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EX-32.2 - EXHIBIT 32.2 - FALCONSTOR SOFTWARE INCex322-q22020.htm
EX-32.1 - EXHIBIT 32.1 - FALCONSTOR SOFTWARE INCex321-q22020.htm
EX-31.2 - EXHIBIT 31.2 - FALCONSTOR SOFTWARE INCex312-q22020.htm
EX-31.1 - EXHIBIT 31.1 - FALCONSTOR SOFTWARE INCex311-q22020.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, 2020
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.)
 
 
701 Brazos Street, Suite 400, Austin, TX
78701
(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)

Securities registered pursuant to Section 12(b) of the Act: None.
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 every Interactive Data File required to be submitted 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 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 x
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, 2020 was 5,919,837.
.




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


3



PART I.  FINANCIAL INFORMATION
Item 1. Financial Statements
 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
June 30, 2020
 
December 31, 2019
 
 
(unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
1,514,351

 
$
1,475,166

Accounts receivable, net of allowances
 
1,856,839

 
3,406,550

Prepaid expenses and other current assets
 
1,892,842

 
2,252,372

Contract assets
 
423,556

 
749,515

Inventory
 
14,571

 
30,014

Total current assets
 
5,702,159

 
7,913,617

Property and equipment, net of accumulated depreciation and amortization
 
278,345

 
369,273

Operating lease right-of-use assets, net
 
1,155,028

 
1,842,254

Deferred tax assets, net
 
258,985

 
258,841

Software development costs, net
 
22,577

 
27,012

Other assets
 
923,275

 
829,335

Goodwill
 
4,150,339

 
4,150,339

Other intangible assets, net
 
91,463

 
57,718

Long-term contract assets
 
254,397

 
327,757

Total assets
 
$
12,836,568

 
$
15,776,146

Liabilities and Stockholders' Deficit
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
696,459

 
$
1,302,290

Accrued expenses
 
2,309,524

 
2,533,824

Current portion of lease liabilities
 
1,438,448

 
1,655,522

Short-term loan, net of debt issuance costs and discounts
 
1,812,210

 
947,501

Deferred revenue
 
2,926,017

 
5,270,190

Total current liabilities
 
9,182,658

 
11,709,327

Other long-term liabilities
 
688,441

 
745,254

Notes payable, net of debt issuance costs and discounts
 
3,113,267

 
2,906,133

Operating lease liabilities, net of current portion
 
31,507

 
624,859

Deferred tax liabilities, net of current portion
 
432,301

 
432,520

Deferred revenue, net of current portion
 
2,442,373

 
2,085,080

Total liabilities
 
15,890,547

 
18,503,173

Commitments and contingencies (Note 11)
 


 


Series A redeemable convertible preferred stock, $.001 par value, 2,000,000 shares authorized, 900,000 shares issued and outstanding, redemption value of $12,809,039 and $12,262,685, respectively
 
12,041,865

 
11,304,279

Stockholders' deficit:
 
 

 
 

Common stock - $.001 par value, 30,000,000 shares authorized, 5,919,837 shares and 5,918,733 shares issued and outstanding, respectively
 
5,920

 
5,919

Additional paid-in capital
 
110,997,871

 
111,727,888

Accumulated deficit
 
(124,185,135
)
 
(123,871,853
)
Accumulated other comprehensive loss, net
 
(1,914,500
)
 
(1,893,260
)
Total stockholders' deficit
 
(15,095,844
)
 
(14,031,306
)
Total liabilities and stockholders' deficit
 
$
12,836,568

 
$
15,776,146

See accompanying notes to unaudited condensed consolidated financial statements.

4



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

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Revenue:
 
 
 
 
 
 
 
 
Product revenue
 
$
1,632,055

 
$
1,470,430

 
$
2,681,018

 
$
3,216,214

Support and services revenue
 
1,867,557

 
2,528,959

 
3,998,781

 
5,276,153

Total revenue
 
3,499,612

 
3,999,389

 
6,679,799

 
8,492,367

Cost of revenue:
 


 
 

 
 

 
 

Product
 
61,830

 
755,796

 
201,290

 
835,470

Support and service
 
334,396

 
537,105

 
742,316

 
1,107,590

Total cost of revenue
 
396,226

 
1,292,901

 
943,606

 
1,943,060

Gross profit
 
3,103,386

 
2,706,488

 
5,736,193

 
6,549,307

Operating expenses:
 
 

 
 

 
 

 
 

Research and development costs
 
534,000

 
764,276

 
1,208,924

 
1,720,847

Selling and marketing
 
1,019,940

 
1,296,909

 
2,001,131

 
2,369,347

General and administrative
 
845,581

 
1,397,886

 
1,938,750

 
2,826,085

Restructuring costs
 
153,685

 
202,679

 
441,145

 
360,372

Total operating expenses
 
2,553,206

 
3,661,750

 
5,589,950

 
7,276,651

Operating income (loss)
 
550,180

 
(955,262
)
 
146,243

 
(727,344
)
Interest and other expense
 
(180,249
)
 
(80,217
)
 
(426,088
)
 
(345,456
)
Income (loss) before income taxes
 
369,931

 
(1,035,479
)
 
(279,845
)
 
(1,072,800
)
Income tax expense (benefit)
 
(36,627
)
 
136,244

 
33,437

 
223,830

Net income (loss)
 
$
406,558

 
$
(1,171,723
)
 
$
(313,282
)
 
$
(1,296,630
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
260,595

 
256,553

 
546,355

 
503,580

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
165,141

 
134,223

 
191,231

 
263,462

Net income (loss) attributable to common stockholders
 
$
(19,178
)
 
$
(1,562,499
)
 
$
(1,050,868
)
 
$
(2,063,672
)
Basic net income (loss) per share attributable to common stockholders
 
$
0.00

 
$
(0.27
)
 
$
(0.18
)
 
$
(0.35
)
Diluted net income (loss) per share attributable to common stockholders
 
$
0.00

 
$
(0.27
)
 
$
(0.18
)
 
$
(0.35
)
Weighted average basic shares outstanding
 
5,919,837

 
5,879,225

 
5,919,740

 
5,875,907

Weighted average diluted shares outstanding
 
5,919,837

 
5,879,225

 
5,919,740

 
5,875,907


See accompanying notes to unaudited condensed consolidated financial statements.


5



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

 
 
Three Months Ended June 30,
Six Months Ended June 30,
 
 
2020
 
2019
2020
 
2019
Net income (loss)
 
$
406,558

 
$
(1,171,723
)
$
(313,282
)
 
$
(1,296,630
)
Other comprehensive income (loss), net of applicable taxes
 
 

 
 

 

 
 

Foreign currency translation
 
(8,087
)
 
(49,410
)
(21,240
)
 
(30,018
)
Total other comprehensive income (loss), net of applicable taxes:
 
(8,087
)
 
(49,410
)
(21,240
)
 
(30,018
)
Total comprehensive income (loss)
 
$
398,471

 
$
(1,221,133
)
$
(334,522
)
 
$
(1,326,648
)
Less: Accrual of Series A redeemable convertible preferred stock dividends
 
260,595

 
256,553

546,355

 
503,580

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
165,141

 
134,223

191,231

 
263,462

Total comprehensive income (loss) attributable to common stockholders
 
$
(27,265
)
 
$
(1,611,909
)
$
(1,072,108
)
 
$
(2,093,690
)

See accompanying notes to unaudited condensed consolidated financial statements.


6



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
(UNAUDITED)


 
 
Common Stock Outstanding
 
Common Stock
 
Additional Paid-In Capital
 
Accumulated Deficit
 
Accumulated Other Comprehensive Loss, Net
 
Total Stockholders' Deficit
Balance at January 1, 2020
 
5,918,733

 
$
5,919

 
$
111,727,888

 
$
(123,871,853
)
 
$
(1,893,260
)
 
$
(14,031,306
)
Net income (loss)
 
 
 
 
 
 
 
(719,840
)
 
 
 
(719,840
)
Restricted stock issued
 
1,104

 
1

 
(1
)
 
 
 
 
 

Share-based compensation to employees
 
 
 
 
 
4,510

 
 
 
 
 
4,510

Accretion of Series A redeemable convertible preferred stock
 
 
 
 
 
(26,090
)
 
 
 
 
 
(26,090
)
Dividends on Series A redeemable convertible preferred stock
 
 
 
 
 
(285,760
)
 
 
 
 
 
(285,760
)
Foreign currency translation
 
 
 
 
 
 
 
 
 
(13,153
)
 
(13,153
)
Balance at March 31, 2020
 
5,919,837

 
$
5,920

 
$
111,420,547

 
$
(124,591,693
)
 
$
(1,906,413
)
 
$
(15,071,639
)
Net income (loss)
 
 
 
 
 
 
 
$
406,558

 
 
 
$
406,558

Share-based compensation to employees
 
 
 
 
 
$
3,060

 
 
 
 
 
$
3,060

Accretion of Series A redeemable convertible preferred stock
 
 
 
 
 
$
(165,141
)
 
 
 
 
 
$
(165,141
)
Dividends on Series A redeemable convertible preferred stock
 
 
 
 
 
$
(260,595
)
 
 
 
 
 
$
(260,595
)
Foreign currency translation
 
 
 
 
 
 
 
 
 
$
(8,087
)
 
$
(8,087
)
Balance at June 30, 2020
 
5,919,837

 
$
5,920

 
$
110,997,871

 
$
(124,185,135
)
 
$
(1,914,500
)
 
$
(15,095,844
)

7



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
(UNAUDITED)


 
 
Common Stock Outstanding
 
Common Stock
 
Additional Paid-In Capital
 
Accumulated Deficit
 
Accumulated Other Comprehensive Loss, Net
 
Total Stockholders' Deficit
Balance at January 1, 2019
 
5,872,552

 
$
5,873

 
$
113,243,227

 
$
(122,119,899
)
 
$
(1,895,102
)
 
$
(10,765,901
)
Net income (loss)
 
 
 
 
 
 
 
(124,907
)
 
 
 
(124,907
)
Share-based compensation to employees
 
 
 
 
 
9,251

 
 
 
 
 
9,251

Accretion of Series A redeemable convertible preferred stock
 
 
 
 
 
(129,239
)
 
 
 
 
 
(129,239
)
Dividends on Series A redeemable convertible preferred stock
 
 
 
 
 
(247,027
)
 
 
 
 
 
(247,027
)
Foreign currency translation
 
 
 
 
 
 
 
 
 
19,392

 
19,392

Balance at March 31, 2019
 
5,872,552

 
$
5,873

 
$
112,876,212

 
$
(122,244,806
)
 
$
(1,875,710
)
 
$
(11,238,431
)
Net income (loss)
 
 
 
 
 
 
 
$
(1,171,723
)
 
 
 
$
(1,171,723
)
Share-based compensation to employees
 
 
 
 
 
$
16,231

 
 
 
 
 
$
16,231

Warrants exercised
 
15,181

 
$
15

 
$
(15
)
 
 
 
 
 
$

Accretion of Series A redeemable convertible preferred stock
 
 
 
 
 
$
(134,223
)
 
 
 
 
 
$
(134,223
)
Dividends on Series A redeemable convertible preferred stock
 
 
 
 
 
$
(256,553
)
 
 
 
 
 
$
(256,553
)
Foreign currency translation
 
 
 
 
 
 
 
 
 
$
(49,410
)
 
$
(49,410
)
Balance at June 30, 2019
 
5,887,733

 
$
5,888

 
$
112,501,652

 
$
(123,416,529
)
 
$
(1,925,120
)
 
$
(12,834,109
)



8



FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
Six Months Ended June 30,
 
 
2020
 
2019
Cash flows from operating activities:
 
 
 
 
Net income (loss)
 
$
(313,282
)
 
$
(1,296,630
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 

 
 

Depreciation and amortization
 
97,065

 
223,783

Amortization of debt discount on notes payable
 
317,843

 
110,913

Amortization of right of use assets
 
687,226

 
437,384

Share-based payment compensation
 
7,570

 
25,482

Provision for (recovery of) returns and doubtful accounts
 
(81,244
)
 
29,346

Deferred income taxes (benefit)
 

 

Changes in operating assets and liabilities:
 
 

 
 

Accounts receivable
 
1,628,983

 
1,915,823

Prepaid expenses and other current assets
 
277,525

 
181,764

Contract assets
 
399,320

 
92,724

Inventory
 
14,571

 
(90,045
)
Other assets
 
(7,160
)
 
(551,582
)
Accounts payable
 
(605,831
)
 
527,623

Accrued expenses and other long-term liabilities
 
(298,558
)
 
(262,193
)
Operating lease liabilities
 
(810,426
)
 
(568,539
)
Deferred revenue
 
(1,988,705
)
 
(699,893
)
Net cash provided by (used in) operating activities
 
(675,103
)
 
75,960

Cash flows from investing activities:
 
 

 
 

Purchases of property and equipment
 

 
(179,048
)
Security deposits
 

 
(6,398
)
Purchase of intangible assets
 
(35,655
)
 
(41,736
)
Net cash provided by (used in) investing activities
 
(35,655
)
 
(227,182
)
Cash flows from financing activities:
 
 

 
 

Proceeds from issuance of PPP loan
 
754,000

 

Payments of long term-debt
 

 
(489,321
)
Net cash provided by (used in) financing activities
 
754,000

 
(489,321
)
Effect of exchange rate changes on cash and cash equivalents
 
(4,057
)
 
(18,181
)
Net increase (decrease) in cash and cash equivalents
 
39,185

 
(658,724
)
Cash and cash equivalents, beginning of period
 
1,475,166

 
3,059,677

Cash and cash equivalents, end of period
 
$
1,514,351

 
$
2,400,953

Supplemental disclosures:
 
 

 
 

Cash paid for interest
 
$
110,708

 
$
119,040

Non-cash investing and financing activities:
 
 

 
 

Undistributed Series A redeemable convertible preferred stock dividends
 
$
546,355

 
$
503,580

Accretion of Series A redeemable convertible preferred stock
 
$
191,231

 
$
263,462


See accompanying notes to unaudited condensed consolidated financial statements.

9



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" or "FalconStor"), 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) Liquidity

As of June 30, 2020, the Company had a working capital deficiency of $3.5 million, which is inclusive of current deferred revenue of $2.9 million, and a stockholders' deficit of $15.1 million. During the six months ended June 30, 2020, the Company had a net loss of $0.3 million and negative cash flow from operations of $0.7 million. The Company's total cash balance at June 30, 2020 was $1.5 million, an increase of $39,185 compared to December 31, 2019. On April 28, 2020, the Company entered into a loan with Peapack-Gladstone Bank in an aggregate principal amount of $754,000 (the "Loan"), pursuant to the Paycheck Protection Program (the "PPP") under the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act").

The Company's ability to continue as a going concern for the next twelve months, depends on its ability to execute its business plan, increase revenue and billings and reduce expenditures. In the third quarter of 2019, the Company adopted a 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 (the "2019 Plan"). In connection with the 2019 Plan, the Company eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. As of June 30, 2020, the 2019 Plan is considered to be substantially completed.

On December 27, 2019, the Company entered into Amendment No. 1 to Amended and Restated Term Loan Credit Agreement (the “Amendment”), by and among the Company, certain of the Company’s affiliates in their capacities as guarantors, HCP-FVA, LLC (“HCP-FVA”) as administrative agent for the lenders party thereto (the “Lenders”), ESW Capital, LLC (“ESW”), as co-agent, and the Lenders, to provide for, among other things, a new $2,500,000 term loan facility to the Company (the “2019 Term Loan”). The Amendment also provides for certain financial covenants. On December 27, 2019, the Company drew down $1,000,000 of the 2019 Term Loan and the Company will pay a fixed amount of interest on such advance equal to 15% of the principal amount advanced.

In connection with the initial advance of the 2019 Term Loan, HCP-FVA funded $620,000, ESW funded $378,439 and Michael Kelly funded $1,561. HCP-FVA is an affiliate of Hale Capital Partners, LP ("Hale Capital"), the Company’s largest stockholder, and an affiliate of a director of the Company, Martin Hale. ESW is a greater than 5% stockholder of the Company and Mr. Kelly is a director of the Company.

Given the commercial uncertainty caused by the novel coronavirus pandemic, or COVID-19, the Company developed and implemented an even more aggressive expense control plan in March 2020, that it is prepared to keep in place for the remainder of 2020. This plan reduces the Company's annual cash expense run rate by $4.0 million or 29%. The Company has furloughed 21 positions worldwide, and 4 of these positions were reinstated in the second quarter of 2020. We believe the reduced expense level will enable FalconStor to remain profitable during the remainder of 2020, even with continued revenue challenges throughout.

There is no assurance that the Company will be successful in generating sufficient bookings, billings, revenue or continue to reduce operating costs or 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. Subject to the foregoing, management believes that, based on projected cash flows and additional financing, the Company will have sufficient capital and liquidity to fund its operations for at least one year from the date of issuance of the accompanying interim financial statements.
We believe that our cash flows from operations and existing cash on hand are sufficient to conduct our planned operations and meet our contractual requirements through August 5, 2021.

(c) Impact of the COVID-19 Pandemic

10



We are closely monitoring the impact of COVID-19, on all aspects of our business. In March 2020, the World Health Organization characterized COVID-19 as a pandemic and the President of the United States declared the COVID-19 outbreak a national emergency. Since then, the COVID-19 pandemic has rapidly spread across the globe and has already resulted in significant volatility, uncertainty and economic disruption. The outbreak of COVID-19 has caused and may continue to cause travel bans or disruptions, and in some cases, prohibitions of non-essential activities, disruption and shutdown of businesses and greater uncertainty in global financial markets. The impact of COVID-19 is fluid and uncertain, but it has caused and may continue to cause various negative effects, including an inability to meet with actual or potential customers, our end customers deciding to delay or abandon their planned purchases or failing to make payments, and delays or disruptions in our or our partners’ supply chains. As a result, we may experience extended sales cycles, our ability to close transactions with new and existing customers and partners may be negatively impacted, our ability to recognize revenue from software transactions we do close may be negatively impacted, our demand generation activities, and the efficiency and effect of those activities, may be negatively affected, and it has been and, until the COVID-19 outbreak is contained, will continue to be more difficult for us to forecast our operating results. These uncertainties have, and may continue to, put pressure on global economic conditions and overall IT spending and may cause our end customers to modify spending priorities or delay or abandon purchasing decisions, thereby lengthening sales cycles and potentially lowering prices for our solutions, and may make it difficult for us to forecast our sales and operating results and to make decisions about future investments, any of which could materially harm our business, operating results and financial condition.
Further, our management team is focused on addressing the impacts of COVID-19 on our business, which has required and will continue to require, a large investment of their time and resources and may distract our management team or disrupt our 2020 operating plans. The extent to which COVID-19 ultimately impacts our results of operations, cash flow and financial position will depend on future developments, which are uncertain and cannot be predicted, including, but not limited to, the duration and spread of the outbreak, its severity, the actions taken by governments and authorities to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. Even after the COVID-19 pandemic has subsided, we may continue to experience materially adverse impacts to our business as a result of its global economic impact, including as a result of any recession that may occur.

(d)  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.
 
(e)  Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("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. During the first quarter of 2018, the Company also had significant estimates in the determination of the fair value of Series A Preferred Stock, notes payable and warrants issued. 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.
 
(f)  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, 2020, and the results of its operations for the three and six months ended June 30, 2020 and 2019. 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, 2019 ("2019 Form 10-K").

11




(g)  Recently Issued Accounting Pronouncements

In August 2018, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2018-14, Compensation—Retirement Benefits—Defined Benefit Plans—General: Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans. The objective of the guidance is to improve the effectiveness of disclosure requirements on defined benefit pension plans and other postretirement plans. The guidance is effective for fiscal years beginning after December 15, 2020. The Company does not expect adoption of the new standard to have a material impact on its condensed consolidated financial statements.

In December 2019, the FASB released ASU 2019-12, which affects general principles within Topic 740, Income Taxes. The amendments of ASU 2019-12 are meant to simplify and reduce the cost of accounting for income taxes. The amendments in ASU 2019-12 are effective for public business entities for fiscal years beginning after December 15, 2020, including interim periods therein. Early adoption of the standard is permitted, including adoption in interim or annual periods for which financial statements have not yet been issued. The Company does not expect adoption of the new standard to have a material impact on its condensed consolidated 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 2019 Form 10-K. There have been no significant changes in the Company's significant accounting policies since December 31, 2019, other than those noted below. For a description of the Company's other significant accounting policies refer to the 2019 Form 10-K.

Revenue from Contracts with Customers and Associated Balances

Nature of Products and Services

Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. Revenue allocated to software maintenance and support services is recognized ratably over the contractual support period.

Hardware products consist primarily of servers and associated components and function independently of the software products and as such are accounted for as separate performance obligations. Revenue allocated to hardware maintenance and support services is recognized ratably over the contractual support period.

Professional services are primarily related to software implementation services and associated revenue is recognized upon customer acceptance.

Contract Balances

Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a contract asset or receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For perpetual licenses with multi-year product maintenance agreements, the Company generally invoices customers at the beginning of the coverage period. For multi-year subscription licenses, the Company generally invoices customers annually at the beginning of each annual coverage period. The Company records a contract asset related to revenue recognized for multi-year on-premises licenses as its right to payment is conditioned upon providing product support and services in future years.

As of June 30, 2020 and December 31, 2019, accounts receivable, net of allowance for doubtful accounts, was $1.9 million and $3.4 million, respectively. As of June 30, 2020 and December 31, 2019, short and long-term contract assets, net of allowance for doubtful accounts, was $0.7 million and $1.1 million, respectively.

Deferred revenue is comprised mainly of unearned revenue related maintenance and technical support on term and perpetual licenses. Maintenance and technical support revenue is recognized ratably over the coverage period. Deferred revenue also includes contracts for professional services to be performed in the future which are recognized as revenue when the Company delivers the related service pursuant to the terms of the customer arrangement.


12



Changes in deferred revenue were as follows:
Six Months Ended June 30, 2020
 
Balance at December 31, 2019
$
7,355,270

   Deferral of revenue
4,686,038

   Recognition of revenue
(6,679,799
)
   Change in reserves
6,881

Balance at June 30, 2020
$
5,368,390


Deferred revenue includes invoiced revenue allocated to remaining performance obligations that has not yet been recognized and will be recognized as revenue in future periods. Deferred revenue was $5.4 million as of June 30, 2020, of which the Company expects to recognize approximately 55% of such amount as revenue over the next 12 months and the remainder thereafter.

Approximately $2.2 million of revenue is expected to be recognized from remaining performance obligations for unbilled support and services as of June 30, 2020. We expect to recognize revenue on approximately 43% of these remaining performance obligations over the next twelve months, with the balance recognized thereafter.

Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 90 days. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined its contracts generally do not include a significant financing component. The primary purpose of the Company’s invoicing terms is to provide customers with simplified and predictable ways of purchasing its products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with maintenance and support revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with product revenue recognized upon delivery.
Significant Judgments
The Company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.
Judgment is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. For products and services aside from maintenance and support, the Company estimates SSP by adjusting the list price by historical discount percentages. SSP for software and hardware maintenance and support fees is based on the stated percentages of the fees charged for the respective products.
The Company’s perpetual and term software licenses have significant standalone functionality and therefore revenue allocated to these performance obligations are recognized at a point in time upon electronic delivery of the download link and the license keys.
Product maintenance and support services are satisfied over time as they are stand-ready obligations throughout the support period. As a result, revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract.
Revenues associated with professional services are recognized at a point in time upon customer acceptance.
Disaggregation of Revenue
Please refer to the condensed consolidated statements of operations and Note (16), Segment Reporting and Concentrations, for discussion on revenue disaggregation by product type and by geography. The Company believes this level of disaggregation sufficiently depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected by economic factors.

Assets Recognized from Costs to Obtain a Contract with a Customer

The Company recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the benefit of those costs to be longer than one year. The Company has determined that its sales commission program meets the requirements for cost capitalization. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets on our consolidated balance sheets. The Company applies a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less.

13




Leases

We have entered into operating leases for our various facilities. We determine if an arrangement is a lease at inception. Operating leases are included in Right-of-Use ("ROU") assets, and lease liability obligations in our condensed consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liability obligations represent our obligation to make lease payments arising from the lease. ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. We have lease agreements with lease and non-lease components and account for such components as a single lease component. As most of our leases do not provide an implicit rate, we estimated our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. We use the implicit rate when readily determinable. The ROU asset also includes any lease payments made and excludes lease incentives and lease direct costs. Our lease terms may include options to extend or terminate the lease. Such extended terms have been considered in determining the ROU assets and lease liability obligations when it is reasonably certain that we will exercise that option. Lease expense is recognized on a straight-line basis over the lease term.

Right of Use Assets and Liabilities

We have various operating leases for office facilities that expire through 2021. Below is a summary of our ROU assets and liabilities as of June 30, 2020.

Right of use assets
$
1,155,028

Lease liability obligations, current
1,438,448

Lease liability obligations, less current portion
31,507

Total lease liability obligations
$
1,469,955

Weighted-average remaining lease term
0.89

Weighted-average discount rate
6.03
%

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2020
 
2019
 
2020
 
2019
Components of lease expense:
 
 
 
 
 
 
 
Operating lease cost
$
352,688

 
$
416,508

 
$
782,402

 
$
834,273

Sublease income
(73,314
)
 
(155,944
)
 
(148,628
)
 
(311,888
)
Net lease cost
$
279,374

 
$
260,564

 
$
633,774

 
$
522,385


During the three months ended June 30, 2020 and 2019, operating cash flows from operating leases was approximately $378,392 and $494,243, respectively. During the six months ended June 30, 2020 and 2019, operating cash flows from operating leases was approximately $757,926 and $995,712, respectively.

Approximate future minimum lease payments for our ROU assets over the remaining lease periods as of June 30, 2020, are as follows:
Remainder of 2020
850,408

2021
639,526

Total minimum lease payments
1,489,934

Less interest
(19,979
)
Present value of lease liabilities
1,469,955




14



(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, warrants and the Series A Redeemable Convertible Preferred Stock ("Series A 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, 2020 and 2019:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Stock options and restricted stock
 
1,200,261

 
11,855

 
1,200,261

 
11,855

Series A redeemable convertible preferred stock
 
87,815

 
87,815

 
87,815

 
87,815

Total anti-dilutive common stock equivalents
 
1,288,076

 
99,670

 
1,288,076

 
99,670


(4) Property and Equipment

The gross carrying amount and accumulated depreciation of property and equipment as of June 30, 2020 and December 31, 2019 are as follows:
 
 
June 30, 2020
 
December 31, 2019
Gross carrying amount
 
$
18,734,145

 
$
18,735,885

Accumulated depreciation
 
(18,455,800
)
 
(18,366,612
)
Property and Equipment, net
 
$
278,345

 
$
369,273


For the three months ended June 30, 2020 and 2019, depreciation expense was $44,778 and $61,612, respectively. For the six months ended June 30, 2020 and 2019, depreciation expense was $90,721 and $133,826, respectively.

(5) Software Development Costs

The gross carrying amount and accumulated amortization of software development costs as of June 30, 2020 and December 31, 2019 are as follows:
 
 
June 30, 2020
 
December 31, 2019
Gross carrying amount
 
$
2,950,132

 
$
2,950,132

Accumulated amortization
 
(2,927,555
)
 
(2,923,120
)
Software development costs, net
 
$
22,577

 
$
27,012


During the three months ended June 30, 2020 and 2019, the Company recorded $1,644 and $11,560, respectively, of amortization expense related to capitalized software costs. During the six months ended June 30, 2020 and 2019, the Company recorded $4,435 and $42,633, respectively, of amortization expense related to capitalized software costs.


15



(6) Goodwill and Other Intangible Assets

The gross carrying amount and accumulated amortization of goodwill and other intangible assets as of June 30, 2020 and December 31, 2019 are as follows: 
 
 
June 30, 2020
 
December 31, 2019
Goodwill
 
$
4,150,339

 
$
4,150,339

Other intangible assets:
 
 

 
 

Gross carrying amount
 
$
3,982,757

 
$
3,947,103

Accumulated amortization
 
(3,891,294
)
 
(3,889,385
)
Net carrying amount
 
$
91,463

 
$
57,718


For the three months ended June 30, 2020 and 2019, amortization expense was $17,080 and $22,740, respectively. For the six months ended June 30, 2020 and 2019, amortization expense was $1,909 and $47,324, respectively.


(7) Share-Based Payment Arrangements

On June 22, 2018, the Company's stockholders adopted the FalconStor Software, Inc. 2018 Incentive Stock Plan (the "2018 Plan"). The 2018 Plan is administered by the Compensation Committee and provides for the issuance of up to 1,471,997 shares of the Company's common stock upon the grant of shares with such restrictions as determined by the Compensation Committee to the employees and directors of, and consultants providing services to, the Company or its affiliates. Exercise prices of the options will be determined by the Compensation Committee of the Company's Board of Directors, subject to the consent of Hale Capital. The vesting terms shall be performance based and determined by the Compensation Committee, subject to the consent of Hale Capital, based on various factors, including (i) the return of capital to the holders of the Series A Preferred Stock and the Company’s Common Stock in the event of a Change of Control, (ii) the repayment of the Company’s obligations under its senior secured debt, and (iii) the Company’s free cash flow.

The following table summarizes the 2018 Plan, which was the only plan under which the Company was able to grant equity compensation as of June 30, 2020
 
 
Shares
 
Shares Available
 
Shares
Name of Plan
 
Authorized
 
for Grant
 
Outstanding
FalconStor Software, Inc. 2018 Incentive Stock Plan
 
1,471,997
 
282,941
 
1,189,056

The following table summarizes the Company’s equity plans that have terminated or expired but that still have equity awards outstanding as of June 30, 2020
Name of Plan
 
Shares Available for Grant
 
Shares Outstanding
FalconStor Software, Inc., 2016 Incentive Stock Plan
 
 
3,850
FalconStor Software, Inc., 2006 Incentive Stock Plan
 
 
7,355

16



 
The following table summarizes the 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, 2020 and 2019:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Cost of revenue - support and service
 
103

 
449

 
206

 
2,042

Research and development costs
 
428

 
861

 
856

 
5,606

Selling and marketing
 
184

 
1,248

 
368

 
3,658

General and administrative
 
2,345

 
13,673

 
6,140

 
14,176

 
 
$
3,060

 
$
16,231

 
$
7,570

 
$
25,482


(8) Income Taxes
 
The Company’s provision for income taxes consists principally 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, 2020, the Company recorded an income tax provision of $33,437. The effective tax rate for the six months ended June 30, 2020 was (9.9%). The effective tax rate differs from the statutory rate of 21% due to the mix of foreign and domestic earnings and the application of valuation allowances. As of June 30, 2020, 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 income tax benefit as such amounts are fully offset with a valuation allowance.

For the six months ended June 30, 2019, the Company recorded an income tax provision of $223,830. The effective tax rate for the six months ended June 30, 2019 was (20.9%). The effective tax differs from the statutory rate of 21% primarily related 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, 2019, 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 income tax expense as such amounts are fully offset with a valuation allowance.

The Company’s total unrecognized tax benefits, excluding interest, at June 30, 2020 and December 31, 2019 were $81,399 and $134,246, respectively. As of June 30, 2020 and December 31, 2019, the Company had $35,499 and $63,404, respectively, of accrued interest reflected in accrued expenses. The Company expects approximately $7,000 of tax benefits during the next twelve months due to expiring statute of limitations, which will impact the Company's effective tax rate.

(9) Notes Payable and Stock Warrants

The notes payable balance consists of the following:


17



Notes payable principal balance
$
3,000,000

Deferred issuance costs
(254,247
)
Discount
(288,504
)
Total notes payable, net at inception on February 23, 2018
2,457,249

Proceeds from issuance of long-term debt
1,000,000

Revaluation of long-term debt
(447,008
)
Accretion of discount
202,195

Deferred issuance costs
(87,609
)
Total notes payable, net at December 31, 2018
$
3,124,827

Repayment of long-term debt
(489,321
)
Proceeds from issuance of long-term debt
1,000,000

Accretion of discount
273,521

Deferred issuance costs
(55,393
)
Total notes payable, net at December 31, 2019
$
3,853,634

Accretion of discount
317,843

Total notes payable, net at June 30, 2020
$
4,171,477


The $4 million senior secured debt bears interest at prime plus 0.75% and matures on June 30, 2021. The $1 million term loan bears interest at 15% and matures on September 27, 2020. As of June 30, 2020, the Company was in compliance with the financial covenants contained in the Amended and Restated Term Loan Credit Agreement.
Loan under the Paycheck Protection Program
On April 28, 2020, the Company entered into the Loan with Peapack-Gladstone Bank in an aggregate principal amount of $754,000, pursuant to the PPP under the CARES Act.
The Loan is evidenced by a promissory note (the “Note”) dated April 28, 2020, which is attached as Exhibit 10.1 to this Form 10-Q. The Loan matures two years from the disbursement date and bears interest at a rate of 1.000% per annum, with the first six months of interest deferred. Principal and interest are payable monthly commencing six months after the disbursement date and may be prepaid by the Company at any time prior to maturity with no prepayment penalties.
Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of loans granted under the PPP. The Loan is subject to forgiveness to the extent proceeds are used for payroll costs, including payments required to continue group health care benefits, and certain rent, utility, and mortgage interest expenses (collectively, “Qualifying Expenses”), pursuant to the terms and limitations of the PPP. The Company intends to use a significant majority of the Loan amount for Qualifying Expenses. However, no assurance is provided that the Company will obtain forgiveness of the Loan in whole or in part.

The Loan is included in notes payable, net of debt issuance costs and discounts in the accompanying condensed consolidated balance sheet.

(10) 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, 2020, the Company did not have any Level 1 category assets included in the condensed consolidated balance sheets.

18




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, 2020 and December 31, 2019, 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, 2020 and December 31, 2019, 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 and cash equivalents categorized as Level 3 as of June 30, 2020 or December 31, 2019.

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at June 30, 2020:
 
 
 
 
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)
Derivative liabilities:
 
 

 
 

 
 

 
 

Derivative Instruments
 
478,312

 

 

 
478,312

Total derivative liabilities
 
478,312

 

 

 
478,312

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
478,312

 
$

 
$

 
$
478,312


The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2019: 
 
 
 
 
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)
Derivative liabilities:
 
 
 
 
 
 
 
 
Derivative Instruments
 
483,804

 

 

 
483,804

Total derivative liabilities
 
483,804

 

 

 
483,804

 
 
 
 
 
 
 
 
 
Total assets and liabilities measured at fair value
 
$
483,804

 
$

 
$

 
$
483,804

 
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 fair value of the Company's Series A Preferred Stock is based on its future cash flows discounted at a 14% yield. The fair value of the Company's note payable is based on its future cash flows discounted at a 17% yield.

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, 2020 and June 30, 2019:

19



 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Beginning Balance
 
$
481,042

 
$
492,327

 
$
483,804

 
$
498,086

Total income recognized in earnings
 
(2,730
)
 
(2,838
)
 
(5,492
)
 
(8,597
)
Ending Balance
 
$
478,312

 
$
489,489

 
$
478,312

 
$
489,489


(11) Commitments and Contingencies
 
The Company’s headquarters are located in Austin, Texas.  The Company has an operating lease covering its Melville, New York office facility that expires in April 2021. The Company has sublet a portion of this lease. The Company also has several additional operating leases related to offices in foreign countries. The expiration dates for these leases range from 2020 through 2021. The following is a schedule of future minimum lease payments as well as sublease income for all operating leases as of June 30, 2020:
 
Payments
Sublease Income
Net Commitments
2020
850,408

(473,149
)
377,259

2021
639,526

(207,925
)
431,601

 
$
1,489,934

$
(681,074
)
$
808,860



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, 2020, 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 on 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.
 
As described under Note (12), the holders of the Series A Preferred Stock have redemption rights upon certain triggering events. As of June 30, 2020, the Company did not fail any non-financial covenants related to the Company's Series A Preferred Stock.

In connection with the appointment of Todd Brooks as Chief Executive Officer, the Board approved an offer letter to Mr. Brooks (the “Brooks Agreement”), which was executed on August 14, 2017. The Brooks Agreement provides that Mr. Brooks is entitled to receive an annualized base salary of $350,000, payable in regular installments in accordance with the Company’s general payroll practices. Mr. Brooks will also be eligible for a cash bonus of $17,500 for any quarter that is free cash flow positive on an operating basis and additional incentive compensation of an annual bonus of up to $200,000, subject to attainment of performance objectives to be mutually agreed upon and established. Mr. Brooks' employment can be terminated at will. Pursuant to the Brooks Agreement and the 2018 Plan, Mr. Brooks received 735,973 shares of restricted stock. If Mr. Brooks’ 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 (6) months of Mr. Brooks’ employment. Except as set forth in the preceding sentence, Mr. Brooks 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 (6) months and his employment was terminated by the Company without cause. Mr. Brooks is also entitled to vacation and other employee benefits in accordance with the Company’s policies as well as reimbursement for an apartment.

In connection with the appointment of Brad Wolfe as the Company's Chief Financial Officer, the Board approved an offer letter to Mr. Wolfe (the “Wolfe Offer Letter”), which was executed on April 4, 2018. The Wolfe Offer Letter provides that Mr. Wolfe is entitled to receive an annualized base salary of $240,000, payable in regular installments in accordance with the Company’s

20



general payroll practices. Mr. Wolfe will also be eligible for a cash bonus of $10,000 for any quarter which has net working capital cash that exceeds the prior quarter and additional incentive compensation of an annual bonus of up to $70,000, subject to attainment of performance objectives to be mutually agreed upon and established.

As described under Note (17), the Company has incurred certain restructuring costs in connection with restructuring plans adopted in 2017 and 2019.

In addition, as of June 30, 2020, the Company's liability for uncertain tax positions totaled $116,849. At this time, the settlement period for this liability, including related accrued interest, cannot be determined.
 
(12) Series A Redeemable Convertible Preferred Stock
 
The Company has 900,000 shares of Series A Preferred Stock outstanding. Pursuant to the Amended and Restated  Certificate of Designations, Preferences and Rights  for the Series A Preferred Stock (the "Certificate of Designations"), each share of Series A Preferred Stock can be converted into shares of the Company’s common stock, at current conversion price of $102.488 per share, subject to appropriate adjustments for any stock dividend, stock split, stock combination, reclassification or similar transaction, (i) at any time at the option of the holder or (ii) by the Company if, following the first anniversary of the issuance of the Series A Preferred Stock (subject to extension under certain circumstances), the volume weighted average trading price per share of the Company’s common stock for sixty (60) consecutive trading days exceeds 250% of the conversion price and continues to exceed 225% of the conversion price through the conversion date, subject at all times to the satisfaction of, and the limitations imposed by, the equity conditions set forth in the Certificate of Designations (including, without limitation, the volume limitations set forth therein).
Pursuant to the Certificate of Designations, the holders of the Series A Preferred Stock are entitled to receive quarterly dividends at the prime rate (provided in the Wall Street Journal Eastern Edition) plus 5% (up to a maximum dividend rate of 10%), payable in cash or in kind (i.e., through the issuance of additional shares of Series A Preferred Stock), except that the Company is not permitted to pay such dividends in cash while any indebtedness under the Company’s Amended and Restated Term Loan Credit Agreement remains outstanding without the consent of the holders of the Series A Preferred Stock. In addition, the declaration and payment of dividends is subject to compliance with applicable law and unpaid dividends will accrue. A holder’s right to convert its shares of Series A Preferred Stock and receive dividends in the form of common stock is subject to certain limitations including, among other things, that the shares of common stock issuable upon conversion or as dividends will not, prior to receipt of stockholder approval, result in any holder beneficially owning greater than 19.99% of the Company’s currently outstanding shares of common stock.
The Series A Preferred Stock dividends shall accrue whether or not the declaration or payment of such Series A Preferred Stock dividends are prohibited by applicable law, whether or not the Company has earnings, whether or not there are funds legally available for the payment of such dividends and whether or not such dividends are authorized or declared.
Upon certain triggering events, such as bankruptcy, insolvency or a material adverse effect or failure of the Company to issue shares of common stock upon conversion of the Series A Preferred Stock in accordance with its obligations, the holders may require the Company to redeem all or some of the Series A Preferred Stock at a price per share equal to the greater of (i) the sum of 100% of the stated value of a share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto, and (ii) the product of the number of shares of common stock underlying a share of Series A Preferred Stock and the closing price as of the occurrence of the triggering event. On or after July 30, 2021, each holder of Series A Preferred Stock can also require the Company to redeem its Series A Preferred Stock in cash at a per share price equal to 100% of the stated value of a share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto. Notwithstanding the forgoing, no holder of Series A Preferred Stock is permitted to exercise any rights or remedies upon a Breach Event or to exercise any redemption rights under the Certificate of Designations, unless approved by the holders of a majority of the then outstanding shares of Series A Preferred Stock.
Upon consummation of a fundamental sale transaction, the Series A Preferred Stock shall be redeemed at a per share redemption price equal to the greater of (y) 250% of the per share purchase price of the Series A Preferred Stock and (z) the price payable in respect of such share of Series A Preferred Stock if such share of Series A Preferred Stock had been converted into such number of shares of common stock in accordance with the Certificate of Designations (but without giving effect to any limitations or restrictions contained therein) immediately prior to such fundamental sale transaction;  provided however that the 250% threshold is changed to 100% if the fundamental sale transaction is approved by the two Series A Directors (as defined in the Certificate of Designations). In addition, if the Company consummates an equity or debt financing that results in more than $5.0 million of net proceeds to the Company and/or its subsidiaries, the holders of Series A Preferred Stock will have the right, but not the obligation, to require the Company to use the net proceeds in excess of $5.0 million to repurchase all or a portion of the Series A Preferred

21



Stock at a per share price equal to the greater of (i) the sum of 100% of the stated value of such share of Series A Preferred Stock plus accrued and unpaid dividends with respect thereto, and (ii) the number of shares of common stock into which such share of Series A Preferred Stock is then convertible multiplied by the greater of (y) the closing price of the common stock on the date of announcement of such financing or (z) the closing price of the Common Stock on the date of consummation of such financing.
Each holder of Series A Preferred Stock has a vote equal to the number of shares of common stock into which its Series A Preferred Stock would be convertible as of the record date. In addition, the holders of a majority of the Series A Preferred Stock must approve certain actions, including approving any amendments to the Company’s Restated Certificate of Incorporation as amended or Amended and Restated Bylaws that adversely affects the voting powers, preferences or other rights of the Series A Preferred Stock; payment of dividends or distributions; any liquidation, capitalization, reorganization or any other fundamental transaction of the Company; issuance of any equity security senior to or on parity with the Series A Preferred Stock as to dividend rights, redemption rights, liquidation preference and other rights; issuances of equity below the conversion price; 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 of the capital stock of the Company.
 The Company has classified the Series A 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 Preferred Stock, the contingent redemption put options in the Series A 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 was bifurcated from the Series A Preferred Stock and recorded as a liability. 

As of June 30, 2020 and December 31, 2019, the fair value of these derivative instruments was $478,312 and $483,804, respectively, and were included in "other long-term liabilities" within the consolidated balance sheets. The loss on the change in fair value of these derivative instruments for the six months ended June 30, 2020 and June 30, 2019 of $5,492 and 8,597, respectively, were included in “interest and other loss, net” within the consolidated statement of operations.

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, 2020 and 2019, were as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Beginning Balance
 
$
481,042

 
$
492,327

 
$
483,804

 
$
498,086

Total income recognized in earnings
 
(2,730
)
 
(2,838
)
 
(5,492
)
 
(8,597
)
Ending Balance
 
$
478,312

 
$
489,489

 
$
478,312

 
$
489,489



22



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 as follows:
Probability of redemption as part of a fundamental sale transaction
0.5%
Probability of redemption absent a fundamental sale transaction
4.75%
Annual volatility
65%

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 Preferred Stock. These costs were being accreted to the Series A 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 at that time. Hale Capital, which was the sole holder of the Series A Preferred Stock agreed to the Series A mandatory extension of the mandatory redemption right and waived prior breaches of the terms of the Series A Preferred Stock. The Company included deductions for accretion, deemed and accrued dividends on the Series A Preferred Stock as adjustments to net loss attributable to common stockholders on the statement of operations and in determining income (loss) per share for the three and six months ended June 30, 2020 and 2019, respectively. The following represents a reconciliation of net loss attributable to common stockholders for the three and six months ended June 30, 2020 and 2019, respectively:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Net income (loss)
 
$
406,558

 
$
(1,171,723
)
 
$
(313,282
)
 
$
(1,296,630
)
Effects of Series A redeemable convertible preferred stock:
 
 

 
 

 
 

 
 

Less: Accrual of Series A redeemable convertible preferred stock dividends
 
260,595

 
256,553

 
546,355

 
503,580

Less: Accretion to redemption value of Series A redeemable convertible preferred stock
 
165,141

 
134,223

 
191,231

 
263,462

Net income (loss) attributable to common stockholders
 
$
(19,178
)
 
$
(1,562,499
)
 
$
(1,050,868
)
 
$
(2,063,672
)

The Series A Preferred Stock consists of the following:

Series A redeemable convertible preferred stock principal balance
$
9,000,000

Accrued dividends
1,312,112

Discount
(1,602,428
)
Total Series A redeemable convertible preferred stock, net at inception on February 23, 2018
8,709,684

Accrued dividends
683,742

Accretion of preferred stock
363,280

Total Series A redeemable convertible preferred stock, net at December 31, 2018
$
9,756,706

Accrued dividends
1,157,762

Accretion of preferred stock
389,811

Total Series A redeemable convertible preferred stock, net at December 31, 2019
$
11,304,279

Accrued dividends
546,355

Accretion of preferred stock
191,231

Total Series A redeemable convertible preferred stock, net at June 30, 2020
$
12,041,865



23



(13) Accumulated Other Comprehensive Loss
 
The changes in Accumulated Other Comprehensive Loss, net of tax, for the three months ended June 30, 2020 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at March 31, 2020
 
$
(1,939,979
)
 
$
33,566

 
$
(1,906,413
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income (loss) before reclassifications
 
(8,087
)
 

 
(8,087
)
Total other comprehensive income (loss)
 
(8,087
)
 

 
(8,087
)
Accumulated other comprehensive income (loss) at June 30, 2020
 
$
(1,948,066
)
 
$
33,566

 
$
(1,914,500
)

The changes in Accumulated Other Comprehensive Loss, net of tax, for the three months ended June 30, 2019 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at March 31, 2019
 
$
(1,902,513
)
 
$
26,803

 
$
(1,875,710
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income (loss) before reclassifications
 
(49,410
)
 

 
(49,410
)
Total other comprehensive income (loss)
 
(49,410
)
 

 
(49,410
)
Accumulated other comprehensive income (loss) at June 30, 2019
 
$
(1,951,923
)
 
$
26,803

 
$
(1,925,120
)


The changes in Accumulated Other Comprehensive Loss, net of tax, for the six months ended June 30, 2020 are as follows:

 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at December 31, 2019
 
$
(1,926,826
)
 
$
33,566

 
$
(1,893,260
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income (loss) before reclassifications
 
(21,240
)
 

 
(21,240
)
Total other comprehensive income (loss)
 
(21,240
)
 

 
(21,240
)
Accumulated other comprehensive income (loss) at June 30, 2020
 
$
(1,948,066
)
 
$
33,566

 
$
(1,914,500
)

The changes in Accumulated Other Comprehensive Loss, net of tax, for the six months ended June 30, 2019 are as follows:


24



 
 
Foreign Currency
Translation
 
Net Minimum
Pension Liability
 
Total
Accumulated other comprehensive income (loss) at December 31, 2018
 
$
(1,921,905
)
 
$
26,803

 
$
(1,895,102
)
Other comprehensive income (loss)
 
 

 
 

 
 

Other comprehensive income (loss) before reclassifications
 
(30,018
)
 

 
(30,018
)
Total other comprehensive income (loss)
 
(30,018
)
 

 
(30,018
)
Accumulated other comprehensive income (loss) at June 30, 2019
 
$
(1,951,923
)
 
$
26,803

 
$
(1,925,120
)

 
(14) Stockholders' Equity

Stock Repurchase Activity
  
During the three and six months ended June 30, 2020 and 2019, the Company did not repurchase any shares of its common stock. As of June 30, 2020, the Company had the authorization under previous Board approved stock repurchase plans to repurchase 49,078 shares of its common stock based upon its judgment and market conditions.

(15)  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.

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.
 
(16) Segment Reporting and Concentrations
 
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, 2020 and 2019, and the location of long-lived assets as of June 30, 2020 and December 31, 2019, are summarized as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,

 
2020
 
2019
 
2020
 
2019
Revenue:
 
 
 
 
 
 
 
 
Americas
 
$
1,156,589

 
$
1,496,988

 
$
2,251,493

 
$
2,497,805

Asia Pacific
 
978,474

 
194,074

 
1,962,269

 
2,267,388

Europe, Middle East, Africa and Other
 
1,364,549

 
2,308,327

 
2,466,037

 
3,727,174

Total Revenue
 
$
3,499,612

 
$
3,999,389

 
$
6,679,799

 
$
8,492,367

 

25



 
 
June 30, 2020
 
December 31, 2019
Long-lived assets:
 
 
 
 
Americas
 
$
6,236,429

 
$
6,811,578

Asia Pacific
 
745,328

 
860,023

Europe, Middle East, Africa and Other
 
152,652

 
190,928

Total long-lived assets
 
$
7,134,409

 
$
7,862,529

 
For the three and six months ended June 30, 2020, the Company had one customer that accounted for 10% or more of total revenue, respectively. For the three and six months ended June 30, 2019, the Company had two customers and one customer that accounted for 10% or more of total revenue, respectively.

As of June 30, 2020, the Company had two customers that accounted for 10% or more of the gross accounts receivable balance. As of December 31, 2019, the Company had one customer that accounted for 10% or more of the gross accounts receivable balance.

(17) Restructuring Costs
 
In June 2017, the Board approved a comprehensive plan to increase operating performance (the “2017 Plan”). The 2017 Plan was substantially completed by the end of the Company’s fiscal year ended December 31, 2017, and when combined with previous workforce reductions in the second quarter of fiscal 2017 reduced the Company’s workforce to approximately 86 employees at December 31, 2018. In making these changes, the Company prioritized customer support and development while consolidating operations and streamlining direct sales resources, allowing the Company to focus on the install base and develop alternate channels to the market. As part of this consolidation effort the Company vacated a portion of the Mellville, NY office space during the three months ended June 30, 2018. In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rental payments for which the Company no longer intends to receive any economic benefit are accrued, net of any anticipated sublease income, when the Company ceases use of the leased space. During the six months ended June 30, 2020, the Company incurred lease disposal-related costs for this property of $0.4 million.

In the third quarter of 2019, the Company adopted the 2019 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 2019 Plan, the Company eliminated 23 positions worldwide, implemented tighter expense controls, ceased non-core activities and downsized several facilities. During the three months ended March 31, 2020, the Company incurred $0.1 million in severance expense as a result of this action. The 2019 Plan was substantially completed as of March 31, 2020.

Given the commercial uncertainty caused by the novel coronavirus pandemic, or COVID-19, the Company developed and implemented an even more aggressive expense control plan in March 2020, that it is prepared to keep in place for the remainder of 2020 (the "2020 Plan"). This plan reduces the Company's annual cash expense run rate by $4.0 million or 29%. The Company has furloughed 21 positions worldwide, and 4 of these positions were reinstated in the second quarter of 2020. During the three months ended June 30, 2020, the Company has not yet incurred severance expense as a result of this action. We believe the reduced expense level will enable FalconStor to remain profitable during the remainder of 2020, even with continued revenue challenges throughout.


26



The following table summarizes the activity during 2019 and 2020 related to restructuring liabilities recorded in connection with the 2017, 2019 and 2020 Plans:
 
 
Severance Related Costs
 
Facility and Other Costs
 
Total
Balance at December 31, 2018
 
$
461,362

 
$
453,446

 
$
914,808

Additions (Reductions)
 

 
157,693

 
157,693

Utilized/Paid
 

 
(187,833
)
 
(187,833
)
Balance at March 31, 2019
 
$
461,362

 
$
423,306

 
$
884,668

Additions (Reductions)
 

 
202,679

 
202,679

Utilized/Paid
 

 
(238,090
)
 
(238,090
)
Balance at June 30, 2019
 
$
461,362

 
$
387,895

 
$
849,257

Additions (Reductions)
 
214,050

 
170,779

 
384,829

Utilized/Paid
 
(214,050
)
 
(257,453
)
 
(471,503
)
Balance at September 30, 2019
 
$
461,362

 
$
301,221

 
$
762,583

Additions (Reductions)
 
31,860

 
327,257

 
359,117

Utilized/Paid
 
(199,423
)
 
(390,985
)
 
(590,408
)
Balance at December 31, 2019
 
$
293,799

 
$
237,493

 
$
531,292

Additions (Reductions)
 
76,708

 
210,752

 
287,460

Utilized/Paid
 
(156,415
)
 
(225,835
)
 
(382,250
)
Balance at March 31, 2020
 
$
214,092

 
$
222,410

 
$
436,502

Additions (Reductions)
 

 
153,685

 
153,685

Translation Adjustment
 
4,674

 

 
4,674

Utilized/Paid
 

 
(201,211
)
 
(201,211
)
Balance at June 30, 2020
 
$
218,766

 
$
174,884

 
$
393,650


The severance and facility related liabilities are included within “accrued expenses” in the accompanying condensed consolidated balance sheets. The expenses under the 2017 and 2019 Plans are included within “restructuring costs” in the accompanying condensed consolidated statements of operations.

27



Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “plans,” “may,” “intends,” “will,” or similar terms.  Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report.
 
OVERVIEW

FalconStor Software, Inc. is a technology company whose mission is to deliver technical innovation that creates investment protection, flexibility, and leverage of modern cloud-based technologies for our enterprise customers. We provide software and cloud services that enable our enterprise customers to better manage, protect, secure, and make use of their valuable data.  Our customers achieve lower costs, simpler operations, greater data security, higher confidence in their business continuity, and greater ability to effectively use their data assets to drive innovation.
Our products are utilized by enterprises and managed service providers across the globe and address two key areas of enterprise data protection; long-term archive retention and reinstatement, and business continuity driven data replication. Our products are software-defined, which means that our technology allows our solutions to be hardware, cloud, and source-data agnostic, giving our customers maximum leverage of existing hardware and software investments. Our innovative integration into modern cloud-based technologies enables our customers to improve the portability, security, and accessibility of their enterprise data. This accessibility is key in our modern world, where data is not only protected, but also intelligently leveraged to facilitate learning, improve product design, and drive competitive advantage.

During 2020, our commercial strategy has been to build on the sales momentum generated in 2019 while increasing profitability. This plan has been anchored on a continued focus on our long-term archive retention and reinstatement products, FalconStor Virtual Tape Library (“VTL”) and StorSafeTM, an increase in go-to-market investment within our core regions of the Americas, EMEA, Japan, Korea, and Southeast Asia, and on carefully managing operating expenses.
    
During Q2, we delivered 11.5% year-over-year total bookings growth despite the economic turmoil caused by the global COVID-19 pandemic. While uncertainties continue to exist as a result of COVID-19, we have seen our customers and prospects continue to invest in the business critical area of data production in which we sell our solutions. The strongest performance came from our Americas region, where bookings increased 72% year-over-year. In addition, bookings in our EMEA region increased by 7%. Total bookings increases in both regions were exclusively driven by increased adoption of our long-term data retention and reinstatement products, VTL and StorSafeTM. Across the globe, bookings from first-time FalconStor customers grew by 251% year-over-year.

Despite our strong year-over-year sales growth and new customer acquisition, resulting GAAP revenue decreased by $500 thousand during the quarter, compared to Q2 2019. This reduction was primarily due to reduced in-period recurring legacy contract renewals, from our non-core markets, including China.

Strong Q2 sales, combined with the proactive expense management plan we implemented at the end of Q1, allowed us to deliver $407 thousand of net income in the quarter, compared to a net loss of $1.2 million in Q2 of 2019. Our dramatically improved profitability has allowed us to make additional targeted investments, primarily related to Sales, R&D, and Support personnel, while maintaining a profitable expense base.

Total cost of revenue for the three months ended June 30, 2020 decreased 69% to $0.4 million, compared with $1.3 million in the prior year period. Total gross profit increased $0.4 million, or 15%, to $3.1 million for the three months ended June 30, 2020, compared with $2.7 million for the prior year period. Total gross margin increased to 89% for the three months ended June 30, 2020, compared with 68% for the prior year period. The increase in our total gross margin, and total gross profit in absolute dollars, was primarily due to an intentional reduction in hardware sales. 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.
Overall, our total GAAP operating expenses for the three months ended June 30, 2020 decreased $1.1 million, or 30%, to $2.6 million, compared to $3.7 million for the same period of the previous year.

28




RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED JUNE 30, 2020 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2019.
 
The following table presents revenue and expense line items reported in our condensed consolidated statements of operations and their corresponding percentage of total revenue for the three months ended June 30, 2020 and 2019 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
  
2020
 
2019
 
Revenue:
  
 
 
 
  
 
 
 
 
 
 
Product revenue
$
1,632,055

 
47
 %
 
$
1,470,430

 
37
 %
 
$
161,625

 
11
 %
Support and services revenue
1,867,557

 
53
 %
 
2,528,959

 
63
 %
 
(661,402
)
 
(26
)%
Total revenue
3,499,612

 
100
 %
 
3,999,389

 
100
 %
 
(499,777
)
 
(12
)%
Cost of revenue:
  

 
 
 
 

 
 
 
 
 
 
Product
61,830

 
2
 %
 
755,796

 
19
 %
 
(693,966
)
 
(92
)%
Support and service
334,396

 
10
 %
 
537,105

 
13
 %
 
(202,709
)
 
(38
)%
Total cost of revenue
396,226

 
11
 %
 
1,292,901

 
32
 %
 
(896,675
)
 
(69
)%
Gross profit
3,103,386

 
89
 %
 
2,706,488

 
68
 %
 
396,898

 
15
 %
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Research and development costs
534,000

 
15
 %
 
764,276

 
19
 %
 
(230,276
)
 
(30
)%
Selling and marketing
1,019,940

 
29
 %
 
1,296,909

 
32
 %
 
(276,969
)
 
(21
)%
General and administrative
845,581

 
24