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EX-32.2 - FALCONSTOR SOFTWARE INCex322to10q04637_06302011.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 June 30, 2011
 
 
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 x     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 July 29, 2011 was 46,712,596
 
 
 

 
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
FORM 10-Q
 
 INDEX
 
   
Page
     
3
     
3
     
 
3
     
 
4
     
 
5
     
 
6
     
26
     
41
     
42
     
42
     
42
 
   
45
     
48
     
48
 
 
2

 

PART I.  FINANCIAL INFORMATION
 
Item 1.
Condensed Consolidated Financial Statements
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
June 30, 2011
   
December 31, 2010
 
Assets
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 16,616,646     $ 17,842,555  
Marketable securities
    20,857,697       18,903,635  
    Accounts receivable, net of allowances of $1,692,826 and                
   $3,242,458, respectively
    17,556,090       23,286,660  
Prepaid expenses and other current assets
    1,500,848       1,190,531  
Inventory
    1,218,828       1,409,659  
Income tax receivable
    385,682       385,682  
Total current assets
    58,135,791       63,018,722  
                 
Property and equipment, net of accumulated depreciation of                  
    $21,489,285 and $19,468,420, respectively
    5,187,547       5,796,013  
Long-term marketable securities
    620,134       578,643  
Deferred tax assets, net.
    220,285       235,197  
Other assets, net
    3,079,242       2,379,225  
Goodwill
    4,150,339       4,150,339  
Other intangible assets, net
    161,686       387,222  
                 
Total assets
  $ 71,555,024     $ 76,545,361  
                 
Liabilities and Stockholders' Equity
               
Current liabilities:
               
Accounts payable
  $ 2,406,796     $ 1,455,013  
Accrued expenses
    9,715,324       9,109,424  
Deferred revenue, net
    18,332,448       16,979,455  
   Total current liabilities
    30,454,568       27,543,892  
                 
Other long-term liabilities
    2,565,712       2,507,169  
Deferred revenue, net
    7,457,507       6,555,437  
                 
   Total liabilities
    40,477,787       36,606,498  
                 
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, 54,699,671 and 54,147,234 shares issued, respectively and 46,694,436 and 46,141,999 shares outstanding, respectively
    54,700       54,147  
Additional paid-in capital
    154,091,705       150,884,184  
Accumulated deficit
    (74,412,818 )     (62,557,515 )
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
    (1,740,011 )     (1,525,614 )
                 
Total stockholders' equity
    31,077,237       39,938,863  
Total liabilities and stockholders' equity
  $ 71,555,024     $ 76,545,361  
 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
3

 
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Revenues:
                       
Product revenues
  $ 11,609,760     $ 12,198,013     $ 22,868,775     $ 22,016,210  
Support and services revenues
    8,018,248       8,072,696       15,718,495       15,374,154  
Total  revenues
    19,628,008       20,270,709       38,587,270       37,390,364  
                                 
Cost of revenues:
                               
   Product
     2,266,040        2,550,540        3,989,045        4,059,225  
   Support and service
    3,734,884       3,303,348       7,102,797       6,916,045  
   Total cost of revenues
    6,000,924       5,853,888       11,091,842       10,975,270  
                                 
Gross profit
  $ 13,627,084     $ 14,416,821     $ 27,495,428     $ 26,415,094  
                                 
Operating expenses
                               
Research and development costs
    4,928,824       6,638,985       10,785,118       13,765,819  
Selling and marketing
    10,521,307       10,427,468       18,995,399       21,441,968  
General and administrative
    2,957,460       2,453,525       5,558,995       4,813,474  
Investigation costs
    1,188,671       -       3,799,791       -  
Total operating expenses
    19,596,262       19,519,978       39,139,303       40,021,261  
                                 
Operating loss
     (5,969,178 )      (5,103,157 )      (11,643,875 )      (13,606,167 )
                                 
Interest and other income (loss), net
    150,007       7,499       450,956       (102,441 )
                                 
Loss before income taxes
    (5,819,171 )     (5,095,658 )     (11,192,919 )     (13,708,608 )
                                 
Provision (benefit) for income taxes
    69,868       (1,720,160 )     662,384       (4,803,045 )
                                 
Net loss
  $ (5,889,039 )   $ (3,375,498 )   $ (11,855,303 )   $ (8,905,563 )
                                 
Basic net loss per share
  $ (0.13 )   $ (0.07 )   $ (0.26 )   $ (0.20 )
                                 
Diluted net loss per share
  $ (0.13 )   $ (0.07 )   $ (0.26 )   $ (0.20 )
                                 
Weighted average basic shares outstanding
     46,643,349        45,554,849        46,453,196        45,129,802  
                                 
Weighted average diluted shares outstanding
     46,643,349        45,554,849        46,453,196        45,129,802  
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
4

 
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
     Six Months Ended
June 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
  $ (11,855,303 )   $ (8,905,563 )
Adjustments to reconcile net loss to net cash from
               
               operating activities:                
Depreciation and amortization
    2,224,070       2,980,215  
Share-based payment compensation
    2,529,229       4,397,103  
    Non-cash professional services expenses
    126,071       575,567  
    Realized loss on marketable securities
    -       120  
    Tax benefit from stock option exercises
    -       (412,815 )
    Provision for returns and doubtful accounts
    (317,809 )     1,332,905  
    Deferred income tax provision
    14,912       23,585  
Changes in operating assets and liabilities:
               
Accounts receivable
    6,060,390       7,072,901  
Prepaid expenses and other current assets
    (263,610 )     (43,847 )
Income tax receivable
    -       (5,512,694 )
Inventory
    190,831       (1,152,838 )
Other assets
    11,854       220,292  
Accounts payable
    936,232       (390,630 )
Accrued expenses and other liabilities
    431,453       (779,709 )
Deferred revenue
    2,248,781       (386,101 )
                 
      Net cash provided by (used in) operating activities
    2,337,101       (981,509 )
                 
Cash flows from investing activities:
               
Sales of marketable securities
    10,284,132       9,113,411  
Purchases of marketable securities
    (12,231,093 )     (10,555,448 )
Purchases of property and equipment
    (1,289,194 )     (1,744,897 )
Capitalized software development costs
    (700,084 )     -  
Security deposits
    (8,522 )     1,981  
Purchase of intangible assets
    (35,220 )     (75,193 )
                 
Net cash used in investing activities
    (3,979,981 )     (3,260,146 )
                 
Cash flows from financing activities:
               
Proceeds from exercise of stock options
    552,774       249,343  
Tax benefits from stock option exercises
    -       412,815  
                 
Net cash provided by financing activities
    552,774       662,158  
                 
Effect of exchange rate changes on cash and cash equivalents
    (135,803 )     (263,734 )
                 
Net decrease in cash and cash equivalents
    (1,225,909 )     (3,843,231 )
                 
Cash and cash equivalents, beginning of period
    17,842,555       15,752,528  
                 
Cash and cash equivalents, end of period
  $ 16,616,646     $ 11,909,297  
                 
Cash paid for income taxes                                                                                                                                               
  $ 278,871     $ 27,500  

The Company did not pay any interest for the six months ended June 30, 2011 and 2010.


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 data protection 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)  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.
 
 (d) 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.
 
In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at June 30, 2011, and the results of its operations for the three and six months ended June 30, 2011 and 2010. 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.
 
(e) 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 June 30, 2011, the Company’s cash equivalents consisted of money market funds. As of December 31, 2010, the Company’s cash equivalents consisted of money market funds and government securities. At June 30, 2011 and December 31, 2010, the fair value of the Company’s cash equivalents amounted to approximately $9.8 million and $14.1 million, respectively. As of June 30, 2011 and December 31, 2010, the Company’s marketable securities consisted of corporate bonds, auction rate securities, and government securities. As of June 30, 2011 and December 31, 2010, the fair value of the Company’s current marketable securities was approximately $20.9 million and $18.9 million, respectively. In addition, as of both June 30, 2011 and December 31, 2010, the Company had an additional $0.6 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.
 
 
6

 
 
(f)  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 June 30, 2011 and December 31, 2010, the fair value of the Company’s financial instruments including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated carrying value due to the short maturity of these instruments. See Note (4) Fair Value Measurements for additional information.
 
 (g) 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. Revenue is recorded net of applicable sales taxes.

In accordance with the authoritative guidance issued by the FASB on revenue recognition, the Company recognizes revenue from product sales 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. For bundle arrangements that include either maintenance or both maintenance and professional services, the Company uses the residual method to determine the amount of product revenue to be recognized. Under the residual method, consideration is allocated to the undelivered elements based upon vendor-specific objective evidence (“VSOE”) of the fair value of those elements, with the residual of the arrangement fee allocated to and recognized as product revenue. The long-term portion of deferred revenue relates to maintenance contracts with terms in excess of one year. The Company provides an allowance for product returns as a reduction of revenue, based upon historical experience and known or expected trends.
 
 
7

 
 
Revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract. 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.
 
 (h)           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 June 30, 2011 and 2010, depreciation expense was $984,639 and $1,171,936, respectively. For the six months ended June 30, 2011 and 2010, depreciation expense was $1,928,887 and $2,410,584, 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.
 
(i)      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 include: (i) assets acquired through business combinations, including customer contracts and intellectual property, and (ii) patents amortized over three years using the straight-line method.
 
For the three months ended June 30, 2011 and 2010, amortization expense was $126,553 and $145,036, respectively. For the six months ended June 30, 2011 and 2010, amortization expense was $260,755 and $288,681, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of June 30, 2011 and December 31, 2010 are as follows:
 
   
June 30,
2011
   
December 31,
2010
 
             
Goodwill
  $ 4,150,339     $ 4,150,339  
Other intangible assets:
               
Gross carrying amount
  $ 2,934,274     $ 2,899,055  
Accumulated amortization
    (2,772,588 )     (2,511,833 )
Net carrying amount
  $ 161,686     $ 387,222  
 
 
8

 
 
(j) 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 product’s estimated life, or the ratio of current revenue of the related products to total current and anticipated future revenue of these products. During the three and six months ended June 30, 2011 the Company capitalized approximately $578,000 and $700,000, respectively, related to software development projects. The Company did not capitalize any software development costs during the same periods in 2010. During the three months ended June 30, 2011 and 2010, the Company recorded $17,525 and $6,725, respectively, of amortization expense related to capitalized software costs. During the six months ended June 30, 2011 and 2010, the Company recorded $34,428 and $13,450, respectively, of amortization expense related to capitalized software costs.
 
Purchased software technology is included in “other assets” in the condensed consolidated balance sheets. As of December, 31, 2010, purchased software technology has been fully amortized. Amortization expense was $133,333 and $267,500 for the three and six months ended June 30, 2010, respectively. Amortization of purchased software technology is recorded at the greater of the straight-line basis over the product’s estimated remaining life or the ratio of current period revenue of the related products to total current and anticipated future revenue of these products.
 
(k) 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 financial reporting 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 consolidated statement of operations. See Note (3) Income Taxes for additional information.
 
 (l) 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.

(m) 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.
 
 
9

 
 
(n) 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 June 30, 2011 and 2010, foreign currency transactional gain (loss) totaled approximately $107,000 and ($73,000), respectively. During the six months ended June 30, 2011 and 2010, foreign currency transactional gain (loss) totaled approximately $341,000 and ($282,000), 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.

(o) 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, attributable to stock option awards, restricted stock awards and restricted stock unit awards outstanding. Due to the net loss for both the three and six months ended June 30, 2011 and 2010, all common stock equivalents, totaling 14,811,235 and 13,332,427, respectively, were excluded from diluted net loss per share because they were anti-dilutive.
 
The following represents a reconciliation of the numerators and denominators of the basic and diluted EPS computation:
 
 
10

 
 
   
Three Months Ended June 30, 2011
   
Three Months Ended June 30, 2010
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
   
Amount
   
(Numerator)
   
(Denominator)
   
Amount
 
Basic EPS
  $ (5,889,039 )     46,643,349     $ (0.13 )   $ (3,375,498 )     45,554,849     $ (0.07 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (5,889,039 )     46,643,349     $ (0.13 )   $ (3,375,498 )     45,554,849     $ (0.07 )
                                                 
                                                 
    Six Months Ended June 30, 2011    
Six Months Ended June 30, 2010
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
   
Amount
   
(Numerator)
   
(Denominator)
   
Amount
 
Basic EPS
  $ (11,855,303 )     46,453,196     $ (0.26 )   $ (8,905,563 )     45,129,802     $ (0.20 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (11,855,303 )     46,453,196     $ (0.26 )   $ (8,905,563 )     45,129,802     $ (0.20 )
 
(p)  Investments
 
As of both June 30, 2011 and December 31, 2010, 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 six months ended June 30, 2011 and 2010, the Company did not recognize any impairment charges related to any of its cost-method investments.
 
(q) Treasury Stock

The Company accounts for treasury stock under the cost method and includes treasury stock as a component of stockholders’ equity.
 
 (r) New Accounting Pronouncements
 
In May 2011, the FASB issued new guidance for fair value measurements intended to achieve common fair value measurement and disclosure requirements. The amended guidance provides a consistent definition of fair value to ensure that the fair value measurement and disclosure requirements are similar between U.S. generally accepted accounting principles and International Financial Reporting Standards. The amended guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for Level 3 fair value measurements. The amended guidance will be effective for the Company for annual periods beginning after December 15, 2011. The Company does not anticipate that these changes will have a significant impact on its condensed consolidated financial statements and disclosures.
 
In June 2011, the FASB issued guidance that modified how comprehensive income is presented in an entity’s financial statements. The guidance issued requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements and eliminates the option to present the components of other comprehensive income as part of the statement of equity. The revised financial statement presentation for comprehensive income will be effective for the Company for annual periods beginning after December 15, 2011. The Company does not anticipate that these changes will have a significant impact on its condensed consolidated financial statements and disclosures.
 
 
11

 
 
(2) Share-Based Payment Arrangements

On January 11, 2011, the Company entered into a Stand-Alone Stock Option Agreement (“McNiel Option Agreement”) with James P. McNiel, the Company’s President and Chief Executive Officer. The McNiel Option Agreement, which was approved by stockholders on May 9, 2011, provides for the grant to Mr. NcNiel of options to purchase up to 1,220,000 shares of the Company’s common stock at an exercise price of $3.22 per share, which vest over a three-year period commencing January 11, 2012 at 33%, 33% and 34% annually.
 
The following table summarizes the plans under which the Company was able to grant equity compensation as of June 30, 2011:
 
   
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
 
217,879
 
7,759,724
 
May 17, 2016
                 
FalconStor Software, Inc., 2010 Outside Directors Equity Compensation Plan
 
400,000
 
330,000
 
63,400
 
May 8, 2020

 
On July 1, 2011, the total shares available for issuance under the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006 Plan”) totaled 2,334,722. 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, 2011, the total number of outstanding shares of the Company’s common stock totaled 46,694,436. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan thus increased by 2,116,843 shares from 217,879 to 2,334,722 shares available for issuance as of July 1, 2011.

The following table summarizes the plans that have expired but still have equity awards outstanding as of June 30, 2011:
 
   
Shares Available
 
Shares
Name of Plan
 
for Grant
 
Outstanding
         
FalconStor Software, Inc., 2000 Stock Option Plan
 
--
 
5,204,011
         
1994 Outside Directors Stock Option Plan
 
--
 
125,500
         
2004 Outside Directors Stock Option Plan
 
--
 
250,000
         
FalconStor Software, Inc., 2007 Outside Directors Equity Compensation Plan
 
--
 
188,600
         
Stand-Alone Stock Option Agreement between the Company and James P. McNiel
 
--
 
1,220,000
 
Options granted under all of the Company’s Plans have terms of ten years.
 
 
12

 

The following table summarizes stock option activity during the six months ended June 30, 2011:
 
               
Weighted
       
         
Weighted
   
Average
       
         
Average
   
Remaining
   
Aggregate
 
   
Number of
   
Exercise
   
Contractual
   
Intrinsic
 
   
Options
   
Price
   
Life (Years)
   
Value
 
                         
                         
Options Outstanding at December 31, 2010
    12,192,884     $ 5.58              
                             
Granted
    725,000     $ 3.66              
Exercised
    (159,355 )   $ 2.93              
Canceled
    (234,653 )   $ 6.45              
Forfeited
    (355,226 )   $ 3.82              
                             
Options Outstanding at March 31, 2011
    12,168,650     $ 5.53       5.99     $ 8,620,896  
                                 
                                 
Granted
    2,436,500     $ 3.68                  
Exercised
    (35,640 )   $ 2.40                  
Canceled
    (122,357 )   $ 10.55                  
Forfeited
    (235,420 )   $ 6.31                  
                                 
Options Outstanding at June 30, 2011
    14,211,733     $ 5.17       6.51     $ 9,999,450  
                                 
Options Exercisable at June 30, 2011
    8,316,557     $ 6.37       4.66     $ 3,877,054  
 
Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended June 30, 2011 and 2010 was $85,421 and $34,322, respectively. The total cash received from stock option exercises for the six months ended June 30, 2011 and 2010 was $552,774 and $249,343, respectively. The total intrinsic value of stock options exercised during the three months ended June 30, 2011 and 2010 was $56,526 and $201,744 respectively. The total intrinsic value of stock options exercised during the six months ended June 30, 2011 and 2010 was $314,822 and $2,415,951, respectively.
 
 
13

 
 
The Company recognized share-based compensation expense for all awards issued under the Company’s stock equity plans in the following line items in the condensed consolidated statements of operations:
 
   
Three months ended June 30,
 
   
2011
   
2010
 
Cost of revenues - Product
  $ 741     $ 7,009  
Cost of revenues - Support and Service
    129,714       290,145  
Research and development costs
    329,369       760,358  
Selling and marketing
    462,555       875,947  
General and administrative
    417,974       336,886  
                 
    $ 1,340,353     $ 2,270,345  
                 
                 
   
Six months ended June 30,
 
      2011       2010  
Cost of revenues - Product
  $ 1,473     $ 13,941  
Cost of revenues - Support and Service
    273,201       610,091  
Research and development costs
    808,411       1,800,330  
Selling and marketing
    885,279       1,896,716  
General and administrative
    686,936       651,592  
                 
    $ 2,655,300     $ 4,972,670  
 
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 June 30,
 
   
2011
   
2010
 
Outside directors, officers and employees
  $ 326,964     $ 662,617  
Non-employee consultants
    19,290       186,004  
                 
    $ 346,254     $ 848,621  
                 
                 
   
Six months ended June 30,
 
      2011       2010  
Outside directors, officers and employees
  $ 721,498     $ 1,432,394  
Non-employee consultants
    21,882       600,340  
                 
    $ 743,380     $ 2,032,734  
 
As of June 30, 2011, an aggregate of 2,803,554 shares of restricted stock had been issued, of which, 1,776,429 had vested and 444,645 had been canceled. As of June 30, 2010, an aggregate of 2,493,154 shares of restricted stock had been issued, of which, 1,154,082 had vested and 407,186 had been canceled.
 
As of June 30, 2011, an aggregate of 90,412 restricted stock units had been issued, of which 70,890 had vested and 2,500 had been canceled. As of June 30, 2010, an aggregate of 90,412 restricted stock units had been issued, of which 40,495 had vested and 1,382 had been canceled.
 
 
14

 
 
The following table summarizes restricted stock and restricted stock units activity during the six months ended June 30, 2011:
 
     
Number of Restricted
     
Stock Awards / Units
       
Non-Vested at December 31, 2010
   
839,422
       
Granted
   
90,000
Vested
   
(293,225)
Forfeited
   
(25,755)
       
Non-Vested at March 31, 2011
   
610,442
       
Granted
   
54,682
Vested
   
(64,217)
Forfeited
   
(1,405)
       
Non-Vested at June 30, 2011
   
599,502
 
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 June 30, 2011 and 2010 was $266,019 and $528,971, respectively. The total intrinsic value of restricted stock for which the restrictions lapsed during the six months ended June 30, 2011 and 2010 was $1,635,512 and $2,068,177, respectively.
 
Options granted to officers, employees and directors during fiscal 2011 and 2010 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.
 
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 June 30,
 
   
2011
   
2010
 
Non-qualified stock options
  $ 17,286     $ (27,579 )
Restricted stock awards
    19,290       186,004  
                 
    $ 36,576     $ 158,425  
                 
                 
   
Six months ended June 30,
 
      2011       2010  
Non-qualified stock options
  $ 104,189     $ (24,773 )
Restricted stock awards
    21,882       600,340  
                 
    $ 126,071     $ 575,567  
 
 
15

 
 
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.
 
As of June 30, 2011, there was approximately $9,924,238 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 federal, state and local, and foreign taxes, as applicable, in amounts necessary to align the Company’s year-to-date tax provision with the effective rate that it expects to achieve for the full year.  The Company’s 2011 annual effective tax rate (excluding discrete items) is estimated to be approximately (6.7%) based upon its anticipated results both in the U.S. and in its foreign subsidiaries.
 
For the six months ended June 30, 2011, the Company recorded an income tax provision of $0.7 million on its pre-tax loss of $11.2 million, consisting of primarily state and local and foreign taxes. During the third quarter of 2010, the Company concluded that its domestic deferred tax assets were no longer realizable on a more-likely-than-not basis, therefore, recording a full valuation allowance against its domestic deferred tax assets. During the six months ended June 30, 2011, the Company’s conclusion did not change with respect to its deferred tax assets and therefore, the Company has not recorded any benefit for its expected net deferred tax assets for the full year 2011. As of June 30, 2011, the valuation allowance totaled approximately $30.3 million. In addition, the Company also recorded an accrual for certain legal matters during the six months ended June 30, 2011 which the Company believes will be non-deductible for US income tax purposes. The tax impact related to this accrual was recorded as a discrete item during the six months ended June 30, 2011.
 
For the six months ended June 30, 2010, the Company recorded an income tax benefit of $4.8 million on its pre-tax book loss of $13.7 million consisting primarily of federal, state and local and foreign taxes.
 
The Company’s total unrecognized tax benefits as of June 30, 2011 and December 31, 2010 were approximately $5.4 million and $5.2 million, respectively, which if recognized, would affect the Company’s effective tax rate. As of June 30, 2011 and December 31, 2010, the Company had recorded an aggregate of approximately $173,000 and $114,000, respectively, of accrued interest and penalties.
 
(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:
 
 
16

 
 
 
·
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 June 30, 2011 and December 31, 2010 totaled $9.8 million and $13.7 million, respectively, which are included within cash and cash equivalents 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 includes government securities and corporate debt securities, which at June 30, 2011 and December 31, 2010 totaled $20.9 million and $19.3 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 at June 30, 2011 and December 31, 2010 totaled $0.6 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 June 30, 2011 and December 31, 2010, 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. Over the past three years, the auction events for most of these instruments failed and, therefore, the Company has determined the estimated fair values of these securities utilizing a discounted cash flow analysis. 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.
 
As of June 30, 2011, the Company recorded a cumulative temporary decline in fair value of approximately $80,000 in accumulated other comprehensive loss. As of December 31, 2010, the Company recorded a cumulative temporary decline in fair value of approximately $121,000 in accumulated other comprehensive loss. During the fourth quarter of 2010, $700,000 of the Company’s auction rate securities were called by the issuer at par value. The Company believes that the temporary declines in fair value are primarily due to liquidity concerns and are not due 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.
 
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:
 
 
17

 
 
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 June 30, 2011:
 
         
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
  $ 9,762,526     $ 9,762,526     $ -     $ -  
Total cash equivalents
    9,762,526       9,762,526       -       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    20,857,697       -       20,857,697       -  
 Auction rate securities
    620,134       -       -       620,134  
Total marketable securities
    21,477,831       -       20,857,697       620,134  
                                 
Total assets measured at fair value
  $ 31,240,357     $ 9,762,526     $ 20,857,697     $ 620,134  

The following table presents the Company’s assets that are measured at fair value on a recurring basis at December 31, 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
  $ 13,660,139     $ 13,660,139     $ -     $ -  
 Corporate debt and government securities
    402,635       -       402,635       -  
Total cash equivalents
    14,062,774       13,660,139       402,635       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    18,903,635       -       18,903,635       -  
 Auction rate securities
    578,643       -       -       578,643  
Total marketable securities
    19,482,278       -       18,903,635       578,643  
                                 
Total assets measured at fair value
  $ 33,545,052     $ 13,660,139     $ 19,306,270     $ 578,643  
 
 
18

 
 
The Company’s valuation methodology for auction rate securities includes a discounted cash flow analysis. 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 June 30th of each of the respective years:
 
   
Fair Value Measurements Using
 
   
Significant Unobservable Inputs
 
   
(Level 3)
 
             
   
Auction Rate Securities
 
             
   
June 30, 2011
   
June 30, 2010
 
Beginning Balance
  $ 578,643     $ 1,077,466  
Total unrealized gains in accumulated
               
 other comprehensive loss
    41,491       2,612  
Ending Balance
  $ 620,134     $ 1,080,078  
 
(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 in interest and other income, net. The cost of available-for-sale securities sold is based on the specific identification method and interest earned is included in interest and other income.
 
The cost and fair values of the Company’s available-for-sale marketable securities as of June 30, 2011, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 620,134     $ 700,000     $ (79,866 )
                         
Government securities
    17,879,998       17,862,012       17,986  
                         
Corporate debt securities
    2,977,698       2,971,217       6,481  
                         
    $ 21,477,830     $ 21,533,229     $ (55,399 )
 
The cost and fair values of the Company’s available-for-sale marketable securities as of December 31, 2010, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 578,643     $ 700,000     $ (121,357 )
                         
Government securities
    17,053,041       17,043,856       9,185  
                         
Corporate debt securities
    1,850,594       1,842,413       8,181  
                         
    $ 19,482,278     $ 19,586,269     $ (103,991 )
 
 
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(6) Inventories
 
Inventories consist of component materials and finished systems. Inventories are stated at the lower of cost (first-in, first-out) or market, not in excess of net realizable value. Component material consists of certain key replacement parts for the finished systems. Inventories are as follows:
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
   Component materials
  $ 54,827     $ 114,893  
   Finished systems
    1,164,001       1,294,766  
                 
Total Inventory
  $ 1,218,828     $ 1,409,659  
 
As of June 30, 2011 and December 31, 2010, 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 from time to time will use 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 their 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 consolidated statements of operations within “interest and other income (loss), net” in the period in which they occur. The Company does not use derivative financial instruments for trading or speculative purposes.
 
The Company did not utilize foreign currency forward contracts during the first six months of 2011, and there were no such contracts outstanding at June 30, 2011 or December 31, 2010. During the three and six months ended June 30, 2010, the Company recorded approximately $0.5 million and $0.8 million, respectively, of gains related to its foreign currency forward contracts.
 
(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.
 
During each of the three and six months ended June 30, 2011, the Company did not repurchase any shares of its common stock. During each of the three and six months ended June 30, 2010,  the Company did not repurchase any shares of its common stock. 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 June 30, 2011, the Company had the authorization to repurchase an additional 5,994,765 shares of its common stock based upon its judgment and market conditions.
 
 
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Preferred Stock
 
The Company is authorized to issue two million shares of $0.001 par value Preferred Stock. No preferred stock has been issued or outstanding for any period presented.
 
 (9) Commitments and Contingencies
 
As of June 30, 2011, the Company had an operating lease covering its corporate office facility that expired 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 2011 through 2014. The following is a schedule of future minimum lease payments for all operating leases as of June 30, 2011:
 
2011
  $ 1,365,533  
2012
    1,167,376  
2013
    218,175  
2014
    40,553  
    $ 2,791,637  
 
Effective August 1, 2011, the Company modified the operating lease covering its corporate office facility so that it now expires in February 2017.  The Company has the option to terminate the lease as of the last date of each month between August 31, 2013 and February 28, 2014, on nine months’ prior written notice. As a result of the modification to operating lease for the corporate offices, the total future minimum lease payments will increase approximately $0.1 million, $1.2 million, $1.4 million and $1.4 million for each of the years 2011 through 2014, respectively. In addition, the Company will have future minimum lease payments of $1.5 million, $1.5 million and $0.3 million for each of the years 2015 through 2017, respectively.
 
The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with the authoritative guidance issued by the FASB on contingencies. To date, the Company has not incurred any costs related to warranty obligations.

Under the terms of substantially all of its software license agreements, the Company has agreed to indemnify its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company’s software infringes the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with the authoritative guidance issued by the FASB on contingencies. As of June 30, 2011 and December 31, 2010, there were no claims outstanding under such indemnification provisions.

On January 11, 2011, the Company entered into an Employment Agreement (“McNiel Employment Agreement”) with James P. McNiel. Pursuant to the McNiel Employment Agreement, the Company agreed to employ Mr. McNiel as President and Chief Executive Officer of the Company effective January 1, 2011 through December 31, 2013, at an annual salary of $400,000 per annum for calendar years 2011, 2012 and 2013. Pursuant to the McNiel Employment Agreement, Mr. McNiel’s base salary is subject to review annually by the Board of Directors and may be increased but not decreased as determined by the Board of Directors based on job performance. The McNiel Employment Agreement also provides for the grant to Mr. McNiel of options to purchase up to 300,000 shares of the Company’s common stock at an exercise price of $3.22 per share, which vest over a three-year period commencing January 11, 2012 at 33%, 33% and 34% annually. In addition, the McNiel Employment Agreement also provides for the grant of 90,000 restricted shares of the Company’s common stock which will vest over a two-year period at 50% and 50% annually. Mr. McNiel is also entitled to certain other benefits set forth in the McNiel Employment Agreement. The options to purchase 300,000 shares of the Company’s common stock and 90,000 restricted shares of the Company common stock were granted to Mr. McNiel by the Company’s Compensation Committee on January 11, 2011.
 
 
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On January 11, 2011, the Company entered into a Stand-Alone Stock Option Agreement (“McNiel Option Agreement”) with James P. McNiel. The McNiel Option Agreement, which was approved by stockholders on May 9, 2011, provides for the grant to Mr. NcNiel of options to purchase up to 1,220,000 shares of the Company’s common stock at an exercise price of $3.22 per share, which vest over a three-year period commencing January 11, 2012 at 33%, 33% and 34% annually.
 
(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.
 
Internal Investigation
 
As part of the internal investigation, counsel to the Special Committee interviewed numerous employees and reviewed internal Company documents but was unable to speak with Mr. Huai and one sales person allegedly involved with the improper payments. On November 10, 2010, counsel to the Special Committee presented its report to the Special Committee. After a detailed review of this matter, the Special Committee concluded that (i) certain employees of one customer of the Company either directly or indirectly received various forms of compensation from the Company between 2008 and 2010, (ii) no more than three Company employees were knowingly involved in procuring these payments, and (iii) there was no evidence of a pattern of improper payments to other customers by the Company.  Based upon the information in its possession, the Company determined that the payments at issue did not have any effect on the Company’s revenue recognition and did not result in any material misstatement of the Company’s financial information in its filings with the Securities and Exchange Commission. Additionally, after the conclusion of its investigation, the Special Committee recommended a number of enhancements to the Company’s controls and procedures. As indicated under Part I, Item 4. Controls and Procedures, the Board of Directors has accepted these recommendations and the Company has implemented substantially all of the changes to its controls and procedures.
 
Government Investigations
 
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. Since that time, the Company has received additional subpoenas and document requests from the USAO seeking, among other things, documents relating to certain of the Company’s employees and other information about the Company. 
 
 
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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. Since that time, the Company has received additional subpoenas seeking among other things, information related to certain of the Company’s employees, customers, policies and practices.
 
The Company is cooperating fully with the investigations of both the USAO and the SEC and has produced documents responsive to all subpoenas and document requests. The Company intends to continue to cooperate fully with both investigations. The Company recorded an accrual of $1.5 million in the first quarter of 2011, and an additional $0.7 million during the second quarter of 2011, for a total accrual of $2.2 million, for certain costs associated with the possible resolution of the government 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 to 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 the scope, timing, or outcome of the investigations, nor can it predict what impact, if any, these matters may have on the Company’s business, financial condition, results of operations, and statement of cash flow.

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 complaint in each of the actions alleges 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 3, 2010, the Actions were consolidated before Judge Edward R. Korman (the combined Actions are referred to as the “Class Action”). Oral argument on motions for the appointment of “lead plaintiff” and for the approval of selection of “lead counsel” in the Class Action was heard by the Court in June, 2011. The Company anticipates that following decisions on these motions, it will receive an amended complaint.

The Company is thus unable to determine what claims will ultimately be asserted in the Class Action.  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 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 Company is therefore unable to estimate reasonably its exposure for the Class Action.

In January 2011, a Company stockholder filed an action in the Suffolk County Division of the Supreme Court of the State of New York, putatively derivatively on behalf of the Company, against the Company, each of the Company’s Directors, and Messrs. Huai, Lam and Weber (the “Walter Derivative Action”). The Walter Derivative Action alleges that the defendants breached their duties to the Company by: (1) causing or allowing the dissemination of false and misleading information; (2) failing to maintain internal controls; (3) failing to manage the Company properly; (4) unjustly enriching themselves; (5) abusing their control of the Company; and (6) wasting Company assets. The Walter Derivative Action also alleges that Messrs. Oxenhorn, Fischer, Kaufman, Lieber and Rubenstein breached their duties to the Company by allowing Mr. Huai to resign.
 
 
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The Company believes that the stockholder failed to make, and was not excused from making, a demand on the Company’s Board to redress these grievances and the Company intends to file a motion to dismiss. The Company further believes that it has meritorious defenses to some or all of the claims of the Walter Derivative Action as filed, and intends to file a motion to dismiss based on these grounds.
 
In April 2011, the parties to the Walter Derivative Action entered into a stipulation staying the Walter Derivative Action indefinitely. Under the terms of the stipulation, any party may lift the stay upon thirty days written notice to the other parties.
 
Counsel for the nominal Plaintiff has indicated that once the stay is lifted, it expects to file an amended complaint. The Company is thus unable to reasonably estimate its exposure for the Walter Derivative Action.
 
In July, 2011, a Company stockholder filed an action in the Suffolk County Division of the Supreme Court of the State of New York, putatively derivatively on behalf of the Company, against the Company, each of the Company’s Directors, the Company’s former Directors Patrick B. Carney, Lawrence S. Dolin and Steven Bock, and Mr. Huai (the “Cascado Derivative Action”).  The Cascado Derivative Action alleges that the defendants breached their duties to the Company by: (1) causing or allowing the dissemination of false and misleading information; (2) failing to maintain internal controls; (3) failing to properly oversee and manage the Company; (4) unjustly enriching themselves; (5) abusing their control of the Company; (6) grossly mismanaging the Company; and (6) wasting Company assets.
 
The Company believes that the stockholder failed to make, and was not excused from making, a demand on the Company’s Board to redress these grievances and the Company intends to file a motion to dismiss. The Company further believes that it has meritorious defenses to some or all of the claims of the Cascado Derivative Action as filed, and intends to file a motion to dismiss based on these grounds.  The Company is unable to reasonably estimate its exposure for the Cascado Derivative Action.
 
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 six months ended June 30, 2011 and 2010, and the location of long-lived assets as of June 30, 2011 and December 31, 2010, are summarized as follows:
 
 
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Three Months Ended June 30,
   
Six Months Ended June 30,
 
Revenues:
 
2011
   
2010
   
2011
   
2010
 
                         
North America
  $ 8,468,250     $ 11,493,524     $ 16,810,779     $ 22,495,494  
Asia Pacific
    5,662,096       3,529,398       10,987,277       6,192,351  
Europe, Middle East, Africa and Other
    5,497,662       5,247,787       10,789,214       8,702,519  
                                 
  Total Revenues
  $ 19,628,008     $ 20,270,709     $ 38,587,270     $ 37,390,364  
                                 
 
 
   
June 30,
   
December 31,
   
Long-lived assets:
    2011       2010    
                   
North America
  $ 11,718,783     $ 11,798,121    
Asia Pacific
    1,316,736       1,340,527    
Europe, Middle East, Africa and Other
    383,714       387,991    
                   
  Total long-lived assets
  $ 13,419,233     $ 13,526,639    
 
For the three months ended June 30, 2011, the Company did not have any customers that accounted for 10% or more of total revenues. For the three months ended June 30, 2010, the Company had one customer that accounted for 10% of revenues. As of June 30, 2011, the Company did not have any customers that accounted for 10% or more of the accounts receivable balance. As of December 31, 2010, the Company had one customer that accounted for 13% of the accounts receivable balance.
 
The Company recorded an expense of approximately $0.2 million during the three months ended June 30, 2011, and, due to cash collections of previously reserved accounts receivable balances, a benefit of approximately $0.7 million during the six months ended June 30, 2011. During the three and six months ended June 30, 2010, the Company recorded an expense of approximately $0.3 million and an expense of approximately $1.2 million, respectively. These amounts are included within revenues in each respective period in the accompanying condensed consolidated statements of operations.
 
(12) Subsequent Events
 
Effective August 1, 2011, the Company modified the operating lease covering its corporate office facility so that it now expires in February 2017.  The Company has the option to terminate the lease as of the last date of each month between August 31, 2013 and February 28, 2014, on nine months’ prior written notice. See Note (9) Commitments and Contingencies for additional information.
 
 
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Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” 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 for the second quarter of 2011 continued to show the pattern we have predicted for some time : Increased revenues from our FalconStor-branded (non-OEM) product revenue coupled with a decline in product revenue from our OEM partners.  Our total revenues for the quarter declined from the same period in 2010 primarily due to the increase in product revenue from our branded solutions did not equal the decrease in product revenue from our OEM solutions. However, on a year-over-year basis, after two quarters, our total revenues are higher.  Importantly, our operating expenses for both the three months and the six months ended June 30, 2011 are lower than they were in the same periods in 2010, even though we incurred over $3 million of expenses relating the ongoing governmental investigations during the first half of 2011.
 
During and after the quarter, we continued to evaluate which current and potential products and services, and which regions, offered the greatest opportunities for growth and profits. We made cuts in those areas that do not appear to have good potential for growth and profits and we reallocated some of those resources to the products, services and regions with the most potential. Even though we have made a concerted effort to reduce our expenses, we will continue to invest in our business for long-term growth in all appropriate areas, including sales and sales support.
 
The investigations by the United States Attorney’s Office for the Eastern District of New York and by the Securities and Exchange Commission continue to cause distraction to our efforts to promote, market and sell our goods and services. We cannot predict how long the external investigations, or the stockholder lawsuits that have been filed, will last or what the outcomes will be. The investigations and the lawsuits are more fully described in Part II, Item 1 – Legal Proceedings of this 10-Q filing. 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 have also incurred, and will continue to incur, significant expenses, and we have made accruals for costs of the investigation. At June 30, 2011, our cash, cash equivalents and marketable securities totaled approximately $38.1 million.
 
Total revenues for the second quarter of 2011 decreased 3% from the second quarter of 2010 to $19.6 million from $20.3 million. Total revenues for the first six months of 2011 were 3% higher than for the first six months of 2010.
 
For the second quarter of 2011, our FalconStor-branded product revenue increased 4% compared to the second quarter of 2010. While this increase indicates that we are continuing to have success in expanding sales of FalconStor-branded products through our resellers and directly to end users, the number is not as high as we expected and was not enough to compensate for the decrease in our product revenue from our OEMs. In  particular, our North America branded product revenue fell below our expectations. We attribute this, in part, to the turnover we have experienced in our North America sales organization. We have had a new Vice President of Sales in place in North America since January, 2011, and he has recruited a substantially new team. While it takes some time for new sales people to develop accounts and to be trained on our products, we had anticipated higher revenues from North American by this point.
 
 
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 Product revenues from our OEM partners for the second quarter of 2011 decreased 35% compared to the second quarter of 2010. Overall, non-OEMs contributed 84% of our product revenues in the second quarter of 2011and OEMs contributed 16%. No OEM contributed 10% or more of our revenues for the second quarter of 2011. We do not expect that OEM product revenue from either EMC or Oracle, which historically has accounted for at least 10% of our total revenues, will ever return to the levels they reached in the past.
 
Overall, our net loss for the second quarter of 2011 was $5.9 million. Of this amount, $1.2 million was related to costs associated with the investigations.
 
Our loss from operations was $6.0 million in the second quarter of 2011, including the $1.2 million in investigation-related costs. While our loss for the second quarter was up slightly from the second quarter of 2010, overall, our loss for the first six months of 2011 is down 14% from the first six months of 2010.
 
Operating expenses for the second quarter of 2011 increased by less than $0.1 million, or less than 1%, compared with the second quarter of 2010. Operating expenses include $1.2 million and $2.0 million in stock-based compensation expense for the second quarters of 2011 and 2010, respectively. We believe this increase of less than $100,000, even after the additional accrual of $0.7 million for costs related to a potential resolution of the government investigations, shows that we have been managing our expenses more carefully.
 
We had negative cash flows from operations for the second quarter of 2011 of $3.3 million, however, for the six months ended June 30, 2011, cash flows from operations totaled $2.3 million.
 
Deferred revenue at June 30, 2011 increased 18%, compared with the balance at June 30, 2010, and increased 10% when compared with the balance at December 31, 2010.
 
RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED JUNE 30, 2011 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2010.
 
Commencing in the second quarter of 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, our revenue is classified as either: (i) product revenue, or (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 our shift in focus, we have a corresponding cost of revenues for each revenue category.
 
Total revenues for the three months ended June 30, 2011 decreased 3% to $19.6 million, compared with $20.3 million for the three months ended June 30, 2010. Our cost of revenues increased 3% to $6.0 million for the three months ended June 30, 2011, compared with $5.9 million for the three months ended June 30, 2010. Included in our cost of revenues for the three months ended June 30, 2011 and 2010 was $0.1 million and $0.3 million, respectively, of share-based compensation expense. Our operating expenses increased less than 1% from $19.5 million for the three months ended June 30, 2010 to $19.6 million for the three months ended June 30, 2011. Included in the operating results for the three months ended June 30, 2011 was $1.2 million of costs associated with the ongoing government investigations that commenced during the second half of 2010. The $1.2 million was comprised of $0.5 million of legal fees, and an additional accrual of $0.7 million for certain costs associated with the possible resolution of the government investigations. In addition, included in our operating expenses for the three months ended June 30, 2011 and 2010 was $1.2 million and $2.0 million, respectively, of share-based compensation expense. Net loss for the three months ended June 30, 2011 was $5.9 million, compared with a net loss of $3.4 million for the three months ended June 30, 2010. Included in our net loss for the three months ended June 30, 2011 was an income tax provision of $0.1 million, compared with an income tax benefit of $1.7 million for the three months ended June 30, 2010. The income tax provision of $0.1 million and income tax benefit of $1.7 million were primarily attributable to the impact of our estimated full year effective tax rate on our pre-tax losses for the three months ended June 30, 2011 and 2010, respectively.
 
 
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Our overall 3% decrease in total revenues was due to declines in both our product revenues and support and service revenues for the three months ended June 30, 2011, compared with the same period in 2010. In total, our product revenues decreased 5%, of which, product revenues from our non-OEM partners increased 4%, while product revenues from our OEM partners decreased 35% for the three months ended June 30, 2011, compared with the same period in 2010. The increase in our non-OEM product revenues was primarily attributable to our continued focus and emphasis on the FalconStor-branded business. In addition, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. We do not anticipate that any of our OEM partners will contribute over 10% of our annual revenues for the foreseeable future. However, because of our well-established installed customer base, our support revenues derived from maintenance agreements continued to grow and have not been as significantly impacted by the disruptions in our OEM business.
 
Overall, our total operating expenses have remained relatively consistent as a result of lower share-based compensation expense, and to a lesser degree, due to a change in the mix of our headcount and despite the additional $1.2 million of costs associated with the ongoing government investigations that we incurred during the three months ended June 30, 2011. We continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 527 employees as of June 30, 2011, compared with 532 employees as of June 30, 2010.
 
Revenues
 
   
Three months ended June 30,
 
   
2011
   
2010
 
Revenues:
           
   Product revenue
  $ 11,609,760     $ 12,198,013  
   Support and services revenue
    8,018,248       8,072,696  
                 
Total Revenues
  $ 19,628,008     $ 20,270,709  
                 
Year-over-year percentage growth
               
   Product revenue
    -5 %     -31 %
   Support and services revenue
    -1 %     18 %
                 
Total percentage growth
    -3 %     -17 %
 
Product revenue
 
Product revenue is comprised of sales of licenses for 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.
 
Product revenue decreased 5% from $12.2 million for the three months ended June 30, 2010 to $11.6 million for the three months ended June 30, 2011. Product revenue represented 59% and 60% of our total revenues for the three months ended June 30, 2011 and 2010, respectively. Overall, during the three months ended June 30, 2011, product revenue from our non-OEM partners increased 4%, while product revenues from our OEM partners decreased 35% compared with the same period in 2010. The increase in our non-OEM product revenues was primarily attributable to our continued focus and emphasis on the FalconStor-branded business. However, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. We do not anticipate that any of our OEM partners will contribute over 10% of our annual revenues for the foreseeable future. Product revenue from our non-OEM partners represented 84% and 77% of our total product revenue for the three months ended June 30, 2011 and 2010, respectively. Product revenue from our OEM partners represented 16% and 23% of our total product revenue for the three months ended June 30, 2011 and 2010, respectively.
 
 
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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.

Support and services revenue

Support and services revenue is comprised of (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) 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 decreased 1% from $8.1 million for the three months ended June 30, 2010 to $8.0 million for the three months ended June 30, 2011.

Although our overall support and services revenue decreased 1% for the three months ended June 30, 2011 compared with the same period in 2010, revenue from our maintenance and technical support services increased from $7.0 million for the three months ended June 30, 2010 to $7.3 million for the same period in 2011. 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.

Professional services revenues decreased from $1.1 million for the three months ended June 30, 2010 to $0.7 million for the same period in 2011. 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.
 
 
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Cost of Revenues
 
   
Three months ended June 30,
 
   
2011
   
2010
 
Cost of revenues:
           
   Product
  $ 2,266,040     $ 2,550,540  
   Support and service
    3,734,884       3,303,348  
Total cost of revenues
  $ 6,000,924     $ 5,853,888  
                 
Total Gross Profit
  $ 13,627,084     $ 14,416,821  
                 
Gross Margin:
               
   Product
    80 %     79 %
   Support and service
    53 %     59 %
Total gross margin
    69 %     71 %
 
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 June 30, 2011 decreased $0.3 million, or 11%, to $2.3 million compared with $2.6 million for the same period in 2010. The decrease in cost of product revenue was primarily attributable to (i) decreased hardware and shipping costs as the result of the 5% decline in product revenues, and (ii) decreased amortization of purchased software costs during the three months ended June 30, 2011 as compared with the same period in 2010.  Our cost of support and service revenues for the three months ended June 30, 2011 increased $0.4 million, or 13% to $3.7 million compared with $3.3 million for the same period in 2010. The increase in cost of support and service revenue is primarily related to costs associated with the recruitment and hiring of management for both our support and services divisions, specifically a senior executive of world-wide support during the three months ended June 30, 2011 as compared with the same period in 2010.
 
Total gross profit decreased $0.8 million, or 6%, from $14.4 million for the three months ended June 30, 2010, to $13.6 million for the three months ended June 30, 2011. Total gross margin decreased to 69% for the three months ended June 30, 2011 from 71% for the same period in 2010. The decrease in both our total gross profit and total gross margins for the three months ended June 30, 2011, compared with the same period in 2010, was primarily due to (i) a 3% decrease in our total revenues, and (ii) investments made in new management for both our support and services divisions. 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 total revenue for both the three months ended June 30, 2011 and June 30, 2010. Share-based compensation expense included in the cost of support and service revenue decreased to $0.1 million from $0.3 million for the three months ended June 30, 2011 and June 30, 2010, respectively. Share-based compensation expense related to cost of support and service revenue was equal to 1% of total revenue for both the three months ended June 30, 2011 and June 30, 2010.
 
 
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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 $1.7 million, or 26%, to $4.9 million for the three months ended June 30, 2011 from $6.6 million in the same period in 2010. The decrease in research and development costs was primarily the result of (i) the capitalization of approximately $0.6 million of costs associated with software development, and (ii) to a decline in salary and personnel costs as a result of lower research and development headcount. 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 $0.3 million from $0.8 million for the three months ended June 30, 2011 and June 30, 2010, respectively. Share-based compensation expense included in research and development costs was equal to 2% and 4% of total revenue for the three months ended June 30, 2011 and 2010, respectively.
 
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 increased $0.1 million, or 1%, to $10.5 million for the three months ended June 30, 2011 from $10.4 million for the same period in 2010. The increase in selling and marketing expenses was primarily due to the costs associated with the recruitment and hiring of (i) additional sales management, and (ii) sales and sales support personnel within North America, in connection with finalizing our transition of the North American sales force during the three months ended June 30, 2011 as compared with the same period in 2010. Share-based compensation expense included in selling and marketing decreased to $0.5 million from $0.9 million for the three months ended June 30, 2011 and 2010, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 2% and 4% of total revenue for the three months ended June 30, 2011 and 2010, respectively.
 
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 increased $0.5 million, or 21%, to $3.0 million for the three months ended June 30, 2011 from $2.5 million for the same period in 2010. The overall increase within general and administrative expenses related to increases in (i) personnel related costs, and (ii) various administrative costs. Share-based compensation expense included in general and administrative expenses increased to $0.4 million from $0.3 million for the three months ended June 30, 2011 and 2010, respectively. Share-based compensation expense included in general and administrative expenses was equal to 2% of total revenue for both the three months ended June 30, 2011 and June 30, 2010.
 
Investigation costs
 
As we have previously disclosed, we have been cooperating fully with investigations conducted by both the U.S. Attorney’s Office for the Eastern District of New York and the Securities and Exchange Commission regarding our disclosure in September 2010 that certain improper payments were made in connection with our licensing of software to one of our customers.  We continue to cooperate fully with these ongoing investigations.
 
Investigation costs for the three months ended June 30, 2011, totaled $1.2 million, which consisted of $0.5 million of legal and professional fees, and an additional accrual of $0.7 million for certain costs associated with the possible resolution of the investigations. See Part II, Item 1 – Legal Proceedings of this quarterly report on Form 10-Q, for a more detailed description of the investigations.
 
 
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We expect our operating expenses will continue to be adversely impacted during 2011 due to professional and service provider fees, and other costs, resulting from the ongoing 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 June 30, 2011, our cash, cash equivalents, and marketable securities totaled $38.1 million, compared with $39.3 million as of June 30, 2010. Interest and other income increased $0.1 million to $0.2 million for the three months ended June 30, 2011, compared with $7,500 for the same period in 2010. The increase in interest and other income was primarily due to foreign currency gains of $0.1 million incurred during the three months ended June 30, 2011as compared with a foreign currency losses of $0.1 million for the same period in 2010.
 
Income Taxes
 
Our provision for income taxes consists of federal, 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 June 30, 2011, we recorded an income tax provision of $0.1 million on our pre-tax loss of $5.8 million, consisting of primarily state and local and foreign taxes. During the third quarter of 2010, we concluded that our domestic deferred tax assets were no longer realizable on a more-likely-than-not basis, therefore, recording a full valuation allowance against our domestic deferred tax assets. During the three months ended June 30, 2011, our conclusion did not change with respect to our deferred tax assets and therefore, we have not recorded any benefit for our expected net deferred tax assets for the full year 2011. As of June 30, 2011, the valuation allowance totaled approximately $30.3 million. In addition, we also recorded an accrual for certain legal matters during the three months ended June 30, 2011, which we believe will be non-deductible for US income tax purposes. The tax impact related to this accrual was recorded as a discrete item during the three months ended June 30, 2011.
 
During the three months ended June 30, 2010, we recorded an income tax benefit of $1.7 million on our pre-tax book loss of $5.1 million consisting primarily of federal, state and local and foreign taxes.
 
RESULTS OF OPERATIONS – FOR THE SIX MONTHS ENDED JUNE 30, 2011 COMPARED WITH THE SIX MONTHS ENDED JUNE 30, 2010.
 
Total revenues for the six months ended June 30, 2011 increased 3% to $38.6 million, compared with $37.4 million for the six months ended June 30, 2010. Our cost of revenues increased 1% to $11.1 million for the six months ended June 30, 2011, compared with $11.0 million for the six months ended June 30, 2010. Included in our cost of revenues for the six months ended June 30, 2011 and 2010 was $0.3 million and $0.6 million, respectively, of share-based compensation expense. Our operating expenses decreased 2% from $40.0 million for the six months ended June 30, 2010 to $39.1 million for the six months ended June 30, 2011.  Included in the operating results for the six months ended June 30, 2011 was $3.8 million of costs associated with the ongoing government investigations that commenced during the second half of 2010. The $3.8 million was comprised of $1.6 million of legal fees, and an accrual of $2.2 million for certain costs associated with the possible resolution of the government investigations. In addition, included in our operating expenses for the six months ended June 30, 2011 and 2010 was $2.4 million and $4.3 million, respectively, of share-based compensation expense. Net loss for the six months ended June 30, 2011 was $11.9 million, compared with a net loss of $8.9 million for the six months ended June 30, 2010. Included in our net loss for the six months ended June 30, 2011 was an income tax provision of $0.7 million, compared with an income tax benefit of $4.8 million for the six months ended June 30, 2010. The income tax provision of $0.7 million and income tax benefit of $4.8 million were primarily attributable to the impact of our estimated full year effective tax rate on our pre-tax losses for the six months ended June 30, 2011 and 2010, respectively.
 
 
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Our overall 3% increase in total revenues was due to increases in both our product revenues and support and service revenues for the six months ended June 30, 2011, compared with the same period in 2010. In total, our product revenues increased 4%, of which, product revenues from our non-OEM partners increased 16%, while product revenues from our OEM partners decreased 35% for the six months ended June 30, 2011, compared with the same period in 2010. The increase in our non-OEM product revenues was primarily attributable to our continued focus and emphasis on the FalconStor-branded business. In addition, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. We do not anticipate that any of our OEM partners will contribute over 10% of our annual revenues. 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 our OEM business.
 
Overall, our total operating expenses have decreased, primarily due to a decline in overall salary and personnel costs as the result of lower headcount, specifically during the first quarter of 2011, and lower share-based compensation expense. This is despite the additional $3.8 million of costs associated with the ongoing government investigations incurred during the six months ended June 30, 2011 We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 527 employees as of June 30, 2011, compared with 532 employees as of June 30, 2010.
 
Revenues
 
   
Six months ended June 30,
 
   
2011
   
2010
 
Revenues:
           
   Product revenue
  $ 22,868,775     $ 22,016,210  
   Support and services revenue
    15,718,495       15,374,154  
                 
Total Revenues
  $ 38,587,270     $ 37,390,364  
                 
Year-over-year percentage growth
               
   Product revenue
    4 %     -31 %
   Support and services revenue
    2 %     11 %
                 
Total percentage growth
    3 %     -18 %
 
Product revenue
 
Product revenue increased 4% from $22.0 million for the six months ended June 30, 2010 to $22.9 million for the six months ended June 30, 2011. These amounts are net of a benefit of $0.7 million recognized during the six months ended June 30, 2011, as compared with an expense of $1.2 million in the same period in 2010, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenue represented 59% of our total revenues for each of the six months ended June 30, 2011 and 2010. Overall, during the six months ended June 30, 2011, product revenue from our non-OEM partners increased 16%, while product revenues from our OEM partners decreased 35% compared with the same period in 2010. The increase in our non-OEM product revenues was primarily attributable to our continued focus and emphasis on the FalconStor-branded business. However, as anticipated, our OEM product revenues continued to decline, as a result of merger and acquisition activity involving some of our historically major OEM partners that began in 2009 and which we have previously reported. We do not anticipate that any of our OEM partners will contribute over 10% of our annual revenues going forward. Product revenue from our non-OEM partners represented 85% and 77% of our total product revenue for the six months ended June 30, 2011 and 2010, respectively. Product revenue from our OEM partners represented 15% and 23% of our total product revenue for the six months ended June 30, 2011 and 2010, 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.

 
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Support and services revenue

The increase in support and services revenue was attributable to maintenance and technical support services, which increased from $13.6 million for the six months ended June 30, 2010 to $14.3 million for the same period in 2011. 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.

Professional services revenues decreased from $1.8 million for the six months ended June 30, 2010 to $1.4 million for the same period in 2011. 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.
 
Cost of Revenues
   
Six months ended June 30,
 
   
2011
   
2010
 
Cost of revenues:
           
   Product
  $ 3,989,045     $ 4,059,225  
   Support and service
    7,102,797       6,916,045  
Total cost of revenues
  $ 11,091,842     $ 10,975,270  
                 
Total Gross Profit
  $ 27,495,428     $ 26,415,094  
                 
Gross Margin:
               
   Product
    83 %     82 %
   Support and service
    55 %     55 %
Total gross margin
    71 %     71 %
 
Cost of revenues, gross profit and gross margin
 
Cost of product revenue for the six months ended June 30, 2011 decreased $0.1 million, or 2%, to $4.0 million compared with $4.1 million for the same period in 2010. The decrease in cost of product revenue was primarily attributable to decreased amortization of purchased software costs during the six months ended June 30, 2011 as compared with the same period in 2010. The overall decrease in cost of product revenue was offset in part by the increased hardware costs associated with our continued focus of selling FalconStor-branded integrated turn-key solutions. Our cost of support and service revenues for the six months ended June 30, 2011 increased $0.2 million, or 3%, to $7.1 million, compared with $6.9 million for the same period in 2010. The increase in cost of support and service revenue is primarily related to costs associated with the recruitment and hiring of management for both our support and services divisions, specifically a senior executive of world-wide support during the six months ended June 30, 2011 as compared with the same period in 2010.
 
Total gross profit increased $1.1 million, or 4%, from $26.4 million for the six months ended June 30, 2010, to $27.5 million for the six months ended June 30, 2011. Total gross margin remained consistent at 71% for both the six months ended June 30, 2011 and 2010. The increase in our total gross profit for the six months ended June 30, 2011, compared with the same period in 2010, was primarily due to a 3% increase in our total revenues. 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.
 
 
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Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for both the six months ended June 30, 2011 and June 30, 2010. Share-based compensation expense included in the cost of support and service revenue decreased to $0.3 million from $0.6 million for the six months ended June 30, 2011 and June 30, 2010, respectively. Share-based compensation expense related to cost of support and service revenue was equal to 1% and 2% of total revenue for the six months ended June 30, 2011 and 2010, respectively.
 
Operating Expenses
 
Research and Development Costs
 
Research and development costs decreased $3.0 million, or 22%, to $10.8 million for the six months ended June 30, 2011 from $13.8 million in the same period in 2010. The decrease in research and development costs was primarily the result of (i) the capitalization of approximately $0.7 million of costs associated with software development, and (ii) a decline in salary and personnel costs as the result of lower research and development headcount. 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 $0.8 million from $1.8 million for the six months ended June 30, 2011 and June 30, 2010, respectively. Share-based compensation expense included in research and development costs was equal to 2% and 5% of total revenue for the six months ended June 30, 2011 and 2010, respectively.
 
Selling and Marketing
 
Selling and marketing expenses decreased $2.4 million, or 11%, to $19.0 million for the six months ended June 30, 2011 from $21.4 million for the same period in 2010. The decrease in selling and marketing expenses was primarily due to a transition of the North American sales force during the first quarter of 2011 which resulted in lower headcount as compared with the past several quarters. These decreases were offset in part by the costs associated with the recruitment and hiring of (i) additional sales management, and (ii) sales and sales support personnel within North America, in connection with finalizing our transition of the North American sales force during the second quarter of 2011. Share-based compensation expense included in selling and marketing decreased to $0.9 million from $1.9 million for the six months ended June 30, 2011 and 2010, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 2% and 5% of total revenue for the six months ended June 30, 2011 and 2010, respectively.
 
General and Administrative
 
General and administrative expenses increased $0.7 million, or 15%, to $5.6 million for the six months ended June 30, 2011 from $4.8 million for the same period in 2010. The overall increase within general and administrative expenses related to increases in (i) personnel related costs, and (ii) various administrative costs. Share-based compensation expense included in general and administrative expenses remained consistent at $0.7 million for both the six months ended June 30, 2011 and June 30, 2010. Share-based compensation expense included in general and administrative expenses was equal to was equal to 2% of total revenue for both the six months ended June 30, 2011 and June 30, 2010.
 
Investigation costs
 
As we have previously disclosed, we have been cooperating fully with investigations conducted by both the U.S. Attorney’s Office for the Eastern District of New York and the Securities and Exchange Commission regarding our disclosure in September 2010 that certain improper payments were made in connection with our licensing of software to one of our customers.  We continue to cooperate fully with these ongoing investigations.
 
 
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Investigation costs for the six months ended June 30, 2011, totaled $3.8 million, which consisted of $1.6 million of legal and professional fees, and an accrual of $2.2 million for certain costs associated with the possible resolution of the investigations.