Attached files

file filename
EX-32.2 - EXHIBIT 32.2 - FALCONSTOR SOFTWARE INCex322-q22017.htm
EX-32.1 - EXHIBIT 32.1 - FALCONSTOR SOFTWARE INCex321-q22017.htm
EX-31.2 - EXHIBIT 31.2 - FALCONSTOR SOFTWARE INCex312-q22017.htm
EX-31.1 - EXHIBIT 31.1 - FALCONSTOR SOFTWARE INCex311-q22017.htm


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

FORM 10-Q
(Mark One)

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2017
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 ý  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 ý  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company x
Emerging growth company o
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 ý
 
The number of shares of Common Stock outstanding as of July 31, 2017 was 44,563,490.




FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



PART I.  FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
June 30, 2017
 
December 31, 2016
 
 
(unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
1,647,695

 
$
3,391,528

Accounts receivable, net of allowances of $359,475 and $260,676, respectively
 
2,986,927

 
5,003,972

Prepaid expenses and other current assets
 
875,598

 
1,245,085

Inventory
 
6,181

 
6,181

Total current assets
 
5,516,401

 
9,646,766

Property and equipment, net of accumulated depreciation of $18,387,382 and $18,580,547, respectively
 
858,978

 
1,174,942

Deferred tax assets, net
 
580,395

 
577,735

Software development costs, net
 
396,630

 
547,558

Other assets
 
1,010,247

 
973,949

Goodwill
 
4,150,339

 
4,150,339

Other intangible assets, net
 
174,200

 
209,456

Total assets
 
$
12,687,190

 
$
17,280,745

Liabilities and Stockholders' Deficit
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
685,384

 
$
419,877

Accrued expenses
 
3,783,381

 
4,471,010

Deferred revenue, net
 
13,998,843

 
15,236,123

Total current liabilities
 
18,467,608

 
20,127,010

Other long-term liabilities
 
1,217,275

 
1,170,844

Deferred tax liabilities, net
 
267,174

 
254,776

Deferred revenue, net
 
7,272,609

 
8,430,692

Total liabilities
 
27,224,666

 
29,983,322

Commitments and contingencies (Note 10)
 


 


Series A redeemable convertible preferred stock, $.001 par value, 2,000,000 shares authorized, 900,000 shares issued and outstanding, redemption value of $9,000,000
 
9,000,000

 
9,000,000

Stockholders' deficit:
 
 

 
 

Common stock - $.001 par value, 100,000,000 shares authorized, 60,054,060 and 59,482,989 shares issued, respectively and 44,525,990 and 43,954,919 shares outstanding, respectively
 
60,054

 
59,483

Additional paid-in capital
 
169,187,879

 
169,091,255

Accumulated deficit
 
(133,734,683
)
 
(131,982,685
)
Common stock held in treasury, at cost (15,528,070 and 15,528,070 shares, respectively)
 
(57,032,917
)
 
(57,032,917
)
Accumulated other comprehensive loss, net
 
(2,017,809
)
 
(1,837,713
)
Total stockholders' deficit
 
(23,537,476
)
 
(21,702,577
)
Total liabilities and stockholders' deficit
 
$
12,687,190

 
$
17,280,745


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,
 
 
2017
 
2016
 
2017
 
2016
Revenue:
 
 
 
 
 
 
 
 
Product revenue
 
$
2,499,655

 
$
2,939,594

 
$
4,420,707

 
$
5,220,452

Support and services revenue
 
4,234,671

 
5,128,357

 
8,352,734

 
10,279,830

Total revenue
 
6,734,326

 
8,067,951

 
12,773,441

 
15,500,282

Cost of revenue:
 
 

 
 

 
 

 
 

Product
 
351,969

 
319,974

 
550,684

 
564,247

Support and service
 
1,418,663

 
1,999,125

 
2,672,579

 
3,761,345

Total cost of revenue
 
1,770,632

 
2,319,099

 
3,223,263

 
4,325,592

Gross profit
 
$
4,963,694

 
$
5,748,852

 
$
9,550,178

 
$
11,174,690

Operating expenses:
 
 

 
 

 
 

 
 

Research and development costs
 
2,025,132

 
3,304,079

 
4,319,995

 
6,960,856

Selling and marketing
 
2,109,599

 
4,124,350

 
4,160,141

 
8,393,150

General and administrative
 
1,345,343

 
1,833,479

 
2,966,894

 
3,539,404

Restructuring
 

 
93,405

 
(236,302
)
 
177,389

Total operating expenses
 
5,480,074

 
9,355,313

 
11,210,728

 
19,070,799

Operating loss
 
(516,380
)
 
(3,606,461
)
 
(1,660,550
)
 
(7,896,109
)
Interest and other (loss) income, net
 
(29,121
)
 
237,251

 
125,800

 
355,434

Loss before income taxes
 
(545,501
)
 
(3,369,210
)
 
(1,534,750
)
 
(7,540,675
)
Provision for income taxes
 
94,300

 
165,672

 
217,248

 
290,819

Net loss
 
$
(639,801
)
 
$
(3,534,882
)
 
$
(1,751,998
)
 
$
(7,831,494
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
215,089

 
195,366

 
419,664

 
387,974

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 

 
170,981

 

 
334,650

Net loss attributable to common stockholders
 
$
(854,890
)
 
$
(3,901,229
)
 
$
(2,171,662
)
 
$
(8,554,118
)
Basic net loss per share attributable to common stockholders
 
$
(0.02
)
 
$
(0.09
)
 
$
(0.05
)
 
$
(0.20
)
Diluted net loss per share attributable to common stockholders
 
$
(0.02
)
 
$
(0.09
)
 
$
(0.05
)
 
$
(0.20
)
Weighted average basic shares outstanding
 
44,440,751

 
43,159,285

 
44,265,525

 
42,521,018

Weighted average diluted shares outstanding
 
44,440,751

 
43,159,285

 
44,265,525

 
42,521,018


See accompanying notes to unaudited condensed consolidated financial statements.


4



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(UNAUDITED)

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Net loss
 
$
(639,801
)
 
$
(3,534,882
)
 
$
(1,751,998
)
 
$
(7,831,494
)
Other comprehensive income (loss), net of applicable taxes:
 
 

 
 

 
 

 
 

Foreign currency translation
 
5,433

 
(334,161
)
 
(180,096
)
 
(561,576
)
Net unrealized gain on marketable securities
 

 
(283
)
 

 
3,756

Net minimum pension liability
 

 
678

 

 
3,854

Total other comprehensive income (loss), net of applicable taxes:
 
5,433

 
(333,766
)
 
(180,096
)
 
(553,966
)
Total comprehensive loss
 
$
(634,368
)
 
$
(3,868,648
)
 
$
(1,932,094
)
 
$
(8,385,460
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
215,089

 
195,366

 
419,664

 
387,974

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 

 
170,981

 

 
334,650

Total comprehensive loss attributable to common stockholders
 
$
(849,457
)
 
$
(4,234,995
)
 
$
(2,351,758
)
 
$
(9,108,084
)

See accompanying notes to unaudited condensed consolidated financial statements.


5



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
Six Months Ended June 30,
 
 
2017
 
2016
Cash flows from operating activities:
 
 
 
 
Net loss
 
$
(1,751,998
)
 
$
(7,831,494
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 

 
 

Depreciation and amortization
 
553,455

 
747,974

Share-based payment compensation
 
501,410

 
637,231

Non-cash professional services expenses
 
41,159

 
1,480,725

Loss on disposal of fixed assets
 
63,774

 

Provision for returns and doubtful accounts
 
99,312

 
61,068

Deferred income taxes
 
30,124

 
(265,756
)
Changes in operating assets and liabilities:
 
 

 
 

Accounts receivable
 
1,961,276

 
1,787,845

Prepaid expenses and other current assets
 
403,937

 
377,103

Inventory
 

 
64,353

Other assets
 
(154,832
)
 
23,429

Accounts payable
 
193,640

 
(42,587
)
Accrued expenses and other long-term liabilities
 
(1,098,547
)
 
(289,754
)
Deferred revenue
 
(2,487,989
)
 
(541,348
)
Net cash used in operating activities
 
(1,645,279
)
 
(3,791,211
)
Cash flows from investing activities:
 
 

 
 

Sales of marketable securities
 

 
6,066,000

Purchases of marketable securities
 

 
(150,000
)
Purchases of property and equipment
 
(44,163
)
 
(110,421
)
Security deposits
 
(17,152
)
 
82,311

Purchase of intangible assets
 
(45,517
)
 
(61,506
)
Net cash (used in) provided by investing activities
 
(106,832
)
 
5,826,384

Cash flows from financing activities:
 
 

 
 

Payments for tax withholding for share-based compensation
 
(25,710
)
 

Net cash used in financing activities
 
(25,710
)
 

Effect of exchange rate changes on cash and cash equivalents
 
33,988

 
(123,221
)
Net (decrease) increase in cash and cash equivalents
 
(1,743,833
)
 
1,911,952

Cash and cash equivalents, beginning of period
 
3,391,528

 
6,013,382

Cash and cash equivalents, end of period
 
$
1,647,695

 
$
7,925,334

Supplemental disclosures:
 
 

 
 

Cash paid for income taxes, net
 
$
135,915

 
$
443,908

Non-cash investing and financing activities:
 
 

 
 

Undistributed Series A redeemable convertible preferred stock dividends
 
$
419,664

 
$
195,366

Series A redeemable convertible preferred stock dividend payment
 
$

 
$
381,413

The Company did not pay any interest for the six months ended June 30, 2017 and 2016.
See accompanying notes to unaudited condensed consolidated financial statements.

6



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements 

(1) Basis of Presentation

(a)  The Company and Nature of Operations
 
FalconStor Software, Inc., a Delaware Corporation (the "Company"), is a leading storage software company offering a converged data services software platform that is hardware agnostic. The Company develops, manufactures and sells data migration, business continuity, disaster recovery, optimized backup and de-duplication solutions and provides the related maintenance, implementation and engineering services.

(b) Going Concern

A fundamental principle of the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP") is the assumption that an entity will continue in existence as a going concern, which contemplates continuity of operations and the realization of assets and settlement of liabilities occurring in the ordinary course of business. This principle is applicable to all entities except for entities in liquidation or entities for which liquidation appears imminent. In accordance with this requirement, the Company has prepared its consolidated financial statements on a going concern basis.

The Company has incurred significant operating losses in the previous eight years and negative cash flow from operations in five of the previous eight years. The Company currently has a working capital deficiency of $13.0 million, which is inclusive of current deferred revenue of $14.0 million and a stockholders' deficit of $23.5 million. During the six months ended June 30, 2017, the Company incurred a net loss of $1.8 million and cash flow used in operations of $1.6 million. The Company's total cash balance at June 30, 2017 was $1.6 million, a decrease of $1.7 million as compared to December 31, 2016. In addition to these financial metrics, as of December 31, 2016, the Company was not in compliance with the financial covenants of the Series A redeemable convertible preferred stock, which were mutually agreed to annually, for two consecutive quarters. This breach provides the holder of the Series A redeemable convertible preferred stock with the right to require the Company to redeem any of the Series A redeemable convertible preferred stock at the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price of the Company's common stock as of December 31, 2016. To date, the holder of the Series A redeemable convertible preferred stock has neither exercised nor waived this right and accordingly this right may be exercised at any time. In addition, the holders of the Series A redeemable convertible preferred stock have the right to request a redemption of the Series A redeemable convertible preferred stock on or after August 5, 2017. If the holders request that the Series A redeemable convertible preferred stock be redeemed, the Company may not have sufficient liquidity or sufficient surplus as such term is defined under the Delaware General Business Corporation Law ("DGCL") to undertake the redemption. If the Company does not redeem the Series A redeemable convertible preferred stock, the holder of the Series A redeemable convertible preferred stock can pursue other remedies. Refer to Note (11) Series A Redeemable Convertible Preferred Stock for further discussion regarding these other remedies. The Company's reduced cash balance and history of losses both in and of itself, and in combination with the redemption rights of the holders of the Series A redeemable convertible preferred stock, raise substantial doubt about the Company's ability to continue as a going concern within one year after August 11, 2017 (the date that these financial statements were issued). 

The Company's ability to continue as a going concern, including in the event of a redemption request by the holder, depends on its ability to execute its business plan, increase revenue and billings and reduce expenditures. During 2016, the Company continued to focus on aligning its expense structure with revenue expectations which included tighter expense controls and overall operational efficiencies which better align the Company's current business plan on a run-rate basis. These efficiencies include among other items, stream-lined personnel related costs and global overhead costs and efficiencies realized on the Company's redesigned go-to-market coverage models. In June 2017, the Company's Board of Directors, approved a comprehensive plan to increase operating performance (the “2017 Plan”). The 2017 Plan will result in a realignment and reduction in workforce. The 2017 Plan was substantially completed as of June 30, 2017. These actions are anticipated to result in an annualized cost savings of approximately $10.0 million. In connection with the 2017 Plan, the Company incurred severance expense of $0.8 million. In making these changes, the Company prioritized customer support and development while consolidating operations and cutting direct sales resources, therefore allowing the company to focus on its install base and develop more efficient market channels. The Company's worldwide headcount was 97 employees as of June 30, 2017, compared with 166 and 226 employees as of December 31, 2016 and 2015, respectively. Although, the Company was able to reduce its operating expenses, the Company's bookings, billings and revenue continued to decline which negatively impacts the Company's ability to continue as a going concern.


7



There is no assurance that the Company will be successful in generating sufficient bookings, billings, revenue or continue to reduce operating costs. In addition, if the Company continues to incur losses, the Company will need to seek additional financing and there can be no assurance that the Company will be able to obtain financing or that such financing will be on favorable terms. Any such financing would be dilutive to our shareholders. Failure to generate sufficient revenue, billings, control or further reduce expenditures and/or the inability to obtain financing will result in an inability of the Company to continue as a going concern.

(c)  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.
 
(d)  Use of Estimates
 
The preparation of financial statements in conformity with GAAP 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, valuation of derivatives, capitalizable software development costs, valuation of goodwill and other intangible assets and income taxes. Actual results could differ from those estimates.
 
The financial market volatility in many countries where the Company operates has impacted and may continue to impact the Company’s business. Such conditions could have a material impact on the Company’s significant accounting estimates discussed above.
 
(e)  Unaudited Interim Financial Information
 
The accompanying unaudited interim condensed consolidated financial statements have been prepared 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 GAAP 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, 2017, and the results of its operations for the three and six months ended June 30, 2017 and 2016. 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. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2016 ("2016 Form 10-K").

(f)  Recently Adopted Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board ("FASB") issued new guidance on accounting for employee share-based payment awards to simplify the accounting related to several aspects of accounting for share-based payment transactions, including income tax consequences of share-based payment transactions, classification of awards as either equity or liabilities, forfeitures, and classification on the statement of cash flows. The Company adopted this guidance as of January 1, 2017. In accordance with this new guidance the Company has made an entity-wide accounting policy election to account for forfeitures when they occur. As a result of this election, the Company recognized additional stock-based compensation expense of approximately $0.1 million in the first quarter of 2017 to adjust for actual forfeitures on historical share-based payment awards.

In January 2017, the FASB issued new guidance on accounting for goodwill to simplify the goodwill impairment test by eliminating Step 2 of the goodwill impairment test. This new guidance also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. The new standard is effective for the annual period beginning after December 15, 2019, including interim reporting periods within that period, which for the Company is the annual period ending December 31, 2020. Early adoption is permitted. The Company elected to adopt this guidance as of January 1, 2017, prospectively for impairment tests performed subsequent to January 1, 2017. The Company's single reporting unit for purposes of its goodwill impairment test had a negative carrying value of $13.8 million as of March 31, 2017 and thus the Company determined there was no impairment of goodwill. During the second quarter of 2017 there were no triggering events that would require a goodwill impairment test to be performed prior to the Company's annual goodwill impairment test. The adoption of this guidance did not have an impact on the Company's financial statements and related disclosures.

8




(g)  Recently Issued Accounting Pronouncements

In May 2017, the FASB issued new guidance on stock-based compensation to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the stock-based compensation guidance to a change to the terms or conditions of a share-based payment award. The amendments in this update provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. This new guidance requires application on a prospective basis. This update is effective for public entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2017, with early adoption permitted, which for the Company will be the annual period ending December 31, 2018. The Company has not yet adopted this guidance and currently does not expect the adoption of the new guidance by the Company to have a significant impact on the Company's financial statements and related disclosures.

In March 2017, the FASB issued new guidance on retirement benefits, which requires employers to disaggregate the service cost component from other components of net periodic benefit costs and to disclose the amounts of net periodic benefit costs that are included in each income statement line item. The standard requires employers to report the service cost component in the same line item as other compensation costs and to report the other components of net periodic benefit costs (which include interest costs, expected return on plan assets, amortization of prior service cost or credits and actuarial gains and losses) separately and outside a subtotal of operating income. The income statement guidance requires application on a retrospective basis. This update is effective for public entities for annual periods beginning after December 15, 2017, including interim periods, with early adoption permitted, which for the Company will be the annual period ending December 31, 2018. The Company has not yet adopted this guidance and currently does not expect the adoption of the new guidance by the Company to have a significant impact on the Company's financial statements and related disclosures.

In August 2016, the FASB issued new guidance on presentation and classification of eight specific items within the statement of cash flows, including (i) debt prepayment or debt extinguishment costs, (ii) settlement of zero-coupon debt instruments or other debt instruments with coupon rates that are insignificant in relation to the effective interest rate of the borrowing, (iii) contingent consideration payments made after a business combination, (iv) proceeds from the settlement of insurance claims, (v) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, (vi) distributions received from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) separately identifiable cash flows and application of the predominance principle. This update is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2017, which for the Company will be the annual period ending December 31, 2018. Early adoption, including adoption in an interim period, is permitted. The Company has not yet adopted this guidance and currently does not expect the adoption of the new guidance by the Company to have a significant impact on the Company's financial statements and related disclosures.

In February 2016, the FASB issued new guidance on leases to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This new guidance will replace existing guidance on leases in accounting principles generally accepted in the United States when it becomes effective. The new standard is effective for the annual period beginning after December 15, 2018, including interim reporting periods within that period, which for the Company will be the annual period ending December 31, 2019. Early application is permitted. The standard requires the use of a modified retrospective transition method; however, certain optional practical expedients may be applied. The Company's preliminary analysis indicates that the Company will recognize a liability for remaining lease payments and a right-of-use asset related to the Company's operating lease covering its corporate office facility that expires in April 2021. Currently the Company's additional operating leases related to offices in foreign countries are set to expire prior to adoption of the new guidance. The Company is in the initial stages of evaluating the effect of the standard on the Company's financial statements.

In January 2016, the FASB issued new guidance on the recognition, measurement, presentation and disclosure of financial assets and financial liabilities. The standard (i) requires an entity to measure equity investments, except those accounted for under the equity method of accounting or those that result in consolidation of the investee, at fair value with changes in fair value recognized in net income, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring an entity to perform a qualitative assessment to identify impairment, (iii) changes certain presentation and disclosure requirements related to financial assets and financial liabilities, and (iv) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity's other deferred tax assets. The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, which for the Company will be the annual period ending December 31, 2018. Early adoption, including adoption in an interim period, is not permitted except for certain amendments in this update. The Company has not yet adopted this guidance and currently does not expect the adoption of the new guidance by the Company to have a significant impact on the Company's financial statements and related disclosures.

9




In May 2014, the FASB issued new guidance which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This new guidance will replace most existing revenue recognition guidance in GAAP in the United States when it becomes effective. The new standard is effective for the annual period beginning after December 15, 2017, including interim reporting periods within that period, which for the Company will be the annual period ending December 31, 2018. Early application as of January 1, 2017 is permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that this new guidance will have on its consolidated financial statements and related disclosures. The Company has formed an implementation team to evaluate the standard's effect on the Company's financial statements. The Company has historically deferred revenue for certain deliverables in its multiple-element arrangements due to a lack of vendor-specific objective evidence (“VSOE”) for those deliverables. The Company's preliminary analysis indicates that the Company will recognize revenue for these arrangements earlier under the new standard than under existing guidance due to the elimination of the VSOE requirement. The Company will use the cumulative effect transition method upon adoption of this guidance. The Company is in the initial stages of evaluating the effect of the standard on the Company's financial statements.

(2) Summary of Significant Accounting Policies

The Company's significant accounting policies were described in Note (1) "Summary of Significant Accounting Policies" of the 2016 Form 10-K. The Company's revenue recognition accounting policy is included below for reference. There have been no significant changes in the Company's significant accounting policies since December 31, 2016, other than those noted below in (b) and (c). For a description of the Company's other significant accounting policies refer to the 2016 Form 10-K.

(a) Revenue Recognition
 
The Company derives its revenue from sales of its products, support and services. Product revenue consists of the Company’s software integrated with industry standard hardware and sold as complete turn-key integrated solutions, as stand-alone software applications or sold on a subscription or consumption basis. Depending on the nature of the arrangement revenue, related to turn-key solutions and stand-alone software applications are generally recognized upon shipment and delivery of license keys. For certain arrangements revenue is recognized based on usage or ratably over the term of the arrangement. 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 when persuasive evidence of an arrangement exists, the fee is fixed or determinable, delivery has occurred, and collection of the resulting receivable is deemed probable. Products delivered to a customer on a trial basis are not recognized as revenue until the trial period has ended and acceptance has occurred by the customer. Reseller and distributor customers typically send the Company a purchase order when they have an end user identified. For bundled 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 VSOE of the fair value of those elements, with the residual of the arrangement fee allocated to and recognized as product revenue. If VSOE does not exist for all undelivered elements of an arrangement, the Company recognizes total revenue from the arrangement ratably over the term of the maintenance agreement. The Company's long-term portion of deferred revenue consists of (i) payments received for maintenance contracts with terms in excess of one year as of the balance sheet date, and (ii) payments received for product sales bundled with multiple years of maintenance but for which VSOE did not exist for all undelivered elements of the arrangement. The Company provides an allowance for product returns as a reduction of revenue, based upon historical experience and known or expected trends.


10



When more than one element, such as hardware, software and services are contained in a single arrangement, the Company will first allocate revenue based upon the relative selling price into two categories: (1) non-software components, such as hardware and any hardware-related items, as required system software that functions with the hardware to deliver the essential functionality of the hardware and related post-contract customer support, and software as service subscriptions and (2) software components and applications, such as post-contract customer support and other services. The Company will then allocate revenue within the non-software category to each element based upon their relative selling price using a hierarchy of VSOE, third-party evidence of selling price (“TPE”) or estimated selling prices (“ESP”), if VSOE or TPE does not exist. The Company will allocate revenue within the software category to the undelivered elements based upon their fair value using VSOE with the residual revenue allocated to the delivered elements. If the Company cannot objectively determine the VSOE of the fair value of any undelivered software element, the Company will defer revenue for all software components until all elements are delivered and services have been performed, until fair value can objectively be determined for any remaining undelivered elements, or until software maintenance is the only undelivered element which the Company does not have VSOE for, in which case revenue is recognized over the maintenance term for all software elements.

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.
 
The Company has entered into various distribution, licensing and joint promotion agreements with OEMs, whereby the Company has provided the OEM 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 these OEMs. Such payments from the OEM or distributor are recognized as revenue in the period reported by the OEM.

From time to time the Company will enter into funded software development arrangements. Under such arrangements, revenue recognition will not commence until final delivery and/or acceptance of the product. For arrangements where the Company has VSOE for the undelivered elements, the Company will follow the residual method and recognize product revenue upon final delivery and/or acceptance of the product. For arrangements where the Company does not have VSOE for the undelivered elements, the Company will recognize the entire arrangement fee ratably commencing at the time of final delivery and/or acceptance through the end of the service period in the arrangement. Certain arrangements, for which VSOE of fair value for the undelivered maintenance elements cannot be established, are accounted for as a single unit of account. The revenue recognized from single units of accounting are typically allocated and classified on the consolidated statements of operations as product revenue and support and services revenue. Since VSOE cannot be established, VSOE of similar maintenance offerings provides the basis for the support and services revenue classification, and the remaining residual consideration provides the basis for the product revenue classification.

(b) Share-Based Payments

The Company accounts for share-based payments in accordance with the authoritative guidance issued by the FASB on share-based 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 actual forfeitures. For share-based payment awards that contain performance criteria share-based compensation, expense is recorded when the achievement of the performance condition is considered probable of achievement and is recorded on a straight-line basis over the requisite service period. If such performance criteria are not met, no compensation cost is recognized and any recognized compensation cost is reversed. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model or the Monte Carlo simulation model if a market condition exists. Share-based compensation expense for a share-based payment award with a market condition is recorded on a straight-line basis over the longer of the explicit service period or the service period derived from the Monte Carlo simulation. 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.


11



(c)
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 evaluates goodwill for impairment annually or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. The Company tests goodwill for impairment by comparing the book value of net assets to the fair value of the reporting unit. If the fair value is determined to be less than the book value, the computed difference represents the amount of impairment. The Company's single reporting unit for purposes of its goodwill impairment test has a negative carrying value of $13.8 million as of March 31, 2017 and thus the Company has determined there was no impairment of goodwill. During the second quarter of 2017, there were no triggering events that would require a goodwill impairment test to be performed prior to the Company's annual goodwill impairment test.
 
(3) Earnings Per Share

Basic earnings per share ("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 the Series A redeemable convertible preferred stock outstanding.

The following represents the common stock equivalents that were excluded from the computation of diluted shares outstanding because their effect would have been anti-dilutive for the three and six months ended June 30, 2017 and 2016:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Stock options and restricted stock
 
6,427,858

 
7,692,595

 
6,427,858

 
7,692,595

Series A redeemable convertible preferred stock
 
8,781,516

 
8,781,516

 
8,781,516

 
8,781,516

Total anti-dilutive common stock equivalents
 
15,209,374

 
16,474,111

 
15,209,374

 
16,474,111


The following represents a reconciliation of the numerators and denominators of the basic and diluted EPS computation:  
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,

 
2017
 
2016
 
2017
 
2016
Numerator
 
 
 
 
 
 
 
 
Net loss
 
$
(639,801
)
 
$
(3,534,882
)
 
$
(1,751,998
)
 
$
(7,831,494
)
Effects of Series A redeemable convertible preferred stock:
 
 

 
 

 
 

 
 

Less: Series A redeemable convertible preferred stock dividends
 
215,089

 
195,366

 
419,664

 
387,974

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 

 
170,981

 

 
334,650

Net loss attributable to common stockholders
 
$
(854,890
)
 
$
(3,901,229
)
 
$
(2,171,662
)
 
$
(8,554,118
)
Denominator
 
 

 
 

 
 

 
 

Weighted average basic shares outstanding
 
44,440,751

 
43,159,285

 
44,265,525

 
42,521,018

Effect of dilutive securities:
 
 

 
 

 
 

 
 

Stock options and restricted stock
 

 

 

 

Series A redeemable convertible preferred stock
 

 

 

 

Weighted average diluted shares outstanding
 
44,440,751

 
43,159,285

 
44,265,525

 
42,521,018

EPS
 
 

 
 

 
 

 
 

Basic net loss per share attributable to common stockholders
 
$
(0.02
)
 
$
(0.09
)
 
$
(0.05
)
 
$
(0.20
)
Diluted net loss per share attributable to common stockholders
 
$
(0.02
)
 
$
(0.09
)
 
$
(0.05
)
 
$
(0.20
)


12



(4) Property and Equipment

The gross carrying amount and accumulated depreciation of property and equipment as of June 30, 2017 and December 31, 2016 are as follows:
 
 
June 30, 2017
 
December 31, 2016
Property and Equipment:
 
 
 
 
Gross carrying amount
 
$
19,246,360

 
$
19,755,489

Accumulated depreciation
 
(18,387,382
)
 
(18,580,547
)
Property and Equipment, net
 
$
858,978

 
$
1,174,942


For the three months ended June 30, 2017 and 2016, depreciation expense was $135,669 and $180,475, respectively. For the six months ended June 30, 2017 and 2016, depreciation expense was $321,754 and $405,376, respectively.

(5) Software Development Costs

The gross carrying amount and accumulated amortization of software development costs as of June 30, 2017 and December 31, 2016 are as follows:
 
 
June 30, 2017
 
December 31, 2016
Software development costs:
 
 
 
 
Gross carrying amount
 
$
2,917,215

 
$
2,917,215

Accumulated amortization
 
(2,520,585
)
 
(2,369,657
)
Software development costs, net
 
$
396,630

 
$
547,558


During the three months ended June 30, 2017 and 2016, the Company recorded $61,687 and $129,870, respectively, of amortization expense related to capitalized software costs. During the six months ended June 30, 2017 and 2016, the Company recorded $150,928 and $260,363, respectively, of amortization expense related to capitalized software costs.

(6) Goodwill and Other Intangible Assets

The gross carrying amount and accumulated amortization of goodwill and other intangible assets as of June 30, 2017 and December 31, 2016 are as follows: 
 
 
June 30, 2017
 
December 31, 2016
Goodwill
 
$
4,150,339

 
$
4,150,339

Other intangible assets:
 
 

 
 

Gross carrying amount
 
$
3,770,954

 
$
3,725,437

Accumulated amortization
 
(3,596,754
)
 
(3,515,981
)
Net carrying amount
 
$
174,200

 
$
209,456


For the three months ended June 30, 2017 and 2016, amortization expense was $39,858 and $40,758, respectively. For the six months ended June 30, 2017 and 2016, amortization expense was $80,773 and $82,235, respectively.


13



(7) Share-Based Payment Arrangements

On June 30, 2017, the total shares available for issuance under the FalconStor Software, Inc. 2016 Incentive Stock Plan (the "2016 Plan") totaled 145,220. Pursuant to the 2016 Plan, if, on July 1st of any calendar year in which the 2016 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 2016 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 2016 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 2016 Plan in the aggregate exceed twenty million shares, subject to adjustment as provided in the 2016 Plan. On July 1, 2017, the total number of outstanding shares of the Company’s common stock totaled 44,525,990. Pursuant to the 2016 Plan, the total shares available for issuance under the 2016 Plan thus increased 2,081,080 to 2,226,300 shares available for issuance as of July 1, 2017.

The following table summarizes the plans under which the Company was able to grant equity compensation as of June 30, 2017
 
 
Shares
 
Shares Available
 
Shares
 
Last Date for Grant
Name of Plan
 
Authorized
 
for Grant
 
Outstanding
 
of Shares
FalconStor Software, Inc., 2016 Incentive Stock Plan
 
2,166,606
 
145,220
 
1,500,000
 
April 27, 2026
FalconStor Software, Inc., 2016 Outside Directors Equity Compensation Plan
 
1,000,000
 
583,532
 
409,868
 
April 27, 2019

The following table summarizes the Company’s equity plans that have expired but that still have equity awards outstanding as of June 30, 2017
Name of Plan
 
Shares Available for Grant
 
Shares Outstanding
FalconStor Software, Inc., 2006 Incentive Stock Plan
 
 
4,410,290
FalconStor Software, Inc., 2013 Outside Directors Equity Compensation Plan
 
 
10,200
FalconStor Software, Inc., 2000 Stock Option Plan
 
 
97,500
 
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 for the three and six months ended June 30, 2017 and 2016:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Cost of revenue - Product
 
$

 
$

 
$

 
$

Cost of revenue - Support and Service
 
8,834

 
44,066

 
65,285

 
68,837

Research and development costs
 
54,813

 
825,635

 
184,528

 
1,571,797

Selling and marketing
 
7,198

 
75,342

 
63,738

 
143,072

General and administrative
 
26,310

 
182,303

 
229,018

 
334,250

 
 
$
97,155

 
$
1,127,346

 
$
542,569

 
$
2,117,956

 
On March 7, 2016, the Company issued an aggregate of 507,070 shares of the Company's common stock to Cumulus Logic, LLC, as a milestone payment pursuant to the terms of a Software License and Development Agreement between the Company and Cumulus Logic, LLC. The shares have an aggregate value of $765,000 based on the 30 day trading day average of the Company's common stock immediately prior to July 29, 2015, the date that the License and Development Agreement was executed. The Company recognized share-based compensation expense of $699,757 related to this transaction based on the fair value per share of the common stock on the date of issue of $1.38. This expense was included in "research and development costs" in the accompanying consolidated statements of operations.


14



On April 1, 2016, the Company issued an aggregate of 591,582 shares of the Company's common stock to Cumulus Logic, LLC, as the final milestone payment pursuant to the terms of a Software License and Development Agreement between the Company and Cumulus Logic, LLC. The shares have an aggregate value of $892,500 based on the 30 day trading day average of the Company's common stock immediately prior to July 29, 2015, the date that the License and Development Agreement was executed. On April 1, 2016, the Company recognized share-based compensation expense of $786,804 related to this transaction based on the fair value per share of the common stock on the date of issue of $1.33.

(8) Income Taxes
 
The Company’s provision for income taxes consists of 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.
 
For the six months ended June 30, 2017 and 2016, the Company recorded an income tax provision of $217,248 and $290,819, respectively, consisting primarily of state and local and foreign taxes. The effective tax rate for the six months ended June 30, 2017 and June 30, 2016 was (14.2%) and (3.9%), respectively. The change in the effective tax rate is attributable to the mix of foreign and domestic earnings as no tax expense or benefit is being recognized on domestic earnings or losses. As of June 30, 2017, the Company’s conclusion did not change with respect to the realizability of its domestic deferred tax assets and, therefore, the Company has not recorded any benefit for its expected net domestic deferred tax assets for the full year 2017 estimated annual effective tax rate. As of June 30, 2017, the valuation allowance totaled approximately $40.4 million.
 
The Company’s total unrecognized tax benefits, excluding interest, at both June 30, 2017 and December 31, 2016 were $217,461. At June 30, 2017, $337,881 of unrecognized tax benefits, including interest, if recognized, would reduce the Company’s effective tax rate. As of June 30, 2017 and December 31, 2016, the Company had $120,420 and $111,278, respectively, of accrued interest.
 
(9) Fair Value Measurements
 
The Company measures its cash equivalents and derivative instruments 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.
 
The methodology for measuring fair value specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs). As a result, observable and unobservable inputs have created the following fair value hierarchy:
 
Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities. At June 30, 2017 the Company did not have any Level 1 category assets included in the condensed consolidated balance sheets. At December 31, 2016, the Level 1 category included money market funds, 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. At June 30, 2017 and December 31, 2016, the Company did not have any Level 2 category assets included 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. At June 30, 2017 and December 31, 2016, the Level 3 category included derivatives, which are included within other long-term liabilities in the condensed consolidated balance sheets. The Company did not hold any cash, cash equivalents categorized as Level 3 as of June 30, 2017 or December 31, 2016.


15



The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at June 30, 2017:
 
 
 
 
Fair Value Measurements at Reporting Date Using
 
 
Total
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant other Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
 
Money market funds
 
$

 
$

 
$

 
$

Total cash equivalents
 

 

 

 

Derivative liabilities:
 
 

 
 

 
 

 
 

Derivative Instruments
 
419,560

 

 

 
419,560

Total derivative liabilities
 
419,560

 

 

 
419,560

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
419,560

 
$

 
$

 
$
419,560


The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2016
 
 
 
 
Fair Value Measurements at Reporting Date Using
 
 
Total
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant other Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
 
Money market funds and commercial paper
 
$
1,133,280

 
$
1,133,280

 
$

 
$

Total cash equivalents
 
1,133,280

 
1,133,280

 

 

Derivative liabilities:
 
 
 
 
 
 
 
 
Derivative Instruments
 
336,862

 

 

 
336,862

Total derivative liabilities
 
336,862

 

 

 
336,862

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
1,470,142

 
$
1,133,280

 
$

 
$
336,862

 
The fair value of the Company’s derivatives were valued using the Black-Scholes pricing model adjusted for probability assumptions, with all significant inputs, except for the probability and volatility assumptions, derived from or corroborated by observable market data such as stock price and interest rates. The probability and volatility assumptions are both significant to the fair value measurement and unobservable. These embedded derivatives are included in Level 3 of the fair value hierarchy.

The following table presents a reconciliation of the beginning and ending balances of the Company's liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2017 and June 30, 2016:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Beginning Balance
 
$
355,612

 
$
133,229

 
$
336,862

 
$
82,024

Total loss recognized in earnings
 
63,948

 
31,441

 
82,698

 
82,646

Ending Balance
 
$
419,560

 
$
164,670

 
$
419,560

 
$
164,670



16



(10) Commitments and Contingencies
 
The Company has an operating lease covering its corporate office facility that expires in April 2021. The Company also has several additional operating leases related to offices in foreign countries with expiration dates ranging from 2017 through 2019. The following is a schedule of future minimum lease payments for all operating leases as of June 30, 2017
2017
$
976,176

2018
1,958,440

2019
1,611,627

2020
1,444,247

2021
491,020

Thereafter

 
$
6,481,510


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. For the three and six months ended June 30, 2017, the Company has not incurred any costs related to warranty obligations.
 
Under the terms of substantially all of its software license agreements, the Company indemnifies 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 guarantees. From time to time, in the ordinary course of business, the Company receives claims for indemnification, typically from OEMs. The Company is not currently aware of any material claims for indemnification.
 
Upon certain triggering events, such as bankruptcy, insolvency or a material adverse effect, failure to achieve minimum financial covenants or failure of the Company to issue shares upon conversion of the Series A redeemable convertible preferred stock in accordance with its obligations, the Series A redeemable convertible preferred stockholders may require the Company to redeem all or some of the Series A redeemable convertible preferred stock at a price equal to the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price as of the occurrence of the triggering event. On or after August 5, 2017, each Series A redeemable convertible preferred stockholder can require the Company to redeem its Series A redeemable convertible preferred stock in cash at a price equal to 100% of the stated value being redeemed plus accrued and unpaid dividends. As of December 31, 2016, the Company was not in compliance with the financial covenants of the Series A redeemable convertible preferred stock for two consecutive quarters, which provides the Series A redeemable convertible preferred stockholders the right to require the Company to redeem any of the Series A redeemable convertible preferred stock at the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price of the Company's common stock as of December 31, 2016. To date, the holders of the Series A redeemable convertible preferred stock have neither exercised nor waived this right and accordingly this right may be exercised at any time. As of June 30, 2017, the Company did not fail any non-financial covenants related to the Company's Series A redeemable convertible preferred stock.

On July 24, 2015, the Company entered into an Independent Marketing Agreement with RFN Prime Marketing Inc., to provide among other items, certain sales and marketing deliverables to the Company in exchange for up to 2.55 million shares of restricted Company common stock which was to be issued based on certain milestone achievements and/or transactions over a twenty-four month period. The Independent Marketing Agreement with RFN Prime Marketing Inc., was terminated effective March 31, 2017 and none of the performance milestones had been met, and therefore no restricted Company common stock was issued.


17



On July 24, 2015, the Company renewed its Employment Agreement (“Quinn Employment Agreement”) with Gary Quinn. Pursuant to the Quinn Employment Agreement, the Company agreed to continue to employ Mr. Quinn as President and Chief Executive Officer of the Company effective July 24, 2015, at an annual salary of $475,000 per annum, which will automatically renew every twelve (12) months unless either party gives notice to the other that it will not renew at least sixty (60) days prior to the end of the term. The Quinn Employment Agreement automatically renewed on July 24, 2016 for an additional twelve (12) months. Among other items, the Quinn Employment Agreement also provided for the grant of 500,000 restricted shares which vest 50% and 50% based upon the achievement of two predetermined milestones of the Company’s common stock closing trading price for ninety (90) consecutive trading days. The 500,000 restricted shares were granted to Mr. Quinn by the Company’s Compensation Committee on July 28, 2015. As of June 30, 2017, neither of the milestones related to this award have been met. Mr. Quinn resigned from all his positions with the Company effective July 1, 2017.

On July 1, 2017, Todd Oseth was appointed Chief Executive Officer of the Company. In connection with this appointment the Board of Director's approved an offer letter to Mr. Oseth (the "Offer Letter") which was executed on June 14, 2017. The Offer Letter provides that Mr. Oseth is entitled to receive an annualized base salary of $350,000. Mr. Oseth will also be eligible for an annual cash bonus of up to $227,500, subject to attainment of performance objectives to be mutually agreed upon and established. Pursuant to the offer letter, it is the intention of the Company to create an equity plan for all employees subject to stockholder approval, for up to 20% of the equity of the Company on a fully diluted basis at the time the equity plan is adopted following stockholder approval. Vesting of the equity issued under the plan would occur only upon a sale of the Company’s assets or capital stock at a premium to the valuation of the Company at the time the equity plan is adopted. Mr. Oseth’s employment can be terminated at will. If Mr. Oseth’s employment is terminated by the Company other than for cause he is entitled to receive severance equal to twelve (12) months of his base salary if (i) he has been employed by the Company for at least twelve (12) months at the time of termination or (ii) a change of control has occurred within six months of Mr. Oseth’s employment. Except as set forth in the preceding sentence, Mr. Oseth is entitled to receive severance equal to six (6) months of his base salary if he has been employed by the Company for less than six months and his employment was terminated by the Company without cause.

During the third quarter of 2013, the Company adopted a restructuring plan intended to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis (the “2013 Plan”).  In connection with the 2013 Plan, the Company eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. As of June 30, 2017, the restructuring accrual totaled $571,694. The 2013 Plan was substantially completed by December 31, 2014; however, the Company expects the majority of the remaining accrued severance related costs to be paid once final settlement litigation is completed, which can be at various times over the next three to twenty-four months.

In addition, as of June 30, 2017, the Company's liability for uncertain tax positions totaled $337,881. At this time, the settlement period for the positions, including related accrued interest, cannot be determined.
 
(11) Series A Redeemable Convertible Preferred Stock
 
On September 16, 2013, the Company issued to Hale Capital Partners, LP (“Hale”) 900,000 shares of the Company’s Series A redeemable convertible preferred stock, par value $0.001 per share, at a price of $10 per share, for an aggregate purchase consideration of $9.0 million, which was subsequently transferred to HCP-FVA LLC. Each share of Series A redeemable convertible preferred stock is convertible into common stock equivalents, at the option of the holder and upon certain mandatory conversion events described below, at a conversion rate of $1.02488 (as adjusted for stock splits, stock dividends, reverse stock splits, stock combinations, reclassifications and similar events). The Company received net proceeds of approximately $8.7 million from the issuance of the redeemable convertible preferred stock in 2013, net of transaction costs.

If the volume weighted average price of common stock for each trading day of any 60 consecutive trading days exceeds 250% of the conversion price and exceeds 225% of the conversion price through the conversion date, and certain equity conditions are met such that shares of common stock issued upon conversion can be immediately salable by the Series A redeemable convertible preferred stockholders, the Company can convert the Series A redeemable convertible preferred stock up to an amount equal to the greater of 25% of the daily trading volume for the 20 consecutive trading days immediately preceding the conversion date or the amount of an identified bona fide block trade at a price reasonably acceptable to the applicable Series A redeemable convertible preferred stockholder, but which price is not less than the arithmetic average of the weighted average prices of the common stock for the five trading days immediately preceding such sale.


18



The holder of the Series A redeemable convertible preferred stock has veto power over certain future financings, and certain rights to participate in any subsequent financing, whether through debt or equity (subject to certain exclusions). In addition, the Company's agreement with the holder of the Series A redeemable convertible preferred stock provide that if, at the time of certain future debt or equity financings, the proceeds of which exceed $5.0 million, the holder of the Series A redeemable convertible preferred stock still has outstanding Series A redeemable convertible preferred stock, then the Company must offer to repurchase their Series A redeemable convertible preferred stock. The holder of the Series A redeemable convertible preferred stock has the right to accept the offer or to retain their Series A redeemable convertible preferred stock. If the Company does a financing, and the holder of the Series A redeemable convertible preferred stock elects to have their Series A redeemable convertible preferred stock repurchased, then the capital raised in excess of $5.0 million will go to repurchase the holders’ Series A redeemable convertible preferred stock, instead of being able to be used for our business.

The Company cannot consummate a fundamental sale transaction in which the consideration is stock or a combination of cash and stock without the consent of the holder of the Series A redeemable convertible preferred stock.

In addition to the veto rights set forth in the preceding paragraph, upon consummation of a fundamental sale transaction in which the consideration is cash and is not approved by the holder of the Series A redeemable convertible preferred stock, the Series A redeemable convertible preferred stock shall be redeemed at a per share redemption price equal to the greater of (i) 250% of the stated value of the Series A redeemable convertible preferred stock (which is currently equal to $22.5 million or $2.56 per share of common stock held by the holder of the Series A redeemable convertible preferred stock on an as converted basis as of June 30, 2017) and (ii) the price such holder would receive in the transaction on an as converted basis. In addition in the event of the liquidation of the Company or a Fundamental Transaction of the Company (which includes a merger or sale of the Company), the holders of the Series A redeemable convertible preferred stock shall be entitled to receive from the proceeds of the transaction, prior to the holders of the Common Stock, an amount equal to 100% of the stated value plus accrued and unpaid dividends. The stated value and accrued and unpaid dividends of the Series A redeemable convertible preferred stock at June 30, 2017 is $9.6 million.

Upon certain triggering events, such as bankruptcy, insolvency or a material adverse effect, failure to achieve minimum financial covenants or failure of the Company to issue shares upon conversion of the Series A redeemable convertible preferred stock in accordance with its obligations, the Series A redeemable convertible preferred stockholder may require the Company to redeem all or some of the Series A redeemable convertible preferred stock at a price equal to the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price as of the occurrence of the triggering event. On or after August 5, 2017, each Series A redeemable convertible preferred stockholder can require the Company to redeem its Series A redeemable convertible preferred stock in cash at a price equal to 100% of the stated value being redeemed plus accrued and unpaid dividends. If the Company does not have the funds necessary to redeem the Series A redeemable convertible preferred stock, the dividends accruing on any outstanding Series A redeemable convertible preferred stock will increase to prime plus 10% (from prime plus 5%). For each six months that the Series A redeemable convertible preferred stock remains unredeemed, the dividend rate increases by 1%, subject to a maximum dividend rate of 19%. In addition, the Company's failure to redeem the Series A redeemable convertible preferred stock would be considered a “Breach Event” under the agreements with the holder of the Series A redeemable convertible preferred stock. If a Breach Event were to occur and the Company is in default under or has breached any provision in respect of its obligations to redeem the Series A redeemable convertible preferred stock, then, under the agreements with the holder of our Series A redeemable convertible preferred stock, the Company's Board of Directors would automatically be increased, with the holders of the Series A redeemable convertible preferred stock having the right to appoint the new directors, so that the holders of the Series A redeemable convertible preferred stock would have appointed a majority of the Board of Directors. This would give the holder of the Series A redeemable convertible preferred stock control of the Company. As of December 31, 2016, the Company was not in compliance with the financial covenants of the Series A redeemable convertible preferred stock for two consecutive quarters, which provides the Series A redeemable convertible preferred stockholder the right to require the Company to redeem any of the Series A redeemable convertible preferred stock at the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price of the Company's common stock as of December 31, 2016. To date, the holder of the Series A redeemable convertible preferred stock has neither exercised nor waived this right and accordingly this right may be exercised at any time. As of June 30, 2017, the Company did not fail any non-financial covenants related to the Company's Series A redeemable convertible preferred stock.


19



The holder of the Series A redeemable convertible preferred stock is entitled to receive quarterly dividends at the Prime Rate (Wall Street Journal Eastern Edition) plus 5% (up to a maximum amount of 10%), payable in cash, provided, that if the Company will not have at least $1.0 million in positive cash flow for any calendar quarter after giving effect to the payment of such dividends, the Company, at its election, can pay such dividends in whole or in part in cash, provided that cash flow from operations is not negative, and the remainder can be accrued or paid in common stock to the extent certain equity conditions are satisfied. As of December 31, 2016, March 31, 2017 and June 30, 2017, due to the lack of sufficient surplus to pay dividends as required by the DGCL, the Company was not permitted to pay the fourth quarter 2016 and first and second quarter 2017 dividends in cash or through the issuance of the Company's common stock and accrued the aforementioned dividends. As of June 30, 2017, the Company's liability for dividends to the holder of the Series A redeemable convertible preferred stock totaled $615,568.

Each share of Series A redeemable convertible preferred stock has a vote equal to the number of shares of common stock into which the Series A redeemable convertible preferred stock would be convertible as of the record date of September 13, 2013. The Company’s closing stock price on the record date was $1.23 per share, which results in voting power of an aggregate of 7,317,073 shares. In addition, holder of the Series A redeemable convertible preferred stock must approve certain actions, including any amendments to the Company's charter or bylaws that adversely affects the voting powers, preferences or other rights of the Series A redeemable convertible preferred stock; payment of dividends or distributions; any liquidation, capitalization, reorganization or any other fundamental transaction of the Company, other than as set forth above; issuance of certain equity securities senior to or in parity with the Series A redeemable convertible preferred stock as to dividend rights, redemption rights, liquidation preference and other rights; issuances of equity below the conversion price; incur any liens or borrowings other than non-convertible indebtedness from standard commercial lenders which does not exceed 80% of the Company’s accounts receivable; and the redemption or purchase of any capital stock of the Company.
 
The Company has classified the Series A redeemable convertible preferred stock as temporary equity in the financial statements as it is subject to redemption at the option of the holder under certain circumstances. As a result of the Company’s analysis of all the embedded conversion and put features within the Series A redeemable convertible preferred stock, the contingent redemption put options in the Series A redeemable convertible preferred stock were determined to not be clearly and closely related to the debt-type host and also did not meet any other scope exceptions for derivative accounting. Therefore the contingent redemption put options are being accounted for as derivative instruments and the fair value of these derivative instruments were bifurcated from the Series A redeemable convertible preferred stock and recorded as a liability. 

The fair value of these derivative instruments and the loss recorded on the change in the fair value of these derivative instruments, which was included in “Interest and other income, net” within the condensed consolidated statement of operations, for the three and six months ended June 30, 2017 and 2016, were as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Beginning Balance
 
$
355,612

 
$
133,229

 
$
336,862

 
$
82,024

Total loss recognized in earnings
 
63,948

 
31,441

 
82,698

 
82,646

Ending Balance
 
$
419,560

 
$
164,670

 
$
419,560

 
$
164,670



20



At the time of issuance the Company recorded transaction costs, a beneficial conversion feature and the fair value allocated to the embedded derivatives as discounts to the Series A redeemable convertible preferred stock. These costs were being accreted to the Series A redeemable convertible preferred stock using the effective interest method through the stated redemption date of August 5, 2017, which represents the earliest redemption date of the instrument. This accretion was accelerated as of December 31, 2016 due to the failure of the financial covenants and the redemption right of the holders as noted above. The Company included deductions for accretion and accrued dividends as adjustments to net loss attributable to common stockholders on the condensed consolidated statement of operations for the three and six months ended June 30, 2017 and 2016. The following represents a reconciliation of net loss attributable to common stockholders for the three and six months ended June 30, 2017 and 2016:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Net loss
 
$
(639,801
)
 
$
(3,534,882
)
 
$
(1,751,998
)
 
$
(7,831,494
)
Effects of Series A redeemable convertible preferred stock:
 
 

 
 

 
 

 
 

Less: Series A redeemable convertible preferred stock dividends
 
215,089

 
195,366

 
419,664

 
387,974

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 

 
170,981

 

 
334,650

Net loss attributable to common stockholders
 
$
(854,890
)
 
$
(3,901,229
)
 
$
(2,171,662
)
 
$
(8,554,118
)

(12) Accumulated Other Comprehensive Loss 

The changes in Accumulated Other Comprehensive (Loss) Income, net of tax, for the three months ended June 30, 2017 are as follows:
 
 
Foreign Currency
Translation
 
Net Unrealized Gains (Losses) on Marketable
Securities
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive (loss) income at March 31, 2017
 
$
(2,051,917
)
 
$

 
$
28,675

 
$
(2,023,242
)
Other comprehensive loss
 
 

 
 

 
 

 
 

Other comprehensive loss before reclassifications
 
5,433

 

 

 
5,433

Amounts reclassified from accumulated other comprehensive loss
 

 

 

 

Total other comprehensive loss
 
5,433

 

 

 
5,433

Accumulated other comprehensive (loss) income at June 30, 2017
 
$
(2,046,484
)
 
$

 
$
28,675

 
$
(2,017,809
)

21




The changes in Accumulated Other Comprehensive (Loss) Income, net of tax, for the six months ended June 30, 2017 are as follows:
 
 
Foreign Currency
Translation
 
Net Unrealized (Losses) Gains on Marketable
Securities
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive (loss) income at December 31, 2016
 
$
(1,866,388
)
 
$

 
$
28,675

 
$
(1,837,713
)
Other comprehensive (loss) income
 
 

 
 

 
 

 
 

Other comprehensive (loss) income before reclassifications
 
(180,096
)
 

 

 
(180,096
)
Amounts reclassified from accumulated other comprehensive (loss) income
 

 

 

 

Total other comprehensive (loss) income
 
(180,096
)
 

 

 
(180,096
)
Accumulated other comprehensive (loss) income at June 30, 2017
 
$
(2,046,484
)
 
$

 
$
28,675

 
$
(2,017,809
)

The changes in Accumulated Other Comprehensive (Loss) Income, net of tax, for the three months ended June 30, 2016 are as follows:
 
 
Foreign Currency
Translation
 
Net Unrealized
Gains (Losses) on Marketable
Securities
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive (loss) income at March 31, 2016
 
$
(1,954,409
)
 
$
633

 
$
30,362

 
$
(1,923,414
)
Other comprehensive (loss) income
 
 

 
 

 
 

 
 

Other comprehensive (loss) income before reclassifications
 
(334,161
)
 
(81
)
 
(550
)
 
(334,792
)
Amounts reclassified from accumulated other comprehensive (loss) income
 

 
(202
)
 
1,228

 
1,026

Total other comprehensive (loss) income
 
(334,161
)
 
(283
)
 
678

 
(333,766
)
Accumulated other comprehensive (loss) income at June 30, 2016
 
$
(2,288,570
)
 
$
350

 
$
31,040

 
$
(2,257,180
)
 
The changes in Accumulated Other Comprehensive (Loss) Income, net of tax, for the six months ended June 30, 2016 are as follows:
 
 
Foreign Currency
Translation
 
Net Unrealized (Losses) Gains on Marketable
Securities
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive (loss) income at December 31, 2015
 
$
(1,726,994
)
 
$
(3,406
)
 
$
27,186

 
$
(1,703,214
)
Other comprehensive (loss) income
 
 

 
 

 
 

 
 

Other comprehensive (loss) income before reclassifications
 
(561,576
)
 
2,513

 
1,423

 
(557,640
)
Amounts reclassified from accumulated other comprehensive (loss) income
 

 
1,243

 
2,431

 
3,674

Total other comprehensive (loss) income
 
(561,576
)
 
3,756

 
3,854

 
(553,966
)
Accumulated other comprehensive (loss) income at June 30, 2016
 
$
(2,288,570
)
 
$
350

 
$
31,040

 
$
(2,257,180
)


22



For the three and six months ended June 30, 2017, the amounts reclassified to net loss related to the Company’s defined benefit plan and maturity of marketable securities. These amounts are included within “Operating loss” within the condensed consolidated statements of operations.
 
(13) Stockholders' Equity

Stock Repurchase Activity
 
On April 22, 2015, the Company’s Board of Directors (the "Board") approved a new stock buy-back program (the "Repurchase Program"). The Repurchase Program authorizes management to repurchase in the aggregate up to five million shares of the Company's common stock. Repurchases may be made by the Company from time to time in open-market or privately-negotiated transactions as permitted by securities laws and other legal requirements, and subject to market conditions and other factors. The Repurchase Program superseded and replaced the Company's prior stock buy-back program. The Repurchase Program does not obligate the Company to make repurchases at any specific time or situation. The Company was required to obtain approvals from the Series A redeemable convertible preferred stockholders for the Repurchase Program. The Repurchase Program does not have an expiration date and may be amended or terminated by the Board at any time without prior notice.
 
During the three and six months ended June 30, 2017 and 2016, the Company did not repurchase any shares of its common stock. As of June 30, 2017, the Company had the authorization to repurchase 4,907,839 shares of its common stock based upon its judgment and market conditions.

(14)  Litigation
 
In view of the inherent difficulty of predicting the outcome of litigation, particularly where the claimants seek very large or indeterminate damages, the Company generally cannot predict what the eventual outcome of the pending matters will be, what the timing of the ultimate resolution of these matters will be, or what the eventual loss, fines or penalties related to each pending matter may be.
 
In accordance with the authoritative guidance issued by the FASB on contingencies, the Company accrues anticipated costs of settlement, damages and losses for claims to the extent specific losses are probable and estimable. The Company records a receivable for insurance recoveries when such amounts are probable and collectable. In such cases, there may be an exposure to loss in excess of any amounts accrued. If, at the time of evaluation, the loss contingency related to a litigation is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable and, the Company will expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, the Company will accrue the minimum amount of the range.

 Other Claims
 
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.
 
(15) Segment Reporting
 
The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenue from the United States to customers in the following geographical areas for the three and six months ended June 30, 2017 and 2016, and the location of long-lived assets as of June 30, 2017 and December 31, 2016, are summarized as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,

 
2017
 
2016
 
2017
 
2016
Revenue:
 
 
 
 
 
 
 
 
Americas
 
$
2,040,247

 
$
2,667,901

 
$
3,641,494

 
$
5,053,626

Asia Pacific
 
2,445,409

 
2,949,051

 
4,696,486

 
5,686,244

Europe, Middle East, Africa and Other
 
2,248,670

 
2,450,999

 
4,435,461

 
4,760,412

Total Revenue
 
$
6,734,326

 
$
8,067,951

 
$
12,773,441

 
$
15,500,282

 

23



 
 
June 30, 2017
 
December 31, 2016
Long-lived assets:
 
 
 
 
Americas
 
$
6,058,326

 
$
6,525,612

Asia Pacific
 
852,238

 
890,051

Europe, Middle East, Africa and Other
 
260,225

 
218,316

Total long-lived assets
 
$
7,170,789

 
$
7,633,979

 
For both the three and six months ended June 30, 2017, the Company had no customers that accounted for 10% or more of total revenue. For both the three and six months ended June 30, 2016, the Company had one customer, Hitachi Data Systems, that accounted for 11% of total revenue.

As of June 30, 2017, the Company had no customers that accounted for 10% or more of the gross accounts receivable balance. As of December 31, 2016, the Company had three customers, Datang Telecom International Technology Co., Ltd, Hitachi Data Systems and Huawei Technologies Co., Ltd, that accounted for 15%, 14% and 12%, respectively, of the gross accounts receivable balance.

(16) Restructuring Costs
 
In the third quarter of 2013, the Company adopted the 2013 Plan to better align the Company’s cost structure with the skills and resources required to more effectively execute the Company’s long-term growth strategy and to support revenue levels the Company expected to achieve on a go forward basis.  In connection with the 2013 Plan, the Company eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. The 2013 Plan was substantially completed by December 31, 2014; however, we expect the majority of the severance related costs to be paid once final settlement litigation is completed, which can be at various times over the next three to twenty-four months. The following table summarizes the activity during 2017 related to restructuring liabilities recorded in connection with the 2013 Plan:
 
 
Severance related costs
Balance at December 31, 2016
 
$
846,337

Provisions/Additions
 
(236,302
)
Utilized/Paid
 

Balance at March 31, 2017
 
$
610,035

Provisions/Additions
 

Utilized/Paid
 
(38,341
)
Balance at June 30, 2017
 
$
571,694

 
  
The severance related liabilities are included within “accrued expenses” in the accompanying condensed consolidated balance sheets. The expenses under the 2013 Plan are included within “restructuring costs” in the accompanying condensed consolidated statements of operations.


24



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

Over the past twenty-four months we continued to drive FreeStor® sales through our originally targeted routes to market which included OEMs, Managed Service Providers and Enterprise customers. We now have over 380 customers using our FreeStor platform, not including the customers of our MSP and OEM partners.
During 2017, we continued to innovate and enhance our FreeStor product. The latest enhancements were delivered in May 2017, including Quality of Service (QoS) capability, chargeback support, improved levels of robustness and performance in I/O Cluster and I/O Multi-Cluster failover, additional client agent management and monitoring, and the integration of Optimized Backup and Deduplication capability into FreeStor, allowing more efficient use of storage.

In June 2017, our Board of Directors, approved a comprehensive plan to increase operating performance (the “2017 Plan”). The 2017 Plan will result in a realignment and reduction in workforce. The 2017 Plan was substantially completed as of June 30, 2017 and we ended the quarter with 97 employees worldwide. These actions are anticipated to result in an annualized cost savings of approximately $10.0 million. In connection with the 2017 Plan, we incurred severance expense of $0.8 million. In making these changes, we prioritized customer support and development while consolidating operations and cutting direct sales resources, therefore allowing us to focus on its install base and develop more efficient market channels.

We ended the quarter with $1.6 million of cash and cash equivalents compared with $3.4 million at December 31, 2016. During the quarter net cash used in operating activities decreased to $1.6 million, compared with $3.8 million in the comparable prior year period. As discussed under "Liquidity and Capital Resources - Going Concern," our ability to continue as a going concern depends on our ability to increase revenue, further reduce expenses and/or obtain financing and there is no assurance that we will be able to accomplish any or all of these objectives.

Deferred revenue as of June 30, 2017 totaled $21.3 million, compared with $23.7 million as of December 31, 2016.

Overall, total revenue for the three months ended June 30, 2017 decreased 17% to $6.7 million, compared with $8.1 million in the prior year period. Revenue from our FreeStor platform increased $0.8 million; however, this increase was more than offset by a decrease of product revenue from our legacy products of $2.2 million for the three months ended June 30, 2017, compared with the comparable prior year period. We attribute the decline in total revenues to several factors. First, although we updated and introduced new versions of FreeStor and our point-solutions to address the needs of customers and the marketplace, the volume of new product licenses and maintenance sales, both for expansion of our existing installed base and in the acquisition of new customers declined from the prior year. Second, customer attrition continued which has decreased maintenance renewal revenue. Third, the level of customer deal elongation and customer indecisiveness to purchase in a timely manner as a result of customers working through their organizational purchasing strategies continues to provide significant headwinds for both the storage software industry and FalconStor.
Total cost of revenue for the three months ended June 30, 2017 decreased 24% to $1.8 million, compared with $2.3 million in the prior year period. Total gross profit decreased $0.8 million, or 14%, to $5.0 million for the three months ended June 30, 2017, compared with $5.7 million for the prior year period. Total gross margin increased to 74% for the three months ended June 30, 2017, compared with 71% for the prior year period. The decrease in our total gross profit was primarily due to the decrease in revenue and the increase in total gross margin was primarily due to the mix of sales and cost reduction initiatives. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales. Our FreeStor product is a subscription-based product offering and primarily sold as a software only solution, which we anticipate will continue to drive higher product gross margins in the future.

25



Overall, our total operating expenses for the three months ended June 30, 2017 decreased 41% to $5.5 million, compared with $9.4 million in the comparable prior year period. This decrease was primarily attributable to tighter expense controls and overall operational efficiencies which better align our current business plan on a run-rate basis. These efficiencies include among other items, stream-lined personnel related costs and global overhead costs and efficiencies realized on our redesigned go-to-market coverage models. Our worldwide headcount was 97 employees as of June 30, 2017, compared with 211 employees as of June 30, 2016.
Operating loss for the three months ended June 30, 2017 decreased to $0.5 million, compared with $3.6 million in the comparable prior year period. Included in our operating results for the three months ended June 30, 2017 and 2016 was severance expense of $0.8 million and $0.6 million, respectively.
RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED JUNE 30, 2017 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2016.
 
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations and their corresponding percentage of total revenue for the three months ended June 30, 2017 and 2016 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment.
 
 Three Months Ended June 30,
 
 Change
Period to Period
  
2017
 
2016
 
 Revenue:
  
 
 
 
  
 
 
 
 
 
 
 Product revenue
$
2,499,655

 
37
 %
 
$
2,939,594

 
36
 %
 
$
(439,939
)
 
(15
)%
 Support and services revenue
4,234,671

 
63
 %
 
5,128,357

 
64
 %
 
(893,686
)
 
(17
)%
 Total revenue
6,734,326

 
100
 %
 
8,067,951

 
100
 %
 
(1,333,625
)
 
(17
)%
 Cost of revenue:
  

 
 
 
  

 
 
 
 
 
 
 Product
351,969

 
5
 %
 
319,974

 
4
 %
 
31,995

 
10
 %
 Support and service
1,418,663

 
21
 %
 
1,999,125

 
25
 %
 
(580,462
)
 
(29
)%
 Total cost of revenue
1,770,632

 
26
 %
 
2,319,099

 
29
 %
 
(548,467
)
 
(24
)%
 Gross profit
4,963,694

 
74
 %
 
5,748,852

 
71
 %
 
(785,158
)
 
(14
)%
 Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 Research and development costs
2,025,132

 
30
 %
 
3,304,079

 
41
 %
 
(1,278,947
)
 
(39
)%
 Selling and marketing
2,109,599

 
31
 %
 
4,124,350

 
51
 %
 
(2,014,751
)
 
(49
)%
 General and administrative
1,345,343

 
20
 %
 
1,833,479

 
23
 %
 
(488,136
)
 
(27
)%
 Restructuring

 
 %
 
93,405

 
1
 %
 
(93,405
)
 
(100
)%
 Total operating expenses
5,480,074

 
81
 %
 
9,355,313

 
116
 %
 
(3,875,239
)
 
(41
)%
 Operating loss
(516,380
)
 
(8
)%
 
(3,606,461
)
 
(45
)%
 
3,090,081

 
(86
)%
 Interest and other (loss) income, net
(29,121
)
 
 %
 
237,251

 
3
 %
 
(266,372
)
 
*

Loss before income taxes
(545,501
)
 
(8
)%
 
(3,369,210
)
 
(42
)%
 
2,823,709

 
(84
)%
 Provision for income taxes
94,300

 
1
 %
 
165,672

 
2
 %
 
(71,372
)
 
(43
)%
 Net loss
$
(639,801
)
 
(10
)%
 
$
(3,534,882
)
 
(44
)%
 
$
2,895,081

 
(82
)%
Less: Accrual of Series A redeemable convertible preferred stock dividends
215,089

 
3
 %
 
195,366

 
2
 %
 
19,723

 
10
 %
Less: Accretion to redemption value of Series A redeemable convertible preferred stock

 
 %
 
170,981

 
2
 %
 
(170,981
)
 
(100
)%
Net loss attributable to common stockholders
$
(854,890
)
 
(13
)%
 
$
(3,901,229
)
 
(48
)%
 
$
3,046,339

 
(78
)%
 
 
 
 
 
 
 
 
 
 
 
 
* Not Meaningful
 
 
 
 
 
 
 
 
 
 
 


26



 Revenue

Our primary sales focus is on selling software solutions and platforms which includes stand-alone software applications, software integrated with industry standard hardware and sold as one complete integrated solution or sold on a subscription or consumption basis. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Total revenue for the three months ended June 30, 2017 decreased 17% to $6.7 million, compared with $8.1 million in the prior year period.

Product revenue
 
Product revenue is comprised of sales of both licenses for our software solutions and sales of the platforms on which the software is installed. This includes stand-alone software applications and software integrated with industry standard hardware, sold as one complete integrated solution or sold on a subscription or consumption basis. Our products are sold through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users. These revenues are recognized when all the applicable criteria under accounting principles generally accepted in the United States are met.

Product revenue for the three months ended June 30, 2017 decreased 15% to $2.5 million, compared with $2.9 million in the prior year period. Product revenue represented 37% and 36% of our total revenue for the three months ended June 30, 2017 and 2016, respectively. Product revenue from our FreeStor product increased $0.5 million; however, this increase was more than offset by a decrease of product revenue from our legacy products of $1.0 million for the three months ended June 30, 2017, compared with the prior year period. The overall decline in product revenue was primarily due to: (i) challenges in obtaining new customers and, (ii) a decrease in the volume of sales from our legacy product lines. Product revenue from our FreeStor product represented 47% and 24% of our total product revenue for the three months ended June 30, 2017 and 2016, respectively. Product revenue from our legacy products represented 53% and 76% of our total product revenue for the three months ended June 30, 2017 and 2016, respectively.

We continue to invest in our product portfolio by refreshing our existing product lines and developing our next generation of innovative product offerings to drive our sales volume in support of our long-term outlook.

Support and services revenue

Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenue 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 or over the contractual term if vendor-specific objective evidence ("VSOE") does not exist for all undelivered elements. Engineering services are recognized upon customer acceptance or over the remaining contract term if VSOE does not exist for the remaining deliverables upon acceptance. 

Support and services revenue for the three months ended June 30, 2017 decreased 17% to $4.2 million, compared with $5.1 million in the prior year period. Our maintenance and technical support service revenue results 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. During the three months ended June 30, 2017, maintenance and technical support services revenue was the primary driver of the decrease. Maintenance and technical support services revenue related to our legacy products decreased $1.2 million, primarily driven by customer attrition and the overall decline in product license sales over the past twelve to twenty-four months, partially offset by a $0.3 million increase in maintenance and technical support services revenue related to our FreeStor product. The conversion of existing customers using our legacy products to our Freestor subscription product has resulted and will continue to result in a shift of revenue from maintenance and technical support services revenue to product revenue.
 
Professional services revenue remained consistent at $0.2 million for the three months ended June 30, 2017 and 2016. Professional services revenue can vary from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.


27



Cost of Revenue, Gross Profit and Gross Margin

Total cost of revenue for the three months ended June 30, 2017 decreased 24% to $1.8 million, compared with $2.3 million in the prior year period. Total gross profit decreased $0.8 million, or 14%, to $5.0 million for the three months ended June 30, 2017, compared with $5.7 million for the prior year period. Total gross margin increased to 74% for the three months ended June 30, 2017, compared with 71% for the prior year period. The decrease in our total gross profit was primarily due to the decrease in revenue and the increase in total gross margin was primarily due to the mix of sales and cost reduction initiatives. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.

Cost of Product Revenue, Gross Profit and Gross Margin

Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of capitalized software and shipping and logistics costs. Cost of product revenue for the three months ended June 30, 2017 increased 10% to $0.4 million, compared with $0.3 million in the prior year period. Product gross margin decreased to 86% for the three months ended June 30, 2017, compared with 89% for the prior year period. The decrease in product gross margin was primarily attributable to a decrease in the percentage of our product revenue from sales of our stand-alone software applications, which have higher gross margins than sales of our fully integrated solutions with hardware appliances, compared with the prior year period.
 
Cost of Support and Service Revenue, Gross Profit and Gross Margin

Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts and training. Cost of support and service revenue for the three months ended June 30, 2017 decreased 29% to $1.4 million, compared with $2.0 million in the prior year period. Support and service gross margin increased to 66% for the three months ended June 30, 2017, compared with 61% for the prior year period, primarily attributable to a reduction in personnel related costs.

Operating Expenses

Our operating expenses for the three months ended June 30, 2017 decreased 41% to $5.5 million, compared with $9.4 million in the prior year period. This decrease was primarily attributable to tighter expense controls and overall operational efficiencies which better align our current business plan on a run-rate basis. These efficiencies include among other items, stream-lined personnel related costs and global overhead costs and efficiencies realized on our redesigned go-to-market coverage models. Our worldwide headcount was 97 employees as of June 30, 2017, compared with 211 employees as of June 30, 2016. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook and to take actions in areas of the Company that are not performing. Included in the operating results for the three months ended June 30, 2017 and 2016 was $0.1 million and $1.1 million of share-based compensation expense, respectively.

Research and Development Costs
 
Research and development costs consist primarily of personnel costs for product development, 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 $1.3 million, or 39%, to $2.0 million for the three months ended June 30, 2017, from $3.3 million in the prior year period. The decrease was primarily related to a decrease in personnel related costs, as we continue to allocate the appropriate level of resources based upon the product development roadmap schedule. We believe we continue 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 expenses for the three months ended June 30, 2017 and 2016 was $0.1 million and $0.8 million, respectively. Included in share-based compensation expense for the three months ended June 30, 2016 was $0.8 million related to costs associated with our exclusive source code license and development agreement which were paid through the issuance of our common stock.
 

28



Selling and Marketing
 
Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses decreased $2.0 million, or 49%, to $2.1 million for the three months ended June 30, 2017, from $4.1 million in the prior year period. The decrease in selling and marketing expenses was primarily attributable to a decrease in personnel related costs including a decrease in our sales and marketing headcount as we continue to optimize our go-to-market coverage models around the world. Share-based compensation expense included in selling and marketing expenses for the three months ended June 30, 2017 and 2016 was less than $0.1 million and $0.1 million, 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 decreased $0.5 million or 27%, to $1.3 million for the three months ended June 30, 2017, from $1.8 million in the prior year period. The decrease in general and administrative expenses was primarily attributable to continuing to optimize personnel costs, professional fees and other various general and administrative costs within the Company. Share-based compensation expense included in general and administrative expenses for the three months ended June 30, 2017 and 2016 was less than $0.1 million and $0.2 million, respectively.

Restructuring
 
In the third quarter of 2013, we adopted a restructuring plan intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy and to support revenue levels we expect to achieve on a go forward basis. In connection with the 2013 Plan, we eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. There were no restructuring expense for the three months ended June 30, 2017, compared with costs incurred of $0.1 million in the prior year period. For further information, refer to Note (16) Restructuring Costs, to our unaudited condensed consolidated financial statements.

Interest and other (loss) income, net
 
Interest and other (loss) income, net, decreased $0.3 million to a loss of less than $0.1 million for the three months ended June 30, 2017, compared with income of $0.2 million in the prior year period. The fluctuation in interest and other (loss) income from quarter to quarter relates to foreign currency gains and losses, interest income, sublease income and the change in our embedded derivatives.

Income Taxes
 
Our provision for income taxes consists of federal, state and local, and foreign taxes. For the three months ended June 30, 2017 and 2016, the Company recorded an income provision of $0.1 million and $0.2 million, respectively. Our domestic deferred tax assets are not realizable on a more-likely-than-not basis and, therefore, we have recorded a full valuation allowance against our domestic deferred tax assets. During the three months ended June 30, 2017, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our expected net domestic deferred tax assets for the full year 2017 estimated annual effective tax rate.


29



RESULTS OF OPERATIONS – FOR THE SIX MONTHS ENDED JUNE 30, 2017 COMPARED WITH THE SIX MONTHS ENDED JUNE 30, 2016.
 
The following table presents revenue and expense line items reported in our Consolidated Statements of Operations and their corresponding percentage of total revenue for the six months ended June 30, 2017 and 2016 and the period-over-period dollar and percentage changes for those line items. Our results of operations are reported as one business segment, represented by our single operating segment.
 
Six Months Ended June 30,
 
 Change
Period to Period
  
2017
 
2016
 
 Revenue:
 
 
 
 
 
 
 
 
 
 
 
 Product revenue
$
4,420,707

 
35
 %
 
$
5,220,452

 
34
 %
 
$
(799,745
)
 
(15
)%
 Support and services revenue
8,352,734

 
65
 %
 
10,279,830

 
66
 %
 
(1,927,096
)
 
(19
)%
 Total revenue
12,773,441

 
100
 %
 
15,500,282

 
100
 %
 
(2,726,841
)
 
(18
)%
 Cost of revenue:
  

 
 
 
  

 
 
 
 
 
 
 Product
550,684

 
4
 %
 
564,247

 
4
 %
 
(13,563
)
 
(2
)%
 Support and service
2,672,579

 
21
 %
 
3,761,345

 
24
 %
 
(1,088,766
)
 
(29
)%
 Total cost of revenue
3,223,263

 
25
 %
 
4,325,592

 
28
 %
 
(1,102,329
)
 
(25
)%
 Gross profit