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EX-32.2 - FALCONSTOR SOFTWARE INCex322to10q04637006_09302010.htm
EX-31.2 - FALCONSTOR SOFTWARE INCex312to10q04637006_09302010.htm
EX-32.1 - FALCONSTOR SOFTWARE INCex321to10q04637006_09302010.htm
EX-31.1 - FALCONSTOR SOFTWARE INCex311to10q04637006_09302010.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2010
 
or
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                 to                                

Commission File Number:  000-23970
 
 
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

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

2 Huntington Quadrangle
Melville, New York
11747
(Address of principal executive offices)
(Zip Code)

631-777-5188
(Registrant’s telephone number, including area code)
 
 
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes x  No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes o     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large accelerated filer ¨
Accelerated filer x
   
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o    No x
 
The number of shares of Common Stock outstanding as of November 5, 2010 was 46,091,068
 
 
 
1

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
FORM 10-Q
 
 
   
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41
     
46
 
 
2

 
PART I.    FINANCIAL INFORMATION
Item 1.  Condensed Consolidated Financial Statements

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
September 30, 2010
   
December 31, 2009
 
Assets
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 8,808,032     $ 15,752,528  
Marketable securities
    23,952,698       24,952,966  
Accounts receivable, net of allowances of $5,652,038 and  $7,503,338, respectively
    19,177,614       24,948,261  
Prepaid expenses and other current assets
    1,721,781       1,556,787  
Income tax receivable
    515,082       830,816  
Inventory
    2,049,972       329,657  
Deferred tax assets, net.
    -       4,320,773  
Total current assets
    56,225,179       72,691,788  
                 
Property and equipment, net of accumulated depreciation of $20,931,632 and $17,380,681, respectively
    6,120,576       7,601,727  
Long-term marketable securities
    1,087,313       1,077,466  
Deferred tax assets, net.
    85,918       9,698,859  
Other assets, net
    2,425,569       2,958,229  
Goodwill
    4,150,339       4,150,339  
Other intangible assets, net
    475,470       823,416  
                 
Total assets
  $ 70,570,364     $ 99,001,824  
                 
Liabilities and Stockholders' Equity
               
Current liabilities:
               
Accounts payable
  $ 1,188,625     $ 1,570,190  
Accrued expenses
    8,227,244       8,454,743  
Deferred revenue, net
    15,233,041       16,570,076  
Total current liabilities
    24,648,910       26,595,009  
                 
Other long-term liabilities
    2,422,714       608,907  
Deferred revenue, net
    5,243,547       5,644,994  
                 
Total liabilities
    32,315,171       32,848,910  
                 
Commitments and contingencies
               
                 
Stockholders' equity:
               
Preferred stock - $.001 par value, 2,000,000 shares authorized
    -       -  
Common stock - $.001 par value, 100,000,000 shares authorized, 54,006,184 and 52,389,028 shares issued,
     respectively and 46,000,949 and 44,383,793 shares outstanding, respectively
    54,006       52,389  
Additional paid-in capital
    149,338,042       141,726,802  
Accumulated deficit
    (62,504,284 )     (27,181,894 )
Common stock held in treasury, at cost (8,005,235 and 8,005,235 shares, respectively)
    (46,916,339 )     (46,916,339 )
Accumulated other comprehensive loss, net
    (1,716,232 )     (1,528,044 )
                 
Total stockholders' equity
    38,255,193       66,152,914  
Total liabilities and stockholders' equity
  $ 70,570,364     $ 99,001,824  
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
3

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenues:
                       
Product revenues
  $ 11,366,493     $ 14,397,983     $ 33,382,701     $ 46,087,209  
Support and services revenues
    7,609,339       7,142,186       22,983,495       20,942,665  
      18,975,832       21,540,169       56,366,196       67,029,874  
Cost of revenues:
                               
   Product      2,120,727        855,566        6,179,952        2,015,567  
   Support and service
    3,104,108       3,456,215       10,020,153       10,133,565  
   Total cost of revenues
    5,224,835       4,311,781       16,200,105       12,149,132  
                                 
Gross profit
  $ 13,750,997     $ 17,228,388     $ 40,166,091     $ 54,880,742  
                                 
Operating expenses:
                               
Research and development costs
    6,445,992       6,911,215       20,211,811       19,890,526  
Selling and marketing
    9,724,007       10,391,931       31,165,975       31,023,224  
General and administrative
    2,403,954       2,388,860       7,217,428       6,996,357  
Total operating expenses
    18,573,953       19,692,006       58,595,214       57,910,107  
Operating loss
     (4,822,956 )      (2,463,618 )      (18,429,123 )     (3,029,365 )
                                 
Interest and other income, net
    205,518       239,516       103,077       18,811  
                                 
Loss before income taxes
    (4,617,438 )     (2,224,102 )     (18,326,046 )     (3,010,554 )
                                 
Provision (benefit) for income taxes
    21,799,389       (192,697 )     16,996,344       (1,394,902 )
                                 
Net loss
  $ (26,416,827 )   $ (2,031,405 )   $ (35,322,390 )   $ (1,615,652 ) 
                                 
Basic net loss per share
  $ (0.58 )   $  (0.05 )   $ (0.78 )   $ (0.04 )
                                 
Diluted net loss per share
  $ (0.58 )   $  (0.05 )   $  (0.78 )   $  (0.04 )
                                 
Weighted average basic shares outstanding
     45,836,621        44,803,379        45,367,998        44,812,807  
                                 
Weighted average diluted shares outstanding
     45,836,621        45,803,379        45,367,998        44,812,807  
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
4

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
   
Nine Months Ended
September 30,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net loss
  $ (35,322,390 )   $ (1,615,652 )
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
               
Depreciation and amortization
    4,354,931       4,351,078  
Share-based payment compensation
    6,393,806       6,448,603  
Non-cash professional services expenses
    776,811       263,946  
Realized (gain) loss on marketable securities
    (7,319 )     27,920  
Deferred tax asset valuation allowance
    16,278,521       -  
Provision for returns and doubtful accounts
    2,281,695       2,190,479  
Deferred income tax provision
    (2,348,722 )     (1,523,285 )
Changes in operating assets and liabilities:
               
Accounts receivable
    3,479,636       1,861,747  
Prepaid expenses and other current assets
    (23,459 )     154,291  
Income tax receivable
    315,734       -  
Inventory
    (1,720,315 )     (20,552 )
Other assets
    156,791       (82,721 )
Accounts payable
    (374,066 )     309,201  
Accrued expenses and other liabilities
    1,609,415       (528,522 )
Deferred revenue
    (1,737,518 )     (1,906,399 )
                 
Net cash (used in) provided by operating activities
    (5,886,449 )     9,930,134  
                 
Cash flows from investing activities:
               
Sale of marketable securities
    18,956,114       17,653,276  
Purchase of marketable securities
    (18,052,117 )     (20,841,595 )
Purchase of property and equipment
    (2,024,786 )     (2,763,391 )
Purchase of software license
    -       (950,000 )
Capitalized software development costs
    -       (80,703 )
Security deposits
    9,081       (30,774 )
Purchase of intangible assets
    (81,688 )     (50,027 )
                 
Net cash used in investing activities
    (1,193,396 )     (7,063,214 )
                 
Cash flows from financing activities:
               
Payments to acquire treasury stock
    -       (1,526,124 )
Proceeds from exercise of stock options
    378,559       11,280  
                 
Net cash provided by (used in) financing activities
    378,559       (1,514,844 )
                 
Effect of exchange rate changes on cash and cash equivalents
    (243,210 )     (477,410 )
                 
Net (decrease) increase in cash and cash equivalents
    (6,944,496 )     874,666  
                 
Cash and cash equivalents, beginning of period
    15,752,528       22,364,235  
                 
Cash and cash equivalents, end of period
  $ 8,808,032     $ 23,238,901  
                 
Cash paid for income taxes
  $ 79,441     $ 130,125  
 
The Company did not pay any interest for the nine months ended September 30, 2010 and 2009.

See accompanying notes to unaudited condensed consolidated financial statements.
 
 
5

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
Notes to Unaudited Condensed Consolidated Financial Statements
 
 
(1)  Summary of Significant Accounting Policies
 
(a)  The Company and Nature of Operations
 
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures and sells network storage solutions and provides the related maintenance, implementation and engineering services.
 
(b)  Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.
 
(c)  Reclassifications
 
Certain prior period amounts have been reclassified to conform to the current period presentation. The Company no longer presents revenues classified as (i) “software licenses,” (ii) “maintenance,” and (iii) “software services and other” within the condensed consolidated statement of operations. The Company presents revenues derived from software solutions integrated with hardware and stand-alone software applications as “product revenue” and revenues derived from maintenance and professional services as “support and services revenue” within the condensed consolidated statement of operations. In addition, the Company presents the related cost of revenues from both “product revenue” and “support and services revenues” as separate line items within the condensed consolidated statement of operations. Certain costs, including personnel, shipping and logistics costs, and share-based compensation expense, from prior periods have been reclassified from various operating expense line items to “cost of revenues – product.” The Company believes the reclassifications provide a more meaningful representation of the Company’s product and services offerings. The reclassifications had no effect on net earnings, total stockholders' equity, total assets or cash flows.
 
(d)  Use of Estimates
 
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company’s significant estimates include those related to revenue recognition, accounts receivable allowances, share-based payment compensation, cost-based investments, marketable securities and deferred income taxes. Actual results could differ from those estimates.
 
The financial market volatility, both in the U.S. and in many other countries where the Company operates, has impacted and may continue to impact the Company’s business. Such conditions could have a material impact to the Company’s significant accounting estimates discussed above, in particular those around accounts receivable allowances, cost-based investments, marketable securities and the recoverability of deferred tax assets.
 
(e)  Unaudited Interim Financial Information
 
The accompanying unaudited interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.
 
 
6

 
In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at September 30, 2010, and the results of its operations for the three and nine months ended September 30, 2010 and 2009. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year.
 
(f)  Cash Equivalents and Marketable Securities
 
The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. The Company records its cash equivalents and marketable securities at fair value in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) on fair value measurements and disclosures. As of September 30, 2010 and December 31, 2009, the Company’s cash equivalents consisted of money market funds, corporate bonds and government securities. At September 30, 2010 and December 31, 2009, the fair value of the Company’s cash equivalents amounted to approximately $5.0 million and $8.8 million, respectively. As of September 30, 2010 and December 31, 2009, the Company’s marketable securities consisted of corporate bonds, auction rate securities, and government securities. As of September 30, 2010 and December 31, 2009, the fair value of the Company’s current marketable securities was approximately $24.0 million and $25.0 million, respectively. In addition, as of both September 30, 2010 and December 31, 2009, the Company had an additional $1.1 million of long-term marketable securities that required a higher level of judgment to determine the fair value. All of the Company’s marketable securities are classified as available-for-sale, and accordingly, unrealized gains and losses on marketable securities, net of tax, are reflected as a component of accumulated other comprehensive loss in stockholders’ equity. Any other-than-temporary impairments are recorded within interest and other loss, net in the condensed consolidated statement of operations. See Note (5) Marketable Securities for additional information.
 
(g)  Fair Value of Financial Instruments
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To increase the comparability of fair value measurements, a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies, is as follows:
 
Level 1—Valuations based on quoted prices for identical assets and liabilities in active markets.
 
Level 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.
 
Level 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment.
 
As of both September 30, 2010 and December 31, 2009, the fair value of the Company’s financial instruments including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated book value due to the short maturity of these instruments. See Note (4) Fair Value Measurements for additional information.
 
(h)  Revenue Recognition
 
The Company derives its revenue from sales of its products and services. Product revenue consists of the Company’s software integrated with industry standard hardware and sold as one complete turn-key integrated solution. Product revenue also consists of stand-alone software applications. Support and services revenue consists of both maintenance revenues and professional services revenues.
 
 
7

 
In accordance with the authoritative guidance issued by the FASB on revenue recognition, the Company recognizes revenue from product revenue when persuasive evidence of an arrangement exists, the fee is fixed and determinable, the product is delivered, and collection of the resulting receivable is deemed probable. Products delivered to a customer on a trial basis are not recognized as revenue until a permanent key code is delivered to the customer. Reseller customers typically send the Company a purchase order when they have an end user identified. When a customer purchases maintenance with any product, the Company allocates a portion of the fee to maintenance for its fair value. Maintenance fees are deferred and recognized as revenue ratably over the term of the contract. The long-term portion of deferred revenue relates to maintenance contracts with terms in excess of one year. The cost of providing technical support is included in cost of support and services revenue. The Company provides an allowance for product returns as a reduction of revenue, based upon historical experience and known or expected trends.
 
Revenues associated with software implementation and software engineering services are recognized when the services are performed. Costs of providing these services are included in cost of support and services revenue.
 
The Company has entered into various distribution, licensing and joint promotion agreements with OEMs and distributors, whereby the Company has provided to the reseller a non-exclusive software license to install the Company’s software on certain hardware or to resell the Company’s software in exchange for payments based on the products distributed by the OEM or distributor. Such payments from the OEM or distributor are recognized as revenue in the period reported by the OEM or distributor
 
For the three months ended September 30, 2010, the Company did not have any customers who accounted for 10% or more of total revenues. For the three months ended September 30, 2009, the Company had two customers that together accounted for 29% of revenues. As of each of September 30, 2010 and December 31, 2009, the Company did not have any customers that accounted for 10% or more of the accounts receivable balance for each of the respective periods.
 
(i)  Property and Equipment
 
Property and equipment are recorded at cost. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets (3 to 7 years). For the three months ended September 30, 2010 and 2009, depreciation expense was $1,103,009 and $1,162,155, respectively.  For the nine months ended September 30, 2010 and 2009, depreciation expense was $3,513,593 and $3,442,954, respectively. Leasehold improvements are amortized on a straight-line basis over the term of the respective leases or over their estimated useful lives, whichever is shorter.
 
(j)  Goodwill and Other Intangible Assets
 
Goodwill represents the excess of the purchase price over the estimated fair value of net tangible and identifiable intangible assets acquired in business combinations. The Company has not amortized goodwill related to its acquisitions, but instead tests the balance for impairment. The Company’s annual impairment assessment is performed during the fourth quarter of each year, and an assessment is made at other times if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. Identifiable intangible assets, which include (i) assets acquired through business combinations, which include customer contracts and intellectual property, and (ii) patents amortized over three years using the straight-line method.
 
For the three months ended September 30, 2010 and 2009, amortization expense was $140,954 and $158,581, respectively. For the nine months ended September 30, 2010 and 2009, amortization expense was $429,635 and $486,301, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of September 30, 2010 and December 31, 2009 are as follows:
 
 
8

 
   
September 30,
2010
   
December 31,
2009
 
Goodwill:
  $ 4,150,339     $ 4,150,339  
Other intangible assets:
               
Gross carrying amount
  $ 2,851,437     $ 2,769,748  
Accumulated amortization
    (2,375,967 )     (1,946,332 )
Net carrying amount
  $ 475,470     $ 823,416  
 
(k)  Software Development Costs and Purchased Software Technology
 
In accordance with the authoritative guidance issued by the FASB on costs of software to be sold, leased, or marketed, costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company’s product development process, technological feasibility is established upon completion of a working model. Amortization of software development costs is recorded at the greater of the straight-line basis over the products estimated life, typically three years, or the ratio of current revenue of the related products to total current and anticipated future revenue of these products. During the nine months ended September 30, 2009, the Company capitalized approximately $81,000 related to software development projects. The Company did not capitalize any software development costs during the nine months ended September 30, 2010. During both the three months ended September 30, 2010 and 2009, the Company recorded $6,725 of amortization expense related to capitalized software costs. During the nine months ended September 30, 2010 and 2009, the Company recorded $20,175 and $13,450, respectively, of amortization expense related to capitalized software costs.
 
Purchased software technology net carrying value of $118,750 and $510,000, after accumulated amortization of $6,208,681and $5,817,431, is included within other assets in the unaudited condensed consolidated balance sheets as of September 30, 2010 and December 31, 2009, respectively. Amortization expense was $124,028 and $134,468 for the three months ended September 30, 2010 and 2009, respectively. Amortization expense was $391,528 and $408,373 for the nine months ended September 30, 2010 and 2009, respectively. Amortization of purchased software technology is recorded at the greater of the straight line basis over the products estimated remaining life or the ratio of current period revenue of the related products to total current and anticipated future revenue of these products.
 
(l)  Income Taxes
 
The Company records income taxes under the liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In determining the period in which related tax benefits are realized for book purposes, excess share-based compensation deductions included in net operating losses are realized after regular net operating losses are exhausted.
 
The Company accounts for uncertain tax positions in accordance with the authoritative guidance issued by the FASB on income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Pursuant to the authoritative guidance, the Company may recognize the tax benefit from an uncertain tax position only if it meets the “more likely than not” threshold that the position will be sustained on examination by the taxing authority, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. In addition, the authoritative guidance addresses de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures. The Company includes interest and penalties related to its uncertain tax positions as part of income tax expense within its condensed consolidated statement of operations. See Note (3) Income Taxes for additional information.
 
 
9

 
(m)  Long-Lived Assets
 
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the sum of the expected future cash flows, undiscounted and without interest is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.
 
(n)  Share-Based Payments
 
The Company accounts for share-based payments in accordance with the authoritative guidance issued by the FASB on stock compensation, which establishes the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Under the provisions of the authoritative guidance, share-based compensation expense is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the requisite employee service period (generally the vesting period), net of estimated forfeitures. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model. The estimation of share-based awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical experience. Additionally, share-based awards to non-employees are expensed over the period in which the related services are rendered, at their fair value. All share-based awards are expected to be fulfilled with new shares of common stock. See Note (2) Share-Based Payment Arrangements for additional information.
 
(o)  Foreign Currency
 
Assets and liabilities of foreign operations are translated at rates of exchange at the end of the period, while results of operations are translated at average exchange rates in effect for the period. Gains and losses from the translation of foreign assets and liabilities from the functional currency of the Company’s subsidiaries into the U.S. dollar are classified as accumulated other comprehensive loss in stockholders’ equity. Gains and losses from foreign currency transactions are included in the condensed consolidated statements of operations within interest and other loss, net.
 
During the three months ended September 30, 2010 and 2009, foreign currency transactional gain totaled approximately $107,000 and $98,000, respectively. During the nine months ended September 30, 2010 and 2009, foreign currency transactional loss totaled approximately $176,000 and $421,000, respectively. The aforementioned foreign currency transactional results are net of the foreign currency forward contracts utilized by the Company as part of the management program to reduce the volatility in earnings caused by exchange rate fluctuations.  See Note (7) Derivative Financial Instruments for additional information.
 
(p)  Earnings Per Share (EPS)
 
Basic EPS is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents. Due to the net loss for both the three and nine months ended September 30, 2010, all common stock equivalents of 13,066,077 were excluded from diluted net loss per share because they were anti-dilutive. Due to the net loss for both the three and nine months ended September 30, 2009, all common stock equivalents of 13,056,165 were excluded from diluted net loss per share because they were anti-dilutive. As of September 30, 2010 and 2009, potentially dilutive common stock equivalents included 13,066,077 and 13,056,165, respectively, attributable to stock option awards, restricted stock awards and restricted stock unit awards outstanding.
 
 
10

 
The following represents a reconciliation of the numerators and denominators of the basic and diluted EPS computation:
 
   
Three Months Ended September 30, 2010
   
Three Months Ended September 30, 2009
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
   
Amount
   
(Numerator)
   
(Denominator)
   
Amount
 
Basic EPS
  $ (26,416,827 )     45,836,621     $ (0.58 )   $ (2,031,405 )     44,803,379     $ (0.05 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and
                                               
      restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (26,416,827 )     45,836,621     $ (0.58 )   $ (2,031,405 )     44,803,379     $ (0.05 )
                                                 
                                                 
   
Nine Months Ended September 30, 2010
   
Nine Months Ended September 30, 2009
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
   
Amount
   
(Numerator)
   
(Denominator)
   
Amount
 
Basic EPS
  $ (35,322,390 )     45,367,998     $ (0.78 )   $ (1,615,652 )     44,812,807     $ (0.04 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and
                                               
      restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (35,322,390 )     45,367,998     $ (0.78 )   $ (1,615,652 )     44,812,807     $ (0.04 )
 
(q)  Investments
 
As of both September 30, 2010 and December 31, 2009, the Company maintained certain cost-method investments aggregating $973,965, which are included within other assets, net in the accompanying condensed consolidated balance sheets. During the three and nine months ended September 30, 2010 and 2009, the Company did not recognize any impairment charges related to any of its cost-method investments.
 
(r)  Treasury Stock

The Company accounts for treasury stock under the cost method and includes treasury stock as a component of stockholders’ equity.
 
(s)  New Accounting Pronouncements
 
In January 2010, the FASB issued authoritative guidance that requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements, and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. The guidance was effective for the Company beginning with its first quarter of 2010, except for Level 3 reconciliation disclosures, which are effective for annual periods beginning after December 15, 2010. The adoption of this authoritative guidance did not have a significant impact on the Company’s condensed consolidated financial statements.
 
In October 2009, the FASB issued authoritative guidance related to the recognition of revenue for multiple-deliverable arrangements. Under the authoritative guidance, revenue may be allocated to the different elements in an arrangement based on relative selling price using the best estimate of selling price if vendor-specific or other third-party evidence of value is not available. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.
 
 
11

 
In October 2009, the FASB issued authoritative guidance altering the scope of revenue recognition guidance for software deliverables to exclude items sold that include hardware with software that is essential to the hardware's functionality. This authoritative guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is still assessing the potential impact of adopting the new authoritative guidance.

(2)  Share-Based Payment Arrangements
 
On May 6, 2010, the Company’s stockholders adopted the FalconStor Software, Inc., 2010 Outside Directors Equity Compensation Plan (the “2010 Plan”). The 2010 Plan is administered by the Board of Directors and provides for the issuance of up to 400,000 shares of Company common stock upon the vesting of options or upon the grant of shares with such restrictions as determined by the Board of Directors to the non-employee directors of the Company. Exercise prices of the options must be equal to the fair market value of the common stock on the date of grant. Options granted have terms of ten years. Shares of restricted stock have the terms and conditions set by the Board of Directors and are forfeitable until the terms of the grant have been satisfied.
 
The following table summarizes the plans under which the Company was able to grant equity compensation as of September 30, 2010:
 
   
Shares
 
Shares Available
 
Shares
 
Last Date for Grant
Name of Plan
 
Authorized
 
for Grant
 
Outstanding
 
of Shares
                 
FalconStor Software, Inc., 2006 Incentive Stock Plan
 
9,928,114
 
2,034,873
 
6,450,623
 
May 17, 2016
                 
FalconStor Software, Inc., 2010 Outside Directors Equity
 
400,000
 
380,000
 
20,000
 
May 8, 2020
 Compensation Plan
               
 
On July 1, 2010, the total shares available for issuance under the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006 Plan”) totaled 2,282,458. Pursuant to the 2006 Plan, if, on July 1st of any calendar year in which the 2006 Plan is in effect, the number of shares of stock as to which options, restricted shares and restricted stock units may be granted under the 2006 Plan is less than five percent (5%) of the number of outstanding shares of stock, then the number of shares of stock available for issuance under the 2006 Plan is automatically increased so that the number equals five percent (5%) of the shares of stock outstanding. In no event shall the number of shares of stock subject to the 2006 Plan in the aggregate exceed twenty million shares, subject to adjustment as provided in the 2006 Plan. On July 1, 2010, the total number of outstanding shares of the Company’s common stock totaled 45,649,155. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan increased by 1,808,729 shares to 2,282,458 shares available for issuance as of July 1, 2010.

The following table summarizes the plans which have expired but still have equity awards outstanding as of September 30, 2010:
 
   
Shares Available
 
Shares
Name of Plan
 
for Grant
 
Outstanding
         
FalconStor Software, Inc., 2000 Stock Option Plan
 
--
 
5,994,454
         
1994 Outside Directors Stock Option Plan
 
--
 
125,500
         
2004 Outside Directors Stock Option Plan
 
--
 
250,000
         
FalconStor Software, Inc., 2007 Outside Directors Equity
 
--
 
225,500
 Compensation Plan
       
 
Options granted under all of the Company’s Plans have terms of ten years.
 
 
12

 
The following table summarizes stock option activity during the nine months ended September 30, 2010:
 
                         
               
Weighted
       
         
Weighted
   
Average
       
         
Average
   
Remaining
   
Aggregate
 
   
Number of
   
Exercise
   
Contractual
   
Intrinsic
 
   
Options
   
Price
   
Life (Years)
   
Value
 
                         
Options Outstanding at December 31, 2009
    12,538,338     $ 5.51              
                             
Granted
    611,000     $ 3.93              
Exercised
    (617,755 )   $ 0.35              
Canceled
    (23,250 )   $ 7.31              
Forfeited
    (82,650 )   $ 4.06              
                             
Options Outstanding at March 31, 2010
    12,425,683     $ 5.69       6.53     $ 3,869,375  
                                 
Granted
    184,000     $ 3.00                  
Exercised
    (75,455 )   $ 0.45                  
Canceled
    (95,026 )   $ 9.55                  
Forfeited
    (87,196 )   $ 6.41                  
                                 
Options Outstanding at June 30, 2010
    12,352,006     $ 5.65       6.35     $ 1,145,147  
                                 
Granted
    577,000     $ 3.11                  
Exercised
    (128,004 )   $ 1.01                  
Canceled
    (218,600 )   $ 6.44                  
Forfeited
    (410,491 )   $ 3.98                  
                                 
Options Outstanding at September 30, 2010
    12,171,911     $ 5.62       6.21     $ 2,054,596  
                                 
Options Exercisable at September 30, 2010
    7,605,822     $ 6.61       4.69     $ 821,411  
 
Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended September 30, 2010 and 2009 was $129,216 and $4,640, respectively. The total cash received from stock option exercises for the nine months ended September 30, 2010 and 2009 was $378,559 and $11,280, respectively. The total intrinsic value of stock options exercised during the three months ended September 30, 2010 and 2009 was $296,722 and $67,754 respectively. The total intrinsic value of stock options exercised during the nine months ended September 30, 2010 and 2009 was $2,712,673 and $111,536, respectively.
 
 
13

 
The Company recognized share-based compensation expense for all awards issued under the Company’s stock option plans in the following line items in the condensed consolidated statements of operations:
 
   
Three months ended September 30,
 
   
2010
   
2009
 
Cost of revenues - product
  $ 9,755     $ 7,086  
Cost of revenues - support and service
    277,839       397,414  
Research and development costs
    680,179       813,929  
Selling and marketing
    978,559       731,571  
General and administrative
    251,615       291,792  
                 
    $ 2,197,947     $ 2,241,792  
                 
                 
   
Nine months ended September 30,
 
      2010       2009  
Cost of revenues - product
  $ 23,696     $ 21,027  
Cost of revenues - support and service
    887,930       1,149,568  
Research and development costs
    2,480,509       2,281,750  
Selling and marketing
    2,875,275       2,425,043  
General and administrative
    903,207       835,161  
                 
    $ 7,170,617     $ 6,712,549  
 
The Company has the ability to issue both restricted stock and restricted stock units. The fair value of the restricted stock awards and restricted stock units are expensed at either (i) the fair value per share at date of grant (outside directors, officers and employees), or (ii) the fair value per share as of each reporting period (non-employee consultants). A summary of the total stock-based compensation expense related to restricted stock awards and restricted stock units, which is included in the Company’s total share-based compensation expense for each respective period, is as follows:
 
   
Three months ended September 30,
 
   
2010
   
2009
 
Outside directors, officers and employees
  $ 673,891     $ 825,098  
Non-employee consultants
    159,263       16,809  
                 
    $ 833,154     $ 841,907  
                 
                 
   
Nine months ended September 30,
 
      2010       2009  
Outside directors, officers and employees
  $ 2,106,285     $ 2,172,073  
Non-employee consultants
    759,603       92,102  
                 
    $ 2,865,888     $ 2,264,175  
 
As of September 30, 2010, an aggregate of 2,637,389 shares of restricted stock had been issued, of which, 1,374,572 had vested and 413,886 had been canceled. As of September 30, 2009, an aggregate of 2,099,080 shares of restricted stock had been issued, of which, 573,655 had vested and 390,500 had been canceled.
 
As of September 30, 2010, an aggregate of 90,412 restricted stock units had been issued, of which 43,795 had vested and 1,382 had been canceled. As of September 30, 2009, an aggregate of 90,412 restricted stock units had been issued, of which none had vested or been canceled.
 
 
14

 
The following table summarizes restricted stock and restricted stock units activity during the nine months ended September 30, 2010:
 
     
Number of Restricted
     
Stock Awards / Units
       
Non-Vested at December 31, 2009
   
1,253,661
       
Granted
   
169,661
Vested
   
(395,313)
Forfeited
   
(5,388)
       
Non-Vested at March 31, 2010
   
1,022,621
       
Granted
   
144,639
Vested
   
(176,839)
Forfeited
   
(10,000)
       
Non-Vested at June 30, 2010
   
980,421
       
Granted
   
144,235
Vested
   
(223,790)
Forfeited
   
(6,700)
       
Non-Vested at September 30, 2010
   
894,166
 
Restricted stock and restricted stock units are fulfilled with new shares of common stock. The total intrinsic value of restricted stock for which the restrictions lapsed during the three months ended September 30, 2010 and 2009 was $677,307 and $967,245, respectively. The total intrinsic value of restricted stock for which the restrictions lapsed during the nine months ended September 30, 2010 and 2009 was $2,745,484 and $1,214,887, respectively.
 
Options granted to officers, employees and directors during fiscal 2010 and 2009 have exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, and a vesting period generally of three years. Based on each respective group’s historical vesting experience and expected trends, the estimated forfeiture rate for officers, employees and directors, as adjusted, was 11%, 24% and 9%, respectively.
 
 
15

 
Options granted to non-employee consultants have exercise prices equal to the fair market value of the stock on the date of grant and a contractual term of ten years. Restricted stock awards granted to non-employee consultants have a contractual term equal to the lapse of restriction(s) of each specific award. Vesting periods for share-based awards granted to non-employee consultants range from immediate vesting to three years depending on service requirements. A summary of the total stock-based compensation expense related to share-based awards granted to non-employee consultants, which is included in the Company’s total share-based compensation expense for each respective period, is as follows:
 
   
Three months ended September 30,
 
   
2010
   
2009
 
Non-qualified stock options
  $ 41,981     $ 49,869  
Restricted stock awards
    159,263       16,809  
                 
    $ 201,244     $ 66,678  
                 
                 
   
Nine months ended September 30,
 
      2010       2009  
Non-qualified stock options
  $ 17,208     $ 171,844  
Restricted stock awards
    759,603       92,102  
                 
    $ 776,811     $ 263,946  
 
The Company estimates expected volatility based primarily on historical daily volatility of the Company’s stock and other factors, if applicable. The risk-free interest rate is based on the United States treasury yield curve in effect at the time of grant. The expected option term is the number of years that the Company estimates that options will be outstanding prior to exercise. The expected term of the awards issued since January 1, 2008, was determined based upon an estimate of the expected term of “plain vanilla” options as prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110. The expected term of the awards issued prior to January 1, 2008, was determined using the “simplified method” prescribed in SAB No. 107.
 
As of September 30, 2010, there was approximately $6,875,601 of total unrecognized compensation cost related to the Company’s unvested options and restricted shares granted under the Company’s equity plans.
 
(3)  Income Taxes
 
The Company’s provision for income taxes consists of U.S., state and local, and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year.  The Company’s 2010 annual effective tax rate (excluding discrete items) is estimated to be approximately (4.3) % based upon our anticipated results both in the U.S. and in its foreign subsidiaries.
 
For the nine months ended September 30, 2010, the Company recorded an income tax provision of $17.0 million. During the third quarter of 2010, the Company concluded that it could no longer realize its domestic deferred tax assets on a more-likely-than-not basis. As a result, the income tax provision for the nine months ended September 30, 2010 does not provide any tax benefit for the current year domestic pre-tax loss and includes a discrete item of $16.2 million related to an increase in a valuation allowance for the deferred tax assets previously recognized.
 
For the nine months ended September 30, 2009, the Company recorded an income tax benefit of $1.4.  The income tax benefit for the nine months ended September 30, 2009 included: (i) a discrete tax benefit of $0.9 million as a result of its previously unrecognized tax benefits in connection with the Company’s completion of a research and development study finalized during the second quarter of 2009, and (ii) an overall decrease in the forecasted full year pre-tax income and the tax impact of certain non-deductible share based compensation expenses for income tax purposes expected to occur.
 
The Company’s total unrecognized tax benefits as of September 30, 2010 and December 31, 2009 were approximately $5.1 million and $4.7 million, respectively, which if recognized, would affect the Company’s effective tax rate. As of September 30, 2010 and December 31, 2009, the Company had recorded an aggregate of approximately $107,000 and $85,000, respectively, of accrued interest and penalties.
 
 
16

 
(4)  Fair Value Measurements
 
The Company measures its cash equivalents and marketable securities at fair value. Fair value is an exit price, representing the amount that would be received on the sale of an asset or that would be paid to transfer a liability in an orderly transaction between market participants. As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:
 
Fair Value Hierarchy
 
The methodology for measuring fair value specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs). As a result, observable and unobservable inputs have created the following fair value hierarchy:
 
 
·
Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities. The Level 1 category includes money market funds, which at September 30, 2010 and December 31, 2009 totaled $3.3 million and $6.4 million, respectively, which are included within cash and cash equivalents and marketable securities in the condensed consolidated balance sheets.
 
 
·
Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly. The Level 2 category at September 30, 2010 and December 31, 2009 includes government securities and corporate debt securities totaling $25.6 million and $27.3 million, respectively, which are included within cash and cash equivalents and marketable securities in the condensed consolidated balance sheets.
 
 
·
Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. The Level 3 category includes auction rate securities, which as of each September 30, 2010 and December 31, 2009 totaled $1.1 million, which are included within long-term marketable securities in the condensed consolidated balance sheets.
 
Measurement of Fair Value
 
The Company measures fair value as an exit price using the procedures described below for all assets and liabilities measured at fair value. When available, the Company uses unadjusted quoted market prices to measure fair value and classifies such items within Level 1. If quoted market prices are not available, fair value is based upon financial models that use, when possible, current market-based or independently-sourced market parameters such as interest rates and currency rates. Items valued using financial generated models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be inputs that are readily observable. If quoted market prices are not available, the valuation model used generally depends on the specific asset or liability being valued. The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments.
 
As of each of September 30, 2010 and December 31, 2009, the Company held certain assets that are required to be measured at fair value on a recurring basis. Included within the Company’s marketable securities portfolio are investments in auction rate securities, which are classified as available-for-sale securities and are reflected at fair value. However, due to events in the U.S. credit markets, the auction events for these securities held by the Company failed commencing in the first quarter of 2008, and continued to fail into 2010. Therefore, the fair values of these securities are estimated utilizing a discounted cash flow analysis and other type of valuation model. These analyses consider, among other items, the collateral underlying the security, the creditworthiness of the issuer, the timing of the expected future cash flows, including the final maturity, and an assumption of when the next time the security is expected to have a successful auction. These securities were also compared, when possible, to other observable and relevant market data, which is limited at this time.
 
 
17

 
As of September 30, 2010, the Company recorded $40,000 cumulatively as an other-than-temporary impairment and a cumulative temporary decline in fair value of approximately $272,687 in accumulated other comprehensive loss. As of December 31, 2009, the Company had recorded $40,000 cumulatively as an other-than-temporary impairment and a cumulative temporary decline in fair value of approximately $282,534 in accumulated other comprehensive loss. The Company believes that the temporary declines in fair value are primarily due to liquidity concerns and not to the creditworthiness of the remaining underlying assets, because the majority of the underlying securities are almost entirely backed by the U.S. Government. However, if at any time in the future a determination that a valuation adjustment is other-than-temporary, the Company will record a charge to earnings in the period of determination.
 
Items Measured at Fair Value on a Recurring Basis
 
The following table presents the Company’s assets that are measured at fair value on a recurring basis at September 30, 2010:
 
         
Fair Value Measurements at Reporting Date Using
 
                         
         
Quoted Prices in
         
Significant
 
         
Active Markets for
   
Significant other
   
Unobservable
 
         
Identical Assets
   
Inputs
   
Inputs
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Cash equivalents:
                       
 Money market funds
  $ 3,301,518     $ 3,301,518     $ -     $ -  
 Corporate debt and government securities
    1,679,962       -       1,679,962       -  
Total cash equivalents
    4,981,480       3,301,518       1,679,962       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    23,952,698       -       23,952,698       -  
 Auction rate securities
    1,087,313       -       -       1,087,313  
Total marketable securities
    25,040,011       -       23,952,698       1,087,313  
                                 
Total assets measured at fair value
  $ 30,021,491     $ 3,301,518     $ 25,632,660     $ 1,087,313  
 
The following table presents the Company’s assets that are measured at fair value on a recurring basis at December 31, 2009:
 
         
Fair Value Measurements at Reporting Date Using
 
                         
         
Quoted Prices in
         
Significant
 
         
Active Markets for
   
Significant other
   
Unobservable
 
         
Identical Assets
   
Inputs
   
Inputs
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Cash equivalents:
                       
 Money market funds
  $ 6,405,104     $ 6,405,104     $ -     $ -  
 Corporate debt and government securities
    2,372,660       -       2,372,660       -  
Total cash equivalents
    8,777,764       6,405,104       2,372,660       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    24,952,966       -       24,952,966       -  
 Auction rate securities
    1,077,466       -       -       1,077,466  
Total marketable securities
    26,030,432       -       24,952,966       1,077,466  
                                 
Total assets measured at fair value
  $ 34,808,196     $ 6,405,104     $ 27,325,626     $ 1,077,466  
 
 
 
18

 
The Company’s valuation methodology for auction rate securities includes a discounted cash flow analysis and other types of valuation models. The following table presents the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of January 1st through September 30th of each of the respective years:
 
   
Fair Value Measurements Using
 
   
Significant Unobservable Inputs
 
   
(Level 3)
 
             
   
Auction Rate Securities
 
             
   
September 30, 2010
   
September 30, 2009
 
Beginning Balance
  $ 1,077,466     $ 1,166,945  
Total unrealized gains in accumulated
               
 other comprehensive loss
    9,847       17,257  
Total realized losses in other income
    -       (40,000 )
Ending Balance
  $ 1,087,313     $ 1,144,202  
 
(5)  Marketable Securities
 
The Company’s marketable securities consist of available-for-sale securities, which are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity. Unrealized gains and losses are computed on the specific identification method. Realized gains, realized losses and declines in value judged to be other-than-temporary, are included within interest and other loss, net. The cost of available-for-sale securities sold is based on the specific identification method and interest earned is included within interest and other loss, net.
 
The cost and fair values of the Company’s available-for-sale marketable securities as of September 30, 2010, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 1,087,313     $ 1,360,000     $ (272,687 )
                         
Government securities
    17,364,848       17,353,541       11,307  
                         
Corporate debt securities
    6,587,850       6,628,873       (41,023 )
                         
    $ 25,040,011     $ 25,342,414     $ (302,403 )
 
 
 
19

 
The cost and fair values of the Company’s available-for-sale marketable securities as of December 31, 2009, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 1,077,466     $ 1,360,000     $ (282,534 )
                         
Government securities
    18,494,044       18,440,506       53,538  
                         
Corporate debt securities
    6,458,922       6,438,616       20,306  
                         
    $ 26,030,432     $ 26,239,122     $ (208,690 )
 
(6)  Inventories
 
Inventories consist of component materials and finished systems. Component material consists of certain key replacement parts for the finished systems. Inventories are as follows:
 
   
As of
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
   Component materials
  $ 202,334     $ 60,545  
   Finished systems
    1,847,638       269,112  
                 
Total Inventory
  $ 2,049,972     $ 329,657  
 
As of September 30, 2010 and December 31, 2009, the Company has not recorded any reserve for excess and/or obsolete inventories in arriving at estimated net realizable value of its inventory.
 
(7)  Derivative Financial Instruments
 
The Company commenced the use of derivative financial instruments during the second quarter of 2009 and continued to use such derivative financial instruments, such as foreign currency forward contracts, as economic hedges to reduce exchange rate risks arising from the change in fair value of certain foreign currency denominated assets and liabilities (i.e., receivables and payables).  The purpose of the Company’s foreign currency risk management program is to reduce volatility in earnings caused by exchange rate fluctuations.  In accordance with the authoritative guidance issued by the FASB on derivatives and hedging, companies are required to recognize all of the derivative financial instruments as either assets or liabilities at fair value in the condensed consolidated balance sheets. The Company’s derivative instruments do not meet the criteria for hedge accounting within the authoritative guidance. Therefore, the foreign currency forward contracts are recorded at fair value, with the gain or loss on these transactions recorded in the condensed consolidated statements of operations within interest and other loss, net in the period in which they occur. The Company does not use derivative financial instruments for trading or speculative purposes.
 
 
20

 
As of September 30, 2010, the Company had no foreign currency forward contracts outstanding. During the three and nine months ended September 30, 2010, the Company recorded approximately ($0.6) million and $0.1 million, respectively, of (losses) gains related to its foreign currency forward contracts. During the three and nine months ended September 30, 2009, the Company recorded approximately ($0.4) million and $0.7 million, respectively, of (losses) gains related to its foreign currency forward contracts. The Company did not utilize foreign currency forward contracts during the first quarter of 2009.
 
(8)  Stockholders’ Equity
 
Stock Repurchase Activity
 
At various times from October 2001 through February 2009, the Company’s Board of Directors has authorized the repurchase of up to 14 million shares of the Company’s outstanding common stock in the aggregate. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company’s management. The terms of the stock repurchases are determined by management based on market conditions.
 
The Company did not repurchase any shares of its common stock during the three and nine months ended September 30, 2010. During the three months ended September 30, 2009, the Company did not repurchase any of its common stock. During the nine months ended September 30, 2009, the Company repurchased 566,885 shares of its common stock in open market purchases for a total cost of $1,526,124. Since October 2001, the Company has repurchased a total of 8,005,235 shares of its common stock at an aggregate purchase price of $46,916,339. As of September 30, 2010, the Company had the authorization to repurchase an additional 5,994,765 shares of its common stock based upon its judgment and market conditions.
 
(9)  Commitments and Contingencies
 
The Company has an operating lease covering its corporate office facility that expires in February 2012. The Company also has several operating leases related to offices in the United States and foreign countries. The expiration dates for these leases range from 2010 through 2013. The following is a schedule of future minimum lease payments for all operating leases as of September 30, 2010:
 
2010
  $ 714,728  
2011
    2,213,052  
2012
    714,181  
2013
    86,020  
    $ 3,727,981  
     
(10)  Litigation
 
On September 29, 2010, the Company announced that it had accepted the resignation of ReiJane Huai, its President and Chief Executive Officer, and the Chairman of its Board of Directors, following his disclosure to the Company that certain improper payments allegedly were made in connection with the Company’s licensing of software to one customer. At the same time, the Company announced that it was cooperating fully with law enforcement authorities with respect to an ongoing investigation into the matter, that it had formed a Special Committee of the Board to conduct a full internal investigation, and that the Special Committee had retained counsel to assist it in its investigation. In addition, the counsel to the Special Committee retained independent forensic accountants to review the Company’s practices.  On November 10, 2010, counsel retained to assist with the internal investigation presented its report to the Special Committee.
 
 
21

 
Initially, the New York County District Attorney’s Office commenced an investigation but thereafter, for reasons unknown to the Company, ceased its investigation.  Separately, the U.S. Attorney’s Office for the Eastern District of New York (“USAO”) and the U.S. Securities and Exchange Commission (“SEC”) each commenced investigations.
 
In October, 2010, in connection with the USAO investigation, the Company received a grand jury subpoena seeking all documents relating to the Company’s September 29, 2010, disclosure of the improper payments. In addition, the Company received a document request from the USAO seeking, among other things, documents relating to certain of the Company’s employees and other information about the Company.
 
Also in October 2010, the Company received a subpoena from the SEC seeking, among other things, documentation relating to the Company’s dealings with the customer in connection with whose licensing of software  improper payments were made and documentation relating to certain of the Company’s accounting practices.
 
The Company is cooperating fully with the investigations of both the USAO and the SEC and has produced documents responsive to both subpoenas and the additional document request. The Company intends to produce more documentation and to cooperate fully with both investigations.
 
The Company cannot predict the scope, timing, or outcome of the USAO and SEC investigations and other matters referred to herein, which may include the institution of administrative, civil injunctive, or criminal proceedings, the imposition of fines and penalties, which may be significant, suspensions or debarments from government contracts, and other remedies and sanctions, any of which could lead to an adverse impact on our credit ratings and ability to obtain financing, an adverse impact on the Company’s stock price, loss of additional senior management, the inability to attract or retain key employees, and the loss of customers. In addition, under the law, any illegal acts of the Company’s employees may be ascribed to the Company. The Company cannot predict what impact, if any, these matters may have on its business, financial condition, results of operations, and liquidity.
 
Stockholder Litigation
 
In October 2010, two purported securities class actions (the “Actions”) were filed in the United States District Court for the Eastern District of New York on behalf of purchasers of the common stock of the Company between February 5, 2009 and September 29, 2010.  The two Actions contain substantially similar allegations and causes of actions. The complaint in each of the Actions name as defendants the Company and Mr. Huai, as well as Wayne Lam an officer of the Company and James Weber the Company’s Chief Financial Officer and interim Chief Operating Officer. The complaints in each of the actions allege that the defendants made a series of materially false and misleading statements related to the Company’s business and operations in violation of the Securities Exchange Act of 1934. The following adverse facts are alleged: (i) that FalconStor was experiencing weak demand for its products and services; (ii) that FalconStor was making improper payments to secure a contract with at least one of its customers; and (iii) as a result of the foregoing, the defendants lacked a reasonable basis for their positive statements about FalconStor and its prospects. The plaintiffs in each Action seek damages from the defendants. On November 1, 2010, the parties to one of the two Actions entered into a stipulation setting forth a schedule for an amended complaint and an answer or other response thereto. On November 3, 2010, the Actions were consolidated before Judge Edward R. Korman.  The Company believes it has meritorious defenses to some or all of the claims of the Actions as filed and intends to file a motion to dismiss.
 
The Actions have now been consolidated and the Company anticipates that it will be receiving an amended complaint. The Company is thus unable to determine what claims will ultimately be asserted.  In addition key issues such as whether a class will be certified and, if so, who the members of the class will be and what time period the class will cover, have not yet been determined. The Company is therefore unable to estimate reasonably its exposure for the Actions.
 
 
22

 
The Company is subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, such matters are not expected to have a material adverse effect on the Company’s financial condition or operating results.
 
(11)  Segment Reporting
 
The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the three and nine months ended September 30, 2010 and 2009, and the location of long-lived assets as of September 30, 2010 and December 31, 2009, are summarized as follows:
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenues:
                       
United States
  $ 9,657,208     $ 12,714,001     $ 32,152,702     $ 39,510,301  
                                 
Asia
    4,385,417       3,843,102       10,577,768       11,975,273  
                                 
Europe, Middle East, Africa and Other
    4,933,207       4,983,066       13,635,726       15,544,300  
                                 
  Total revenues
  $ 18,975,832     $ 21,540,169     $ 56,366,196     $ 67,029,874  
 
   
September 30,
2010
   
December 31,
2009
 
Long-lived assets:
           
             
United States
  $ 12,541,421     $ 24,295,603  
                 
Asia
    1,345,710       1,505,856  
                 
Europe, Middle East, Africa and other
    458,054       508,577  
                 
Total long-lived assets
  $ 14,345,185     $ 26,310,036  

 
 
23

 
Item 2.                       Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “plans,” “may,” “intends,” “will,” or similar terms.  Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report.
 
OVERVIEW
 
Our results of operations for the third quarter of 2010 were overshadowed by our discovery, in the last week of the quarter that improper payments had been made in connection with a customer’s licensing of software from us.  Following the discovery of the improper payments, ReiJane Huai, our President and Chief Executive Officer, and the Chairman of our Board of Directors, resigned from all positions with the Company. We conducted an internal investigation of the issue and we are being investigated by the United States Attorney’s Office for the Eastern District of New York and by the Securities and Exchange Commission. In addition, stockholder lawsuits have been filed against the Company. The investigations and the lawsuits are more fully described in Item 1 – Legal Proceedings of Part II of this 10-Q filing.
 
James McNiel, previously a Vice President and our Chief Strategy Officer, was appointed interim Chief Executive Officer and interim President. James Weber, a Vice President and our Chief Financial Officer, was given the additional title and responsibilities of interim Chief Operating Officer. Eli Oxenhorn, one of our Directors, was named non-executive Chairman of the Board of Directors. Together, Messrs. McNiel, Weber and Oxenhorn have been conducting a thorough review of our operations and have already begun to make changes to both personnel and the organization of the Company.
 
Since these events occurred near the end of the third quarter, they did not significantly impact our results for the three months ended September 30, 2010. However, these events distracted us from, and continue to cause distraction to, our efforts to promote, market and sell our goods and services. In addition, these events could negatively impact the perception that customers or potential customers have of our Company which could reduce our potential revenues. We cannot predict how long the external investigations or the stockholder lawsuits will last or what the outcomes will be. We have also incurred, and will continue to incur, significant expenses, primarily for legal counsel and legal services providers, due to the internal and external investigations. At September 30, 2010, our cash, cash equivalents and marketable securities totaled approximately $33.8 million, compared with $41.8 million at December 31, 2009. We anticipate a further decrease in our cash, cash equivalents and marketable securities due to the costs resulting from the internal and external investigations.
 
With regard to our business operations, on a year over year basis we continued to see benefits from our renewed sales efforts for FalconStor-branded products. We also continued to cut costs from our operations. These sales and cost cuts mitigated the continuing impact of the decline in OEM revenues that has resulted from EMC’s purchase of Data Domain and Sun’s acquisition by Oracle.
 
Total revenues for the third quarter decreased 6% from the second quarter of 2010 to $19 million. Revenues were 12% lower than in the third quarter of 2009.
 
Our non-OEM product revenue decreased 2% from the second quarter of 2010, but increased 3% over the third quarter of 2009. This indicates that we are continuing to have success in expanding sales of FalconStor-branded products through our resellers and directly to end users. Product revenues from OEMs decreased 24% from the second quarter of 2010. Overall, non-OEMs contributed 81% of our product revenues in the quarter and OEMs contributed 19%.
 
 
24

 
On a year over year basis, OEM product revenue declined 61%. For the second straight quarter, no OEM contributed 10% or more of our revenues. We do not expect that OEM product revenue from either EMC or Oracle will ever return to the levels they reached in the past.
 
While revenues are down on a year over year basis, we are pleased that we were able to replace some of the lost OEM revenues with other revenue. We attribute this to the plans we already had in place to put increased emphasis on sales of FalconStor-branded solutions. This effort includes greater emphasis on selling integrated turn-key hardware/software solutions in response to market demand.
 
Overall, our net loss for the quarter was $26.4 million. This loss is composed of a loss from operations of $4.8 million and an income tax provision of $21.8 million. The income tax provision of $21.8 was the result of a full valuation allowance recorded on substantially all of our existing deferred tax assets as a result of our inability to utilize our deferred tax assets on a more-likely-than-not basis in future periods.
 
Our loss from operations was $4.8 million in the third quarter of 2010, down from $5.1 million in the second quarter. We continue to look for ways to reduce expenses. Our headcount at September 30, 2010 was 512, down from 532 at June 30, 2010. Our new management team is reviewing every aspect of our operations to find areas where expenses can be cut.  However, we anticipate that in the short term our expenses will increase due to the significant costs of the internal and the external investigations.
 
Operating expenses decreased by $1.1 million, or 6%, compared with the third quarter of 2009. Operating expenses include $2.2 million in stock-based compensation expense for both the third quarter of 2010 and 2009. This decrease shows that we have been managing our expenses more carefully.
 
Deferred revenue at September 30, 2010 increased 2%, compared with the balance at September 30, 2009, and declined 8% when compared with the balance at December 31, 2009.
 
Our gross margins decreased on a year over year basis to 72% from 80%.  Our margins decreased primarily as the result of the increase in hardware costs associated with increased sales of our integrated appliances as compared with sales of our stand-alone software solutions.
 
RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED SEPTMBER 30, 2010 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2009.
 
During 2010, we shifted our focus to selling turn-key solutions, whereby our software is integrated with industry standard hardware and sold as one complete integrated solution. As a result, commencing in the second quarter of 2010, we reclassified our revenue into two categories: (i) product revenue, and (ii) support and services revenue. Product revenue consists of both integrated solutions and stand-alone software revenues. Support and services revenues consists of both maintenance revenues and professional services revenues. As a result of the reclassification, we have a corresponding cost of revenues for each revenue category.
 
Revenues for the three months ended September 30, 2010 decreased 12% to $19.0 million, compared with $21.5 million for the three months ended September 30, 2009. Our cost of revenues increased 21% from $4.3 million for the three months ended September 30, 2009 to $5.2 million for the three months ended September 30, 2010. Included in our cost of revenues for the three months ended September 30, 2010 and 2009 was $0.3 million and $0.4 million, respectively, of share-based compensation expense. Our operating expenses decreased 6% from $19.7 million for the three months ended September 30, 2009 to $18.6 million for the three months ended September 30, 2010. Included in our operating expenses for the three months ended September 30, 2010 and 2009 was $1.9 million and $1.8 million, respectively, of share-based compensation expense. Net loss for the three months ended September 30, 2010 was $26.4 million, compared with net loss of $2.0 million for the three months ended September 30, 2009. Included in our net loss for the three months ended September 30, 2010 was an income tax provision of $21.8 million, compared with an income tax benefit of $0.2 million for the three months ended September 30, 2009. The income tax provision of $21.8 million recorded during the three months ended September 30, 2010, was the result of a full valuation allowance recorded on substantially all of our existing deferred tax assets as a result of our inability to utilize our deferred tax assets on a more-likely-than-not basis in future periods. The income tax benefit of $0.2 million was the result of our pre-tax loss of approximately $2.2 million recorded during the three months ended September 30, 2009.
 
 
25

 
Our overall 12% decline in revenues was primarily due to a significant decrease in our product revenue. This decline was offset by increases in our support and services revenues for the three months ended September 30, 2010, compared with the same period in 2009. Our product revenues from our non-OEM partners increased 3%, while our product revenues from our OEM partners decreased by 61% for the three months ended September 30, 2010, compared with the same period in 2009. The overall increase in our non-OEM product revenues was primarily attributable to our ongoing focus on the FalconStor-branded business. The decrease in our OEM product revenues continues to result primarily from the merger and acquisition activity that commenced during 2009 that affected some of our key OEM partners, specifically, EMC and Oracle USA (formerly Sun Microsystems). Historically, both EMC and Sun Microsystems each represented over 10% of our annual revenues. As we have stated over the past several quarters, we do not anticipate that revenues from either OEM partner will return to their historical peaks, which has resulted in our continued and ongoing focus of the non-OEM FalconStor-branded business. However, because of our well-established installed customer base, support and services revenues continued to grow and have not been as significantly impacted by the disruptions in both our OEM and non-OEM channels.
 
Our worldwide headcount was 512 employees as of September 30, 2010, compared with 533 employees as of September 30, 2009. Commencing in the second quarter of 2010, we have implemented expense controls and a hiring freeze. We will continue to evaluate the appropriate headcount levels to properly align such requirements with our current and long-term outlook.
 
   
Three months ended September 30,
   
   
2010
 
2009
 
Revenues:
             
   Product revenue
  $ 11,366,493   $ 14,397,983  
   Support and services revenue
    7,609,339     7,142,186  
                   
Total Revenues
  $ 18,975,832   $ 21,540,169  
                   
Year-over-year percentage growth
                 
   Product revenue
    -21 %     12 %  
   Support and services revenue
    7 %     6 %  
                   
Total percentage growth
    -12 %     10 %  
 
Product revenue
 
Product revenue is comprised of sales of our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively “non-OEMs”). These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing stand-alone software applications sold, integrated solutions sold and/or permanent key codes are delivered to the customer.
 
 
26

 
Product revenue decreased 21% from $14.4 million for the three months ended September 30, 2009 to $11.4 million for the three months ended September 30, 2010. Product revenue represented 60% and 67% of our total revenues for the three months ended September 30, 2010 and 2009, respectively. Overall, during the three months ended September 30, 2010, product revenue decreased 61% from our OEM partners, while product revenue from our non-OEM partners increased 3% when compared with the same period in 2009. The decrease in our OEM partner product revenue was primarily attributable to the impact of merger and acquisition activity involving some of our key OEM partners that commenced during 2009. We do not anticipate that revenues from these OEM partners will return to their historical peaks. The increase in our non-OEM partner product revenue was the result of our ongoing focus on the FalconStor-branded business. Product revenue from our non-OEM partners represented 81% and 62% of our total product revenue for the three months ended September 30, 2010 and 2009, respectively.  Product revenue from our OEM partners represented 19% and 38% of our total product revenue for the three months ended September 30, 2010 and 2009, respectively.

We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook. We anticipate that our investments in the FalconStor-branded business will result in our non-OEM generated product revenue growing at a greater rate in future periods as compared with our OEM generated product revenue.

Support and services revenue

Support and services revenue is comprised of (i) maintenance and technical support services, and (ii) professional services primarily related to the implementation of our software and engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Revenue from engineering services is primarily related to customizing software product masters for some of our OEM partners. Revenue from engineering services is recognized in the period in which the services are completed. Support and services revenue increased 7% from $7.1 million for the three months ended September 30, 2009 to $7.6 million for the three months ended September 30, 2010.

The increase in support and services revenue was attributable to maintenance and technical support services, which increased from $6.5 million for the three months ended September 30, 2009 to $7.0 million for the same period in 2010. As we are in business longer, and as we license more integrated solutions and stand-alone software applications to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. The anticipated growth in our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire.

Our professional services revenue remained consistent at $0.7 million for both the three months ended September 30, 2010 and 2009. The professional services revenue varies from period to period based upon (i) the number of integrated solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that were completed during the period. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our integrated solutions.
 
 
27


Cost of Revenues
 
   
Three months ended September 30,
   
   
2010
 
2009
 
Cost of revenues:
             
   Product
  $ 2,120,727   $ 855,566  
   Support and service
    3,104,108     3,456,215  
Total cost of revenues
  $ 5,224,835   $ 4,311,781  
                   
Total Gross Profit
  $ 13,750,997   $ 17,228,388  
                   
Gross Margin:
                 
   Product
    81 %     94 %  
   Support and service
    59 %     52 %  
Total gross margin
    72 %     80 %  
 
Cost of revenues, gross profit and gross margin
 
Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for a turn-key integrated solution, personnel costs, amortization of purchased and capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the three months ended September 30, 2010 increased $1.3 million, or 148%, to $2.1 million compared with $0.9 million for the same period in 2009. The increase in cost of product revenue was primarily due to the increased hardware costs associated with our new focus in 2010 of selling FalconStor-branded integrated turn-key solutions. Our cost of support and service revenues decreased $0.4 million, or 10% to $3.1 million compared with $3.5 million for the same period in 2009.  The decrease in cost of support and service revenue is primarily related to our cost savings controls and a hiring freeze that were implemented during the second quarter of 2010.
 
Total gross profit decreased $3.5 million, or 20%, from $17.2 million for the three months ended September 30, 2009, to $13.8 million for the three months ended September 30, 2010. Total gross margin decreased to 72% for the three months ended September 30, 2010 from 80% for the same period in 2009. The decrease in both our total gross profit and total gross margins for the three months ended September 30, 2010, compared with the same period in 2009, was primarily due to (i) a 12% decline in our revenue, and (ii) increased hardware costs associated with our new focus in 2010 of selling FalconStor-branded turn-key integrated solutions. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and service mix of sales.
 
Share-based compensation expense included in the cost of product revenue was less than 1% of revenue for both the three months ended September 30, 2010 and September 30, 2009. Share-based compensation expense included in the cost of support and service revenue decreased to $0.3 million from $0.4 million for the three months ended September 30, 2010 and September 30, 2009, respectively. Share-based compensation expense related to cost of support and service revenue was equal to 1% and 2% of revenue for the three months ended September 30, 2010 and 2009, respectively.
 
 
28

 
Operating Expenses
 
Research and Development Costs
 
Research and development costs consist primarily of personnel costs for product development personnel, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.5 million, or 7%, to $6.4 million for the three months ended September 30, 2010 from $6.9 million in the same period in 2009. The decrease in research and development costs was primarily the result of our cost savings controls and a hiring freeze that were implemented during the second quarter of 2010. While implementing our cost savings initiatives, we believe we continued to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.7 million from $0.8 million for the three months ended September 30, 2010 and September 30, 2009, respectively. Share-based compensation expense included in research and development costs was equal to 4% of revenue for both the three months ended September 30, 2010 and September 30, 2009.
 
Selling and Marketing
 
Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses decreased $0.7 million, or 6%, to $9.7 million for the three months ended September 30, 2010 from $10.4 million for the same period in 2009. The decrease in selling and marketing expenses was primarily due to (i) lower commissions paid as a result of our 12% decline in total revenue, and (ii) cost savings controls and a hiring freeze that were implemented during the second quarter of 2010. Share-based compensation expense included in selling and marketing increased to $1.0 million from $0.7 million for the three months ended September 30, 2010 and 2009, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 5% of revenue for the three months ended September 30, 2010 and 3% for the same period in 2009.
 
General and Administrative
 
General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses remained consistent at $2.4 million for both the three months ended September 30, 2010 and September 30, 2009. Share-based compensation expense included in general and administrative expenses totaled $0.3 million for both the three months ended September 30, 2010 and September 30, 2009. Share-based compensation expense included in general and administrative expenses was equal to 1% of revenue for both the three months ended September 30, 2010 and September 30, 2009. We expect our general and administrative expenses to increase significantly in the future periods due to professional fees and service provider fees resulting from the internal and external investigations and stockholder lawsuits.
 
Interest and Other Income
 
We invest our cash primarily in money market funds, government securities, and corporate bonds. As of September 30, 2010, our cash, cash equivalents, and marketable securities totaled $33.8 million, compared with $46.9 million as of September 30, 2009. Interest and other income remained consistent at $0.2 million for both the three months ended September 30, 2010 and September 30, 2009.
 
 
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Income Taxes
 
Our provision for income taxes consists of U.S., state and local, and foreign taxes in amounts necessary to align our year-to-date tax provision with the effective rate that we expect to achieve for the full year. For the three months ended September 30, 2010, we recorded an income tax provision of $21.8 million, compared with an income tax benefit of $0.2 million for the same period in 2009. During the three months ended September 30, 2010, we concluded that we could no longer realize substantially all of our deferred tax assets on a more-likely-than-not basis and we recorded a discrete item of approximately $16.2 million related to an increase in a valuation allowance on our deferred tax assets previously recognized. During the three months ended September 30, 2009, we recorded an income tax benefit of $0.2 million on our pre-tax loss of $2.2 million.
 
RESULTS OF OPERATIONS – FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2009.
 
Revenues for the nine months ended September 30, 2010 decreased 16% to $56.4 million, compared with $67.0 million for the nine months ended September 30, 2009. Our cost of revenues increased 33% from $12.1 million for the nine months ended September 30, 2009 to $16.2 million for the nine months ended September 30, 2010. Included in our cost of revenues for the nine months ended September 30, 2010 and 2009 was $0.9 million and $1.2 million, respectively, of share-based compensation expense. Our operating expenses increased 1% from $57.9 million for the nine months ended September 30, 2009 to $58.6 million for the nine months ended September 30, 2010. Included in our operating expenses for the nine months ended September 30, 2010 and 2009 was $6.3 million and $5.5 million, respectively, of share-based compensation expense. Net loss for the nine months ended September 30, 2010 was $35.3 million, compared with a net loss of $1.6 million for the nine months ended September 30, 2009. Included in our net loss for the nine months ended September 30, 2010 was an income tax provision of $17.0 million, compared with an income tax benefit of $1.4 million for the nine months ended September 30, 2009. During the three months ended September 30, 2010, we recorded an income tax provision of $21.8 million in connection with recording a valuation allowance on substantially all of our existing deferred tax assets due to our determination during the quarter that we would not utilize our deferred tax assets on a more-likely-than-not basis in future periods. The income tax benefit of $1.4 million was primarily attributable to a discrete benefit of $0.9 million related to research and development credits we recognized during the nine months ended September 30, 2009.
 
Our overall 16% decline in revenues was primarily due to a significant decrease in our product revenue. This decline was offset by increases in our support and services revenues for the nine months ended September 30, 2010, compared with the same period in 2009. Our product revenues from our non-OEM partners decreased 12%, while our product revenues from our OEM partners decreased 56%, for the nine months ended September 30, 2010, compared with the same period in 2009. The overall decrease in our non-OEM product revenues was primarily attributable to the impact of one transaction that accounted for 44% of the total non-OEM product revenue in the second quarter of 2009. The impact of the one non-OEM transaction in 2009 was offset by increases in our non-OEM product revenue revenues as a result of our ongoing focus on the FalconStor-branded business. The decrease in our OEM product revenues continues to result primarily from the merger and acquisition activity that commenced during 2009 that affected some of our key OEM partners, specifically, EMC and Oracle USA (formerly Sun Microsystems). Historically, both EMC and Sun Microsystems each represented over 10% of our annual revenues. As we have stated over the past several quarters, we do not anticipate that revenues from either OEM partner will return to their historical peaks, which has resulted in our continued and ongoing focus of the non-OEM FalconStor-branded business. However, because of our well-established installed customer base, support and services revenues continued to grow and have not been as significantly impacted by the disruptions in both our OEM and non-OEM channels.
 
Our operating expenses have increased slightly. Commencing in the second quarter of 2010, we  implemented expense controls and a hiring freeze. We have begun to recognize the benefits of these cost savings initiatives, but the full impact of these initiatives have yet to be recognized on a full year basis.  We will continue to evaluate the appropriate headcount levels to properly align requirements with our current and long-term outlook. Our worldwide headcount was 512 employees as of September 30, 2010, compared with 533 employees as of September 30, 2009.
 
 
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Revenues
 
   
Nine months ended September 30,
 
   
2010
 
2009
 
Revenues:
             
   Product revenue
  $ 33,382,701   $ 46,087,209  
   Support and services revenue
    22,983,495     20,942,665  
                   
Total Revenues
  $ 56,366,196   $ 67,029,874  
                   
Year-over-year percentage growth
                 
   Product revenue
    -28 %     2 %  
   Support and services revenue
    10 %     13 %  
                   
Total percentage growth
    -16 %     5 %  
 
Product revenue
 
Product revenue decreased 28% from $46.1 million for the nine months ended September 30, 2009 to $33.4 million for the nine months ended September 30, 2010. Product revenue represented 59% and 69% of our total revenues for the nine months ended September 30, 2010 and 2009, respectively. The decrease in product revenue was primarily attributable to a decline of 12% and 56% in product revenue from both our non-OEM partners and our OEM partners, respectively, for the nine months ended September 30, 2010, compared with the same period in 2009. The overall decrease in our non-OEM product revenues was primarily attributable to the impact of one transaction that accounted for 44% of the total non-OEM product revenue in the second quarter of 2009. The impact of the one non-OEM transaction in 2009 was offset by increases in our non-OEM product revenue revenues as a result of our ongoing focus on the FalconStor-branded business. The decrease in our OEM partner product revenue was primarily attributable to the impact of merger and acquisition activity involving some of our key OEM partners that commenced during 2009. We do not anticipate that revenues from these OEM partners will return to their historical peaks. Product revenue from our non-OEM partners represented 78% and 64% of our total product revenue for the nine months ended September 30, 2010 and 2009, respectively. Product revenue from our OEM partners represented 22% and 36% of our total product revenue for the nine months ended September 30, 2010 and 2009, respectively.

We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook. We anticipate that our investments in the FalconStor-branded business will result in our non-OEM generated product revenue growing at a greater rate in future years when compared with our OEM generated product revenue.

Support and services revenue

Support and services revenue increased 10% from $20.9 million for the nine months ended September 30, 2009 to $23.0 million for the nine months ended September 30, 2010.

The increase in support and services revenue was attributable to maintenance and technical support services, which increased from $18.8 million for the nine months ended September 30, 2009 to $20.5 million for the same period in 2010. As we are in business longer, and as we license more integrated solutions and stand-alone software applications to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. The anticipated growth in our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire.
 
 
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The increase in support and services revenue was also attributable to our professional services revenue, which increased from $2.1 million for the nine months ended September 30, 2009, to $2.4 million for the same period in 2010. Our professional services revenue varies from period to period based upon (i) the number of integrated solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that were completed during the period. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our integrated solutions.
 
   
Nine months ended September 30,
 
   
2010
 
2009
 
Cost of revenues:
             
   Product
  $ 6,179,952   $ 2,015,567  
   Support and service
    10,020,153     10,133,565  
Total cost of revenues
  $ 16,200,105   $ 12,149,132  
                   
Total Gross Profit
  $ 40,166,091   $ 54,880,742  
                   
Gross Margin: