(UNAUDITED)

(1)

The information in this column was derived from the Company's audited consolidated financial statements as of December 31, 2002.

See Notes to Condensed Consolidated Financial Statements

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DIGIMARC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements

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DIGIMARC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements

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

1.     The Company, Basis of Presentation

        Digimarc Corporation ("Digimarc", the "Company", "our", "us" or "we") is a leading provider of patented digital watermarking technologies that allow imperceptible digital codes to be embedded in all forms of media content, including photographs, movies, music, banknotes and other financial instruments, personal identification documents, and product packages. The embedded codes within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital processing devices. The Company also is a leading supplier of secure personal identification systems. The Company supplies the issuance systems for the majority of driver licenses produced in the United States and provides all or part of the issuance systems for national identifications, voter identifications, and driver licenses in more than twenty-four non-U.S. countries. The Company is developing and marketing enhanced security for personal identification documents enabled by Digimarc's proprietary digital watermarking technology.

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

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

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

        These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2002 included in the Company's 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003. The results of operations for the interim periods presented in these condensed consolidated financial statements are not necessarily indicative of the results for the full year.

2.     Income (Loss) Per Share Computation

        Basic and diluted net income (loss) per share is computed using the weighted average number of shares of common stock outstanding for the period. The effect of 4,471 and 4,591 outstanding stock options for the three and six months ended June 30, 2003, respectively, are excluded from the calculation of diluted net income per share because their inclusion would be antidilutive. The effect of 5,845 and 5,694 outstanding stock options and warrants for the three and six months ended June 30,

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2002, respectively, are excluded from the calculation of diluted net loss per share for the periods presented because the Company was in a loss position and their inclusion would be antidilutive.

3.     Pro Forma Income (Loss) Per Share

        At June 30, 2003, the Company has various stock-based compensation plans, including stock incentive plans and an employee stock purchase plan. The Company continues to apply the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, as allowed by Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation. Under APB Opinion No. 25, no stock- based compensation expense is recognized for stock awards granted with an exercise price at or above fair market value on the measurement date.

        The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

4.     Segment Information

        The Company derives its revenue from a single operating segment, secure media solutions. There was no single customer in the three or six months ended June 30, 2003 or 2002 that accounted for more than 10% of total revenue.

5.     Stock-based Compensation Expense Allocation

        Stock-based compensation expense is based on the difference between the fair market value of the Company's common stock and the exercise price of options to purchase that stock on the measurement date, and is being recognized over the vesting period of the related options, usually four years. Stock-based compensation expense of $418 and $862 was recorded for the three and six months ended June 30, 2003, respectively, and $463 and $934 for the three and six months ended June 30, 2002, respectively. Stock-based compensation expense is included in the respective statements of operations expense categories for the employees to which it applies. At June 30, 2003, $429 of stock-based compensation remains deferred and we expect the entire balance to be amortized to expense in 2003.

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6.     Commitments and Contingencies

        Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of the Company's initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the Company's initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of the Company's stock in the after-market subsequent to the Company's initial public offering. Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters' alleged compensation arrangements and manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a Court Order dated October 9, 2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, Digimarc and the other issuers in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including Digimarc. The claims against Digimarc under Section 10(b), however, were dismissed. In June 2003, a committee of the Company's board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of Digimarc and of the individual defendants for the conduct alleged in the amended complaint to be wrongful. Digimarc would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Digimarc may have against its underwriters. Any direct financial impact of the proposed settlement (other than defense costs incurred and expensed prior to May 31, 2003) is expected to be borne by Digimarc's insurers. The committee agreed to approve the settlement subject to a number of conditions, including the participation of a substantial number of other issuer defendants in the proposed settlement, the consent of Digimarc's insurers to the settlement, and the completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the litigation. Due to the inherent uncertainties of litigation and because the settlement process is still at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

        DIDS in its normal course of business from time to time experiences delays in identification system implementation, timely acceptance for identification systems programs, concerns regarding identification system program performance, and other contractual disputes. Management does not believe that there will be any material effect to the results of operations for costs related to these contingencies.

        The Company's product license and services agreements include a limited indemnification provision for claims from third-parties relating to the Company's intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, Accounting for Contingencies. The indemnification is generally limited to the amount paid by the customer. To date, claims under such indemnification provisions have not been significant.

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

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7.     Comprehensive Income (Loss)

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

8.     Recent Accounting Pronouncements

        In November 2002, the EITF reached a consensus on Issue No. 00-21 ("EITF 00-21"), Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for interim periods beginning after June 15, 2003. We do not expect this issue to have a material impact on our consolidated financial position or results of operations.

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

        The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements relating to future events or the future financial performance of Digimarc, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Risks Related to Our Business" and "Risks Related to Our Markets," and those risks described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003. This discussion and analysis should be read in conjunction with our interim unaudited Condensed Consolidated Financial Statements and related notes included in this quarterly report on Form 10-Q.

Overview

        We are a leading provider of patented digital watermarking technologies that allow imperceptible digital codes to be embedded in all forms of media content, including photographs, movies, music, banknotes and other financial instruments, personal identification documents, and product packages. The embedded codes within various types of media content can be detected and read by software or hardware detectors in personal computers and other digital processing devices.

        We also are a leading supplier of secure personal identification systems. We supply the issuance systems for the majority of driver licenses produced in the United States and provide all or part of the issuance systems for national identifications, voter identifications, and driver licenses in more than twenty-four non-U.S. countries. We are developing and marketing enhanced security for personal identification documents enabled by our proprietary digital watermarking technology.

        The majority of our revenues come from multi-year contracts with government agencies, including U.S. state departments of motor vehicles. We anticipate increasing our revenue through increasing adoption of our products and services, marketing new digital watermarking applications, and licensing our intellectual property. We expect to target, among other sources of revenue, government agencies, commercial printers, packaging companies, publishers, advertisers, proprietors of large image collections, and other producers of printed materials. Our aim is to license our technologies to those content producers so that they may embed our digital watermarks in their printed media, such as identification documents, magazine advertisements and articles, direct mail coupons, catalogs, stationery and envelopes, product packaging, labels and tags, trading cards, credit cards, and business cards. Our current and anticipated products are intended to enable content producers to control reproduction and alteration of their content, as well as to enable their printed materials to provide a link to relevant network services. Revenue from our new applications may include one-time license fees, time-based or volume-based fees, subscription fees, royalties and revenue-sharing arrangements. We anticipate that the calculation of fees and royalties will be based at least in part on the size of the installed base of personal computers, cameras, scanners, digital image capture and output devices, and software carrying our patented reader technology, as well as the nature of the use of, and the nature and amount of licensed content carrying, our digital watermarks.

Critical Accounting Policies and Estimates

        The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including, among others, those related to bad debts, inventories, intangible assets, income taxes, restructuring, long-term service contracts, warranties, investments, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue recognition on long-term service contracts:    We recognize revenue and profit as work progresses on long-term, fixed price service contracts (other than our long-term identification and driver license production contracts) using the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. We follow the percentage-of-completion method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Revenue is recognized based on the percentage of completion of the contract using budgeted amounts established with the customer at the inception of the contract. Progress towards completion is measured using allowable costs incurred as compared to the budgeted amounts contained in the contract. Recognized revenue and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. Any estimation process, including that used in preparing contract accounting models, involves inherent risk. We reduce the inherent risk relating to revenue and cost estimates in percentage-of-completion models through our contract approval and budget monitoring processes. Our estimates of revenue and costs on customer contracts change periodically in the normal course of business, occasionally due to modifications of our contractual arrangements.

We recognize revenue on long-term identification and driver license production contracts using a price-per-card method. We use actual monthly volume amounts, if available, or we estimate the card production volume on a monthly basis for certain of these contracts in order to recognize revenue earned during the period. In the case of estimates, when the actual production information becomes available, which is typically within four weeks, we bill the customer accordingly and any differences from the estimates are recognized in the month the billing occurs. These amounts represent our best estimates of cards produced and are based on historical trends, known events during the period, and discussions with contract representatives. The price-per-card is known; therefore, these estimates represent the best available information regarding revenue earned during that specific period. The estimated amounts are recorded as unbilled receivables on the balance sheet until the actual production information is available and the billing occurs. Any estimation process involves inherent risk. We reduce the inherent risk relating to production estimation through our approval and monitoring processes related to accounting estimates.

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

Inventory valuation:    Inventory consists of consumable supplies that are used in the production of driver licenses and products held for resale to customers. We value inventory at the lower of cost or market value (which lower amount is the net realizable value). We reduce the value of our

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inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

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

Results of Operations

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

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Revenue

        Total revenue was $22.5 million and $44.3 million for the three and six months ended June 30, 2003, respectively, compared to total revenue of $20.8 million and $39.3 million for the three and six months ended June 30, 2002, respectively. The increase in total revenue between each of the comparable three and six month periods of 2003 and 2002 resulted from increased international sales and services, in particular as a result of the execution of a number of international voter registration contracts, and increased issuance revenues from U.S. state driver license programs. Revenue from identified international customers was $3.8 million and $8.3 million for the three and six months ended June 30, 2003, respectively, and $3.9 million and $6.4 million for the three and six months ended June 30, 2002, respectively. Management believes that international growth opportunities exist for us and we expect to continue to invest in personnel and resources to support our potential revenue growth outside of the United States.

        Product and subscription.    Product and subscription revenue was $3.7 million and $8.4 million for the three and six months ended June 30, 2003, respectively, compared to $4.0 million and $7.1 million for the three and six months ended June 30, 2002, respectively. The $0.3 million or 7% decrease and $1.2 million or 17% increase for the three and six months ended June 30, 2003, respectively, was primarily related to the fluctuation in international sales and domestic equipment sales. A portion of our revenue each year is generated from the licensing of technology. In the competitive environment in which we operate, product generation, development and marketing processes relating to technology are uncertain and complex, requiring accurate prediction of demand as well as successful management of various development risks inherent in technology development. In light of these dependencies, it is possible that failure to successfully manage future changes in technology with respect to our technology could have a long-term impact on our revenue.

        Service.    Service revenue was $18.8 million and $35.9 million for the three and six months ended June 30, 2003, respectively, compared to $16.8 million and $32.2 million for the three and six months ended June 30, 2002, respectively. The $2.0 million or 12% increase and $3.7 million or 12% increase for the three and six months ended June 30, 2003, respectively, as compared to the corresponding three and six month periods of 2002 was primarily the result of increased issuance revenue.

Cost of Revenue

        Product and subscription.    Cost of product and subscription revenue primarily includes compensation for operations personnel, costs of consumables sold to third parties, costs of machinery sold to third parties, Internet service provider connectivity charges and image search data fees to support the services offered to our subscription customers. Cost of product and subscription revenue was $2.4 million and $4.9 million for the three and six months ended June 30, 2003, respectively, compared to $2.5 million and $3.6 million for the three and six months ended June 30, 2002, respectively. The $0.1 million or 3% decrease and $1.3 million or 36% increase for the three and six months ended June 30, 2003, respectively, was a result of the fluctuation in international sales activity and domestic equipment sales activity.

        Service.    Cost of service revenue primarily includes compensation for software developers, quality assurance personnel, product managers, field operations personnel, and business development personnel, outside contractors, costs of consumables used in delivering a service, depreciation charges for machinery used specifically for service delivery, and travel costs directly attributable to service and development contracts. Cost of service revenue was $9.9 million and $19.3 million for the three and six months ended June 30, 2003, respectively, compared to $9.6 million and $19.1 million for the three and six months ended June 30, 2002, respectively. The $0.3 million or 3% increase and $0.2 million or 1% increase for the three and six months ended June 30, 2003, respectively, as compared to the corresponding three and six month periods of 2002 was primarily the result of incremental increases in costs associated with maintaining service levels to a broader number of customers, offset by our continued focus on cost controls. Field operations employees totaled 153 and 138 at June 30, 2003 and 2002, respectively.

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Operating Expenses

        Sales and marketing.    Sales and marketing expenses consist primarily of compensation, benefits and related costs of sales and marketing personnel, product managers and sales engineers, as well as recruiting, travel, market research, and costs associated with marketing programs, such as trade shows, public relations and new product launches. Sales and marketing expenses were $3.3 million and $6.3 million for the three and six months ended June 30, 2003, respectively, compared to $3.9 million and $7.8 million for the three and six months ended June 30, 2002, respectively. The $0.6 million or 17% decrease for the three months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased administrative costs of approximately $0.3 million related to sales and marketing activities, approximately $0.3 million in decreased use of sales and marketing personnel to provide services for our revenue generating contracts that would have been included in cost of service revenue, decreased use of outside consulting services of $0.2 million, and, decreased marketing and advertising costs of approximately $0.1 million, partially offset by increased salaries and other employee related costs of approximately $0.2 million. The $1.4 million or 18% decrease for the six months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased use of outside consulting services of $0.5 million, decreased administrative costs of approximately $0.4 million related to sales and marketing activities, decreased salaries and other employee related costs of approximately $0.2 million, $0.2 million in decreased use of sales and marketing personnel to provide services for our revenue generating contracts that would have been included in cost of service revenue, and decreased marketing and advertising costs of approximately $0.1 million. Sales and marketing employees totaled 48 and 59 as of June 30, 2003 and 2002, respectively. Although overall sales and marketing expenses have decreased in recent periods, we anticipate that we will invest significantly in sales and marketing in the foreseeable future.

        Research, development and engineering.    Research, development and engineering expenses consist primarily of compensation, benefits and related costs of software developers and quality assurance personnel and payments to outside contractors. Research, development and engineering expenses were $2.1 million and $4.3 million for the three and six months ended June 30, 2003, respectively, compared to $2.8 million and $5.6 million for the three and six months ended June 30, 2002, respectively. The $0.7 million or 25% decrease for the three months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased costs related to outside consultants of approximately $1.6 million and decreased salaries and other employee related costs of approximately $0.1 million, partially offset by $1.0 million related to increased use of research, development and engineering personnel to provide services for our revenue generating contracts and to develop internal-use software. The $1.4 million or 24% decrease for the six months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased costs related to outside consultants of approximately $2.5 million and decreased administrative costs related to research, development and engineering activities of $0.2 million, partially offset by $1.3 million related to increased use of research, development and engineering personnel to provide services for our revenue generating contracts and to develop internal-use software. Research, development and engineering personnel totaled 109 and 134 as of June 30, 2003 and 2002, respectively. Although overall research, development and engineering expenses have decreased in recent periods, we anticipate that we will invest significantly in product research, development and engineering in the foreseeable future.

        General and administrative.    General and administrative expenses consist primarily of compensation, benefits and related costs of executive, finance and administrative personnel, facilities costs, legal and other professional fees, and depreciation and amortization expense. General and administrative expenses were $4.7 million and $9.2 million for the three and six months ended June 30, 2003, respectively, compared to $5.2 million and $10.8 million for the three and six months ended June 30, 2002, respectively. The $0.5 million or 10% decrease for the three months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased costs of

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$0.2 million related to outside consultants and decreased administrative costs of $0.3 million, which includes depreciation, amortization, and bad debt expense. The $1.6 million or 15% decrease for the six months ended June 30, 2003 as compared to the same period ended June 30, 2002 resulted from decreased costs of $1.0 million related to outside consultants and decreased administrative costs of $0.6 million, which includes depreciation, amortization, and bad debt expense. General and administrative employees totaled 52 and 44 as of June 30, 2003 and 2002, respectively. Although general and administrative expenses have decreased in recent periods, we anticipate that we will invest in general and administrative costs in the foreseeable future.

        Stock-based compensation.    Stock-based compensation expense includes costs relating to stock-based employee compensation arrangements. Stock-based compensation expense is based on the difference between the fair market value of our common stock and the exercise price of options to purchase that stock on the measurement date, and is being recognized over the vesting periods of the related options, usually four years. Stock-based compensation expense of $0.4 million and $0.9 million was recorded for the three and six months ended June 30, 2003, respectively, compared to $0.5 million and $0.9 million for the three and six months ended June 30, 2002, respectively. Stock-based compensation is included in the respective statements of operations expense categories for the employees to which it applies. At June 30, 2003, $0.4 million of stock-based compensation remains deferred and we expect the entire amount to be recognized as expense in 2003.

        Total other income, net.    Total other income, net consists primarily of interest received and paid. Total other income, net was $0.2 million and $0.3 million for the three and six months ended June 30, 2003, respectively, compared to $0.3 million and $0.6 million for the three and six months ended June 30, 2002, respectively. The $0.2 million or 52% decrease and $0.3 million or 56% decrease for the three and six months ended June 30, 2003, respectively, as compared to the same periods ended June 30, 2002 resulted primarily from lower cash balances and interest rates during 2003.

        Provision for Income Taxes.    We provided less than $0.1 million and $0.1 million for income taxes for the three and six months ended June 30, 2003, respectively, compared to no provision for income taxes for the three and six months ended June 30, 2002, respectively. The provision relates to taxes we believe we will pay in non-U.S. countries due to our profitable foreign operations.

Liquidity and Capital Resources

        As of June 30, 2003, we had cash and cash equivalents, restricted cash, and short-term investments of $51.6 million, representing a decrease of $1.5 million from $53.2 million at December 31, 2002. As of June 30, 2003, $16.3 million of cash and cash equivalents is restricted as a result of the requirements of performance bonds that we are obligated to maintain in connection with some of our long-term contracts in our personal identification systems business. Working capital at June 30, 2003 was $63.5 million, compared to working capital of $63.3 million at December 31, 2002.

        The $4.0 million of cash provided by operations for the six months ended June 30, 2003 was positively impacted by net income for the period, depreciation and amortization of $5.0 million, a decrease in other current assets of $1.0 million, stock-based compensation expense of $0.9 million, an increase in deferred revenue of $0.8 million, and an increase in accrued payroll and related costs of $0.7 million. Cash provided by operations for the six months ended June 30, 2003 was negatively impacted by a decrease in accounts payable of $3.0 million, an increase in inventory of $0.7 million, an increase in restricted cash of $0.6 million, and an increase in trade and unbilled accounts receivable, net of $0.3 million. The $1.1 million of cash used in operations in the six months ended June 30, 2002 was positively impacted by an increase in accounts payable of $4.7 million, depreciation and amortization of $4.5 million, an increase in deferred revenue of $1.3 million, stock-based compensation expense of $0.9 million, an increase of accrued payroll and related costs of $0.7 million, and a decrease in other current assets of $0.4 million. Cash used in operations for the six months ended June 30, 2002

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was negatively impacted by a net loss of $7.5 million, an increase in trade and unbilled accounts receivable, net of $5.3 million, an increase in inventory of $0.4 million, and an increase in other assets, net of $0.3 million.

        The $11.1 million of cash used in investing activities for the six months ended June 30, 2003 was related primarily to the purchase of property and equipment of $4.2 million, $3.6 million of capitalized software development costs, and $3.3 million net purchases of short-term investments. The $14.8 million of cash provided by investing activities for the six months ended June 30, 2002 related primarily to net sales or maturities of $24.3 million of short-term investments, partially offset by the purchase of $5.3 million of property and equipment and $3.9 million of capitalized software development costs.

        The $1.7 million of cash provided by financing activities for the six months ended June 30, 2003 primarily related to the issuance of stock for $1.7 million related to our stock incentive plans. The $1.0 million of cash provided by financing activities for the six months ended June 30, 2002 primarily related to the issuance of stock for $1.5 million related to our stock incentive plans and $0.4 million of principal payments under capital leases.

        Our significant commitments consist of obligations under non-cancelable operating leases, which totaled $7.4 million as of June 30, 2003, and are payable in monthly installments through October 2010.

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

        We believe that our current cash, cash equivalents, and short-term investment balances will satisfy our projected working capital and capital expenditure requirements for at least the next 12 months. Thereafter, we anticipate continuing to use cash, cash equivalents, and short-term investment balances to satisfy our projected working capital and capital expenditure requirements. However, because of our concern that currently weak economic conditions may continue through 2003, if not longer, we have taken and continue to take steps to limit our expenses and align our cost structure to our revenues.

        In order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities although we do not believe at this time that our long-term working capital and capital expenditures will be of such a nature that we would be required to take steps presently to remedy any such potential deficiency. If it were necessary to obtain additional financings or credit facilities, we may not be able to do so, or if these funds are available, they may not be available on satisfactory terms.

Recent Accounting Pronouncements

        In November 2002, the EITF reached a consensus on Issue No. 00-21 ("EITF 00-21"), Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for interim periods beginning after June 15, 2003. We do not expect this issue to have a material impact on our consolidated financial position or results of operations.

Risks Related to Our Business

The markets for digital watermark applications are new and developing

        Digital watermarking is a new and developing technology. Our success depends on the acceptance of this technology and the adoption of applications in areas such as digital media commerce, counterfeiting and piracy deterrence, self-authentication of documents, and security and intelligence applications. The markets for products and services using digital watermarks are evolving and are

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characterized by an increasing number of market entrants who have introduced or developed products and services using digital watermarking or alternative technologies. As is typical in a new and evolving industry, demand and market acceptance of recently introduced products and services are subject to a high level of uncertainty. Our products and services relating to digital watermarking are currently used by only a limited number of customers. We are actively working, independently and with others, to expand the market for using digital watermarking technology, such as in the monitoring and tracking of usage of programming content broadcast by television networks and stations and in the security features of driver licenses. While we believe a trend may have begun in the use of digital watermarking security features in digital driver licenses during our second fiscal quarter of 2003, as a number of states, such as Nebraska, Michigan, Vermont and New Jersey, have begun to adopt digital watermarking security features in their digital driver licenses, and while we believe that such a trend, if it continues, may have a materially favorable impact on our revenues, it is difficult to predict the future growth rate, if any, and ultimate size of this market or any other digital watermarking markets or our anticipated future markets. We cannot assure you that new markets for our products and services will develop or that our existing markets will grow.

The majority of our revenues are subject to government procurement processes that are subject to unpredictable delays or unexpected changes

        We derive substantial portions of our revenue from government contracts which are subject to periodic open competitive bids. The timing of such bids is solely within the discretion of the governmental authority. Consequently, large components of new revenue are tied to procurement schedules, which could shift as the needs of the related government procurement agencies change. Many U.S. state customers are facing budget cuts, and some international customers are facing debt crises, introducing added uncertainty. Any shift in the government procurement process, which is outside of our control and may not be predictable, could result in delays in bookings forecasted for any particular financial period, could impact the predictability of our quarterly results and may potentially have a material negative effect on our financial position, results of operation or cash flows.

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

        Our business involves embedding digital watermarks in traditional and digital media, including identification documents, secure documents, and images distributed on the Internet, and licensing our intellectual property. Through 2001, our revenue stream was based primarily on a combination of development, consulting, subscription and license fees from copyright protection and counterfeit deterrence applications. Beginning in 2002 and for the foreseeable future, we have seen, and we anticipate, that the majority of our revenues will be from government and private sector customers for security-related applications relating to secure personal identification, copyright protection, and counterfeit deterrence to government and private sector customers. We have not fully developed revenue models for our future applications and licensing endeavors. In addition, because some of our products and services are not yet fully established in the marketplace and because such products and services will be sold in new and undeveloped markets, we cannot be certain that the pricing structure and marketing for them will be effective. We cannot assure you that our anticipated products and services and licensable intellectual property will be able to compete effectively against other alternative technologies in our target markets or that we will be able to compete effectively against current or future digital watermarking suppliers in terms of price, performance, applications or other features of their technologies. In addition, as we develop models for generating revenue, they may not be sustainable over time, and as a result, our business, operating results and financial condition may seriously be harmed.

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

        Contracts between government agencies and our wholly-owned subsidiary, Digimarc ID Systems, LLC, and/or its affiliates (collectively known as "DIDS") have varying duration, averaging four to five years in length, after which the government agency can re-open the contract for competitive bidding. If we were to lose a contract, in addition to the loss of revenue and margin on a prospective basis, we could also incur accelerated amortization expense or impairment of tangible or intangible assets related to the customer. The loss of one or more large contracts with governmental agencies may seriously harm our business, operating results and financial condition.

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

        The integration of the operations of DIDS into our business involves a number of risks, including:

•

Problems associated with integrating operations and personnel of DIDS into Digimarc;



•

The loss of resources for our existing business resulting from the diversion of these resources to facilitate the integration of DIDS into Digimarc;



•

Problems associated with integrating the respective equipment, networks and technologies, financial and information systems and brand names of Digimarc and DIDS;



•

Difficulties associated with successfully combining the different corporate cultures of Digimarc and DIDS;



•

Inherent problems surrounding the coordination of geographically separated facilities and work forces;



•

Risks associated with integrating a number of component technologies, provided from different vendors and subject to possible interruptions in supply;



•

Our relatively limited involvement to date in markets in which we may not have all of the necessary patent or other intellectual property rights to compete;



•

Management challenges associated with the integration of Digimarc and DIDS;



•

Difficulties associated with the coordination of the sales, marketing and service development efforts of DIDS with our existing business;



•

Difficulties common to the assimilation of new management personnel with disparate business backgrounds into an existing business; and



•

Difficulties in maintaining consistent standards, controls, procedures and policies across a larger business with various new focuses.

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

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

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

•

Costs relating to the elimination of duplicate systems and facilities, possible severance and employee relocation, and other integration costs;



•

Building out DIDS' existing infrastructure;



•

Replacing fidelity and performance bonds previously held by Polaroid with Digimarc bonds; and,



•

Consolidation of some of DIDS' operations in the Fort Wayne, Indiana facility.

        While we have completed more than a year's worth of transition activities and many of the activities are complete or nearing completion, we expect these activities to continue for the next few quarters and the aggregate amount of additional expenses, if any, is not yet determinable, but could be significant. In addition, we cannot assure you that we will not incur additional charges in subsequent quarters to reflect costs and residual risks associated with the integration of DIDS' operations. Adverse developments could include employee turnover, problems in integrating new financial and information systems, problems associated with the relocation to new office space, and remaining film and other dependencies involving Polaroid. Any remaining costs that exceed our expectations could materially affect our business, financial condition, and results of operations.

We may not realize the synergistic benefits expected from the acquisition of DIDS

        We cannot assure you that we will realize the synergistic benefits sought through the acquisition of DIDS. Although we view this acquisition as an opportunity to significantly enhance the security and usefulness of driver licenses and other DIDS products, we cannot assure you that we will be successful in combining our current technological applications and product offerings with those of DIDS or that the combined product offerings will be acceptable in the marketplace. We believe that we have begun to demonstrate the synergy between our principle areas of business, as several states in the United States announced adoption of digital watermarking security features in their driver licenses. While we expect many more states to do the same in the future, factors that could affect acceptance of these combined product offerings are changes in government regulations and industry standards, and increased competition from DIDS' competitors who may develop superior or alternative technology that is more widely acceptable in the marketplace. We cannot assure you that, if we fail to realize the synergistic benefits sought through the acquisition of DIDS, the resulting effect will not harm our business, operating results and financial condition.

We have a history of losses and we cannot assure you that we will maintain profitability

        We have incurred significant net losses since inception. Our accumulated deficit as of June 30, 2003 was approximately $55.7 million. In order to maintain profitability, we will need to generate higher revenue than we have in prior years while controlling expenditures related to those higher revenues. Even though we achieved profitability during the first two quarters of 2003, we may not be able to sustain or increase our profitability. If our revenue grows more slowly than we anticipate, or if our operating expenses exceed our expectations, our operating results will be harmed and we may not be profitable.

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Our future growth will depend to some extent on our successful implementation of our intellectual property in solutions provided by third-party partners

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

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

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

•

We may be unable to develop revenue models that generate and sustain revenue because our current and anticipated products and services may be unable to attract or retain customers;



•

The intense competition and rapid technological change in our industry could adversely affect the market's acceptance of our products and services;



•

We may be unable to build and maintain our brand;



•

We may be unable to develop and maintain the strategic relationships upon which we currently rely for portions of our revenue; and



•

Our quarterly operating results may fluctuate significantly.

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

A significant portion of our business depends on large public sector contracts, which can be terminated at the convenience of the government authority, are subject to a variety of requirements and influences and may only result in one-time revenue without potential for renewal

        A significant portion of our business depends on a limited number of large public sector contracts. Government contracts are generally subject to termination for convenience or lack of appropriation at the determination of the subject agency. Further, some government contracts may be one-time events, such as in the case of some personal identification systems in non-U.S. markets involving voter registration programs. In such cases, we may generate substantial revenues without renewal. Moreover, government contracts result from purchasing decisions made by public sector agencies that may be subject to political influence, unusual procurement procedures, strict legal requirements, budget changes and cutbacks during economic downturns, variations in appropriations cycles, and protests of contract awards. Additionally, some governmental authorities require performance or fidelity bonds that we are obligated to maintain during the life of the contract. Often, the terms of these bonds require that we maintain large restricted cash reserves as a guarantee, reducing our ability to use these funds for our other business purposes. The size, nature and purpose of, and the risks and uncertainties associated with, public sector contracts can impact the predictability of our quarterly results and may potentially have a material negative effect on our financial position, results of operation or cash flows.

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

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

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

•

The timing, introduction and successful commercialization of our new products and services;



•

The loss of or reduction in revenue from any large customer;



•

The market's acceptance of our products and services;



•

Our ability to establish and maintain strategic relationships;



•

The potential costs of litigation and intellectual property protection;



•

The operating costs and capital expenditures related to the expansion of our business operations and infrastructure, domestically and internationally, including the hiring of key personnel and new employees;



•

The introduction of similar or substitute technologies by our competitors;



•

The costs and timing of completing the integration of DIDS into our existing business;



•

The unpredictability and irregularity of our revenue from government contracts due to political, budgetary appropriations, purchasing and delivery constraints;



•

The timing of future licensing revenue;



•

The costs associated with marketing arrangements that we enter into during early market development; and,



•

The failure or delay in efforts to establish industry standards involving watermarking.

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

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

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

        We face risks associated with our patent position, including the potential and sometimes actual need to engage in significant legal proceedings to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete

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against us without infringing our patents and the possibility that our products may infringe patent rights of third parties. Budgetary concerns may cause us not to file, or continue, litigation against known infringers of our patent rights. Failure to reliably enforce our patent rights against infringers may make licensing more difficult. If we fail to protect our intellectual property rights and proprietary technologies adequately, if there are changes in applicable laws that are adverse to our interests, or if we become involved in litigation relating to our intellectual property rights and proprietary technologies or relating to the intellectual property rights of others, our business could be seriously harmed.

        As part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, directors, consultants and corporate partners, and attempt to control access to and distribution of our technologies, solutions, documentation and other proprietary information. Despite these procedures, third parties could copy or otherwise obtain and make unauthorized use of our technologies, solutions or other proprietary information or independently develop similar technologies, solutions or information. The steps that we have taken to prevent misappropriation of our solutions, technologies or other proprietary information may not prevent their misappropriation, particularly outside the United States where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States.

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

        Some of our contracts include provisions assuring non-infringement of third party intellectual property rights. If an infringement arose in a context governed by such a contract, our exposure could be large and our business could be materially harmed.

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

        We have registered "DIGIMARC", "MARCSPIDER", "MARCCENTRE", "MEDIABRIDGE", "PICTUREMARC" and the "D" logo as trademarks in the United States and some other countries, and are pursuing registration of the "DIGIMARC" trademark in additional countries. However, our tradenames or trademarks may be registered by third parties in other countries, impairing our ability to enter and compete in these markets. In the United States, the trademark "Digimark" and the domain names "Digimark.com" and "Mediabridge.com" have been registered by unrelated companies. While we have put in place formal arrangements for co-existence with one of these unrelated companies, and while we have co-existed successfully to date with the others, if we were forced to change our name or were prevented from using our other brand names, we would lose a significant amount of our brand equity, and our business would suffer.

        As more companies engage in business activities relating to digital watermarking and develop intellectual property rights, it is increasingly likely that claims may arise which assert that some of our products or services infringe upon other parties' intellectual property rights. These claims could subject us to costly litigation, divert management resources and result in the invalidation of our intellectual property rights. These claims may require us to pay significant damages, cease production of infringing products, terminate our use of infringing technologies or develop non-infringing technologies. In these

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circumstances, continued use of our technologies may require that we acquire licenses to the intellectual property that is the subject of the alleged infringement, and we might not be able to obtain these licenses on commercially reasonable terms or at all. Our use of protected technologies may result in liability that threatens our continuing operation. In addition, we offer indemnification against intellectual property infringement for some contracts to which we are a party. If a claim were made under such an indemnity provision, we could incur significant expense.

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

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

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

Our products could have unknown defects or errors, which may give rise to claims against us or divert application of our resources from other purposes

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

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        Because many customers rely on our products for critical security applications, defects or errors in our products or services might discourage customers from purchasing future products and services. These defects or errors could also result in product liability or warranty claims. Although we attempt to reduce the risk of losses resulting from these claims through warranty disclaimers and liability limitation clauses in our sales agreements, these contractual provisions are sometimes not included and may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this insurance coverage may not adequately cover these claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by insurance, our business could be materially harmed.

        During 2002, DIDS engaged in activities in a number of jurisdictions to finish projects begun prior to our acquisition from Polaroid Corporation and its affiliates of the U.S. large government programs identification systems and international digital identification systems businesses. DIDS also engaged in activities in several jurisdictions to correct legacy defects from installations prior to our acquisition that were identified during or since the acquisition process as needing remedial action. We have made considerable progress with regard to these activities. Nonetheless, there may be additional issues or defects that we have not yet identified that may require significant efforts and resources to correct and that would cause us to divert resources away from other purposes.

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

        As of June 30, 2003 we had 362 employees and 60 contract workers. To effectively manage our operations, management must continue to improve our operational and financial systems and train, improve and manage our employee base. As part of our goal to continue to improve operating efficiencies, we re-organized our operations into a portfolio of peer-level operating units under a corporate umbrella, consisting of two units, the first of which is Watermarking Solutions and the second of which is ID Systems, both of which are overseen by a small corporate staff. While our management anticipates that this new operating structure will facility effective management of the continuing growth and expansion of our business, we cannot assure you that the new operating structure will be effective or achieve the desired results. Additionally, less than optimal rates of growth of our product lines and areas of business may require us to restructure our business from time to time which, in turn, could significantly strain our managerial and financial resources. If we cannot manage our growth effectively, we may not be able to coordinate the activities of our technical, legal, accounting and marketing staffs, and our business could be harmed.

If there is a sustained downturn in purchases or adoption of new technologies, our business may be harmed

        Our growth plans assume, in part, that new technologies will gain widespread market acceptance and be purchased by a growing number of customers. If there is a sustained downturn in purchases or adoption of new technologies, we may be unable to realize anticipated future revenue and our business could be materially harmed.

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

        From time to time we have discussions with third parties about potential acquisitions. If appropriate opportunities present themselves, we may attempt to acquire other businesses or technologies. We may not be able to identify, negotiate or finance any future acquisition successfully. Other than the acquisition of DIDS, we have limited experience in integrating an acquired business into our existing business. The process of integration may produce operating difficulties and expenditures and may require significant attention of our management that otherwise would be available for the ongoing development of our business. In the end, we may be unsuccessful in integrating an acquired business or technology with our existing business. Moreover, if we make

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acquisitions, we may issue shares of our stock that would dilute the equity holdings of our existing stockholders, incur debt, assume contingent liabilities or create additional expenses related to amortizing intangible and other acquired assets. Any of these might negatively affect our financial results and cause our stock price to decline. Our due diligence of acquired companies may fail to reveal material risks or liabilities. Additionally, in order to take advantage of opportunities, we may find it necessary to obtain additional equity financing, debt financing, or credit facilities, and we may not be successful in doing so on satisfactory terms. Any financing that we might need for future acquisitions may also place restrictions on our business. Furthermore, we may never achieve any of the benefits that we might anticipate from a future acquisition.

We depend on key employees for our future success

        Our success depends to a significant extent on the performance and continued service of our senior management. Almost all of our senior management do not have employment agreements. Although our employees generally have executed agreements containing non-competition clauses, there is no assurance that a court would enforce all of the terms of these clauses or the clauses generally. If these clauses were not fully enforced, our employees would be freely able to join our competitors. The loss of the services of any of our senior management or any of our other key employees could harm our business.

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

        Our ability to successfully develop, market, sell and license our products, services, and intellectual property depends to a significant degree upon the continued contributions of our key personnel in engineering, sales, marketing and operations, many of whom would be difficult to replace. We believe our future success will also depend in large part upon our ability to retain our current key employees or our ability to attract, integrate and retain other highly skilled managerial, engineering, sales, marketing, and operations personnel in the future. Our business is based in part on patented technology, which is unique and not generally known. New employees require substantial training, involving significant resources and management attention. Competition for experienced personnel in our market segments can be intense. If we do not succeed in attracting new, qualified personnel or in integrating, retaining and motivating our current personnel, our business could be harmed.

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

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

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

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

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

•

Our board of directors is divided into three classes of directors, with a separate class of directors being elected at each successive annual meeting for a term of three years;



•

Special meetings of the stockholders may be called only by our president, our secretary, or at the discretion of our board of directors;



•

Vacancies on our board of directors may be filled by a majority of directors in office, without the approval of the stockholders; and



•

Our board of directors may issue preferred stock and determine the price, designations, rights and preferences as well as qualifications, limitations, and restrictions of those shares without any vote or further action by the stockholders.

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

There are many risks associated with our international operations which may impact future revenue growth

        We expect revenues from sales of products and services to governments and other customers outside of the United States to represent a growing percentage of our total revenues in the future. International sales and services are subject to a number of risks, including the following:

•

changes in foreign government regulations and security requirements;



•

export license requirements, tariffs and taxes;



•

trade barriers;



•

difficulty in protecting intellectual property;



•

difficulty in collecting accounts receivable;



•

currency fluctuations;



•

difficulty in managing foreign operations; and



•

political and economic instability.

        If our customers are affected by currency devaluations or general economic downturns or persistent economic difficulties, their ability to purchase our products and subscriptions and services could be reduced significantly. Payment cycles for international customers typically are longer than those for customers in the United States. Foreign customers may decide to terminate or delay the implementation of our products and services. Any action like this by foreign customers, in particular foreign government authorities, could potentially delay or reduce our anticipated revenues under our contracts with such customers and we may have limited recourse against them to recover any potential losses.

        While we generally invoice our foreign sales in U.S. dollars, we may elect in the future to take payment in other foreign currencies and, if we do, we may be exposed to losses as the result of foreign currency fluctuations. We currently do not engage in foreign currency hedging transactions. We may in the future choose to limit our exposure by the purchase of forward foreign exchange contracts or through similar hedging strategies. No currency hedging strategy can fully protect against exchange-related losses. In addition, if the relative value of the U.S. dollar in comparison to the currency of our foreign customers should increase, the resulting effective price increase of our products and services to those foreign customers could result in decreased sales.

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Risks Related to Our Markets

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

        Our future success will depend in part on our ability to enhance and improve the responsiveness, functionality and features of our products and services in accordance with regulatory or industry standards. Our ability to remain competitive will depend in part on our ability to influence and respond to emerging industry and statutory standards, including any standards that may be adopted for the protection of audio, video, and image content, and for other uses of metadata with such content, in a timely and cost-effective manner. For example, we have been actively working with a group of companies to establish a digital video watermarking solution standard for DVD devices. However, while our group already has submitted to the DVD Copy Control Association, or DVDCCA, a proposed standard, the DVDCCA to date has delayed its selection and, even if a selection is made, the standard proposed by our group may not be adopted. If we are unable to influence these or other standards or respond to such standards effectively, our business could be harmed.

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

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

•

Enhance and improve the responsiveness, functionality and other features of the products and services we offer or plan to offer;



•

Continue to develop our technical expertise; and



•

Develop and introduce new services, applications and technologies to meet changing customer needs and preferences and to integrate new technologies.

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

If leading companies in our industry or standard setting bodies or institutions downplay, minimize, or reject the use of watermarking, our business could be harmed

        Many of our business endeavors, such as our licensing of intellectual property in support of audio and video applications, can be impeded or frustrated by larger, more influential companies or by standard setting bodies or institutions downplaying, minimizing or rejecting the value or use of watermarking technology or any of our other technologies. Such a negative position by these companies, bodies or institutions, if taken, may result in obstacles for us that we would be incapable of overcoming and may make achieving our business objectives difficult or impossible, harming our business as a result.

Our markets for digital watermarking applications are highly competitive

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

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competition from unexpected sources. Alternative technologies that may directly or indirectly compete with particular applications of our watermarking technologies include:

•

Encryption—securing data during distribution using a secret code so it cannot be accessed except by authorized users;



•

Containers—inserting a media object in a wrapper, which prevents the media object from being duplicated;



•

Dataglyphs—a slightly visible modification of the characteristics of an image or document that is machine-readable;



•

Scrambled Indicia—an optical refraction-based data-hiding technique that is inserted into an image and can be read with a lens;



•

Traditional anti-counterfeiting technologies—a number of solutions used currently by many governments (and that compete for budgetary outlays) designed to deter counterfeiting, including optically sensitive ink, magnetic threads and other materials used in the printing of currencies;



•

Radio frequency tags—embedding a chip that emits a signal when in close proximity with a receiver, which is being used in photo identification, labels and tags;



•

Internet technologies—numerous existing and potential Internet access and search methods will be potentially competitive with the Digimarc MediaBridge system;



•

Digital fingerprints and signatures—a metric, or metrics, computed solely from a source image or audio or video track, that can be used to uniquely identify an image or track, or authenticate the image or track;



•

Smart cards—badges and cards including a semiconductor memory and/or processor used for authentication and related purposes; and



•

Bar codes—a data-carrying code, typically visible in nature (but invisible if printed in ultraviolet- or infrared-responsive inks).

        In addition, as we more broadly apply our technologies to the Internet through new commercial solutions applications, we may begin to compete with a wide range of other types of companies beyond those companies using digital watermarking technologies and alternative technologies. Moreover, many of the companies that currently compete with us, as well as other companies with whom we may compete in the future, are national or international in scope and may have greater technical, financial, marketing, and political resources than we do. These resources could enable these companies to initiate severe price cuts or take other measures in an effort to gain market share or otherwise impede our progress in target markets. We cannot assure you that digital watermarking technologies, and our products and services using these technologies, will gain widespread market acceptance.

        New developments are expected to continue, and we cannot assure you that discoveries by others, including current and potential competitors, will not render our services and products noncompetitive. Moreover, because of rapid technological changes, we may be required to expend greater amounts of time and money than currently anticipated to develop new products and services, which in turn may necessitate us to require greater revenue streams on such products and services to cover developmental costs. We cannot assure you that we will be able to compete successfully against current or future participants in our markets or against alternative technologies, nor can we assure you that the competitive pressures we face will not harm our business, operating results and financial condition.

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Terrorist attacks and threats or actual war may negatively impact all aspects of our operations, revenues, costs and stock price

        Threats of terrorist attacks in the United States, as well as future events occurring in response or connection to them, including, without limitation, future terrorist attacks or threats against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions may impact our operations. While any of these events could result in an increased need for new security features that may, as a result, favorably impact our revenues from our DIDS business and our sales of product and subscription and service in connection with our digital watermarking technology, any of these events could also, or alternatively, result in increased volatility in the United States and worldwide financial markets and economies, negatively impacting our business in other ways, such as by driving up research, development and engineering costs associated with attempting to achieve heightened effectiveness in new products. Also, any of these terrorist-related events could result in economic recession in the United States or abroad. If such negative consequences were to occur, they could have a significant impact on our operating results, revenues and costs and may result in the volatility of the future market price of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

        The Company's market risk disclosures set forth in Item 7A of its Annual Report on Form 10-K for the year ended December 31, 2002 have not changed materially. In addition, if market interest rates were to increase immediately and uniformly by 10% from levels as of December 31, 2002, the decline of the fair market value of our fixed income portfolio and loans outstanding would not be material.

Item 4. Controls and Procedures.

        As of June 30, 2003 our management evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. Our management also evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, any change that occurred in our internal control over financial reporting during the fiscal quarter ended June 30, 2003. No such change materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION.

Item 1. Legal Proceedings.

        As previously reported in our Form 10-Q for the quarterly period ended March 31, 2003, beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Digimarc, certain of its officers and directors, and certain underwriters of Digimarc's initial public offering as defendants. The complaints have since been consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of our initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in our initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of our stock in the after-market subsequent to our initial public offering. Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an

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alleged failure to disclose the underwriters' alleged compensation arrangements and manipulative practices. The complaint seeks unspecified damages. The individual officer and director defendants entered into tolling agreements and, pursuant to a Court Order dated October 9, 2002, were dismissed from the litigation without prejudice. Furthermore, in July 2002, Digimarc and the other issuers in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim. The motion to dismiss claims under Section 11 was denied as to virtually all the defendants in the consolidated actions, including Digimarc. The claims against Digimarc under Section 10(b), however, were dismissed. In June 2003, a committee of our board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of Digimarc and of the individual defendants for the conduct alleged in the amended complaint to be wrongful. Digimarc would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Digimarc may have against its underwriters. Any direct financial impact of the proposed settlement (other than defense costs incurred and expensed prior to May 31, 2003) is expected to be borne by Digimarc's insurers. The committee agreed to approve the settlement subject to a number of conditions, including the participation of a substantial number of other issuer defendants in the proposed settlement, the consent of Digimarc's insurers to the settlement, and the completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the litigation. Due to the inherent uncertainties of litigation, and because the settlement process is still at a preliminary stage, the ultimate outcome of the matter cannot be predicted.

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

        We held our annual meeting of stockholders on May 22, 2003. Two proposals were voted on by our stockholders and the results for each proposal were as follows:

        Proposal 1:    Election of Three Class I Directors

        The election of three Class I directors was approved as follows:

        Proposal 2:    Ratification of the Appointment of the Company's Independent Auditors

        KPMG LLP was ratified as our independent auditors for the fiscal year ending December 31, 2003 with 12,041,673 votes in favor, 780,068 votes against, 11,221 abstentions, and 4,879,503 non-votes.

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

(a)

Exhibits.

See attached exhibit index.

(b)

Reports on Form 8-K.

On April 22, 2003, Digimarc filed with the Securities and Exchange Commission a current report on Form 8-K which included reports under items 7 and 12 thereto and attached a press release issued by Digimarc on April 22, 2003 announcing its preliminary financial results for the quarterly period ended March 31, 2003.

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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.

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EXHIBIT INDEX

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QuickLinks

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Item 4. Controls and Procedures.
PART II. OTHER INFORMATION.
Item 1. Legal Proceedings.
Item 4: Submission of Matters to a Vote of Security Holders.
Item 6: Exhibits and Reports on Form 8-K.