ITEM 1. BUSINESS
OVERVIEW
FalconStor Software, Inc. ("FalconStor" or the "Company") is a provider of network storage infrastructure software solutions and related maintenance, implementation and engineering services. FalconStor's unique open software approach to storage networking enables companies to embrace state-of-the-art equipment (based on SCSI, Fibre Channel or iSCSI) from any storage manufacturer without rendering their existing or legacy solutions obsolete. Several strategic partners have recognized the industrial strength of FalconStor's flagship software, IPStor(R), and utilized it to power their special purpose storage appliances to perform Real Time Data Migration, Data Replication, Virtual Tape Library backup, and other advanced storage services. IPStor leverages the high performance IP or FC based network to help corporate IT aggregate storage capacity and contain the run-away cost of administering mission-critical storage services such as snapshot, backup, data replication, and other storage services in a distributed environment. Over 400 customers around the world have deployed IPStor in production environments to manage their storage infrastructure with minimal TCO (Total Cost of Ownership) and optimal ROI (Return on Investment). FalconStor's products have been certified by such industry leaders as Adaptec, Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Emulex, Fujitsu, Gadzoox, Hitachi Data Systems, Hitachi Engineering Co., Ltd., IBM, Intel, LSI Logic, McDATA Corporation, Microsoft, NEC, Novell, NS Solutions Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, QLogic, Quantum, StorageTek, SUN and Tivoli. FalconStor has agreements with original equipment manufacturers ("OEMs") including StorageTek, NEC, Runtop, Accton, and MaXXan, to incorporate FalconStor's IPStor technology with such companies' products.
Network Peripherals, Inc. ("NPI"), was incorporated in California in March 1989 and reincorporated in Delaware in 1994. FalconStor, Inc., was incorporated in Delaware in February 2000. On August 22, 2001, FalconStor, Inc., merged with NPI, a publicly traded company, with NPI as the surviving corporation. Although NPI acquired FalconStor, as a result of the transaction, FalconStor, Inc., stockholders held a majority of the voting interests in the combined enterprise after the merger. Accordingly, for accounting purposes, the acquisition was a "reverse acquisition" and FalconStor, Inc., was the "accounting acquirer." Further, as a result of NPI's decision on June 1, 2001 to discontinue its NuWave and legacy business, at the time of the merger NPI was a non-operating public shell with no continuing operations, and no intangible assets associated with NPI were purchased by FalconStor. As a result, the transaction was accounted for as a recapitalization of FalconStor and recorded based on the fair value of NPI's net tangible assets acquired by FalconStor, with no goodwill or other intangible assets being recognized. In connection with the merger, the name of NPI was changed to FalconStor Software, Inc. For more information relating to the merger, see Note 2 of Notes to Consolidated Financial Statements.
INDUSTRY BACKGROUND
Corporations continue to face challenges that force them to better manage their operations and the IT infrastructures they have in place to support their current business and future growth. These challenges, coupled with the recent economic environment have prompted a renewed focus on cost management, efficiency, and return on investment.
Yankee Group estimates that storage budgets typically range from 10 to more than 20 percent of a company's overall IT infrastructure budget. The growing importance of storage has triggered a move by companies to establish separate storage groups within their IT organizations. Today, approximately 48 percent of companies have separate storage groups, according to a 2003 Yankee Group survey of 289 storage decision makers. Similar to other parts of companies' IT strategies, a number of larger IT governance philosophies focus on how to improve IT management in an effort to maximize storage budgets today. The overriding goal is: measuring IT and storage operations value. The first step is to fully understand the costs associated with various aspects of the IT infrastructure, including storage.
For this reason, companies are focusing on:
o Lowering the costs of migration and the operational costs associated with managing the environment.
o Preserving core operations and key business data in alignment with business requirements and broader government regulations compliance, security of data, and maintaining business operations through business continuity strategies.
o Standardizing best practices in storage management, procurement, and storage systems to achieve better economies of scale and make the storage environment flexible enough to adapt to real-time changes in business needs and demands.
According to Yankee Group, financial investments that once focused on storage systems and supporting infrastructure are now distributed among storage systems, management tools, networking, and salaries. In 2003, the most significant portion of the storage budget went to storage systems, averaging 22 percent of the budget. Storage management tools tied for second place with storage networks, each accounting for 18 percent of the storage budget.
The growing complexities of storage environments are forcing companies to do a number of things. First, to improve storage management, companies are more aggressively moving to networked storage in 2004. Yankee Group predicts that in 2004 network storage will outpace traditional direct attached storage for overall investment. Second, enterprises continue to face the issue of heterogeneous storage management and will select products capable of supporting multiple storage platforms from a single tool. Third, escalating regulatory compliance requirements are forcing companies to gain better control of their data. This includes classifying data based on overall priorities, retention requirements, the value of the data to be retained, and how service levels can be classified to support different types of data.
However, the most significant challenge remains the time needed to manage a complex storage infrastructure. In measuring costs associated with the labor of managing storage, the majority of companies viewed reduced maintenance costs as proof of a return on investment (ROI), according to a 2003 Yankee Group survey. Respondents to this survey also cited increasing the number of servers managed per administrator (27 percent), as well as terabytes managed per full-time employee (17 percent), as important measures. Labor costs associated with storage management tasks can mount, depending on the operations. A significant percentage of survey respondents indicated that they were spending more than 10 hours per week on a number of specific storage-related tasks. For example, backup operations take the most time per week to manage, averaging six hours per storage administrator.
Lastly, downtime remains a primary business concern. The Yankee Group estimates that the financial services market has the largest cost of downtime of any vertical market, with an average of $2.1 million an hour. A related industry, banking, has an estimated hourly downtime cost of $1.5 million. In both cases, the highly transactional nature of their businesses requires minimal downtime without outages. Other industries, such as manufacturing, are also experiencing significant costs for an hour of downtime of $680,000.
Over the next few years, key business technology initiatives established by companies around the world will most likely be in the areas of storage consolidation and upgrading existing storage management tools designed to support disaster recovery and business continuity plans to reflect the growing importance of compliance. Other initiatives will be in the areas of data retention programs and the acceleration of data backup methods to ensure data protection.
Companies continue to look for software that enables them to take better advantage of their existing storage environment. Enterprises are considering storage management tools focused on data migration, capacity planning and provisioning -- all of which help improve the utilization and efficiency of existing storage infrastructure.
PRODUCTS AND TECHNOLOGY
IPStor, FalconStor's flagship product, is a comprehensive set of state of the art network storage infrastructure software solutions that delivers an open, intelligent SAN/NAS infrastructure across heterogeneous environments by providing advanced storage services for enterprise applications - optimizing storage utilization, accelerating backup and recovery, maximizing performance and ensuring business continuity.
SOFTWARE SOLUTIONS
The base software, running on either a layer of stand-alone or pair of clustered, Linux/Solaris servers (the IPSTOR APPLIANCES) is responsible for aggregating and provisioning storage capacity and services to application servers via all industry standard protocols with speed, security, reliability, interoperability, and scalability.
IPStor offers Storage Consolidation, Business Continuity/Disaster Recovery, I/O Performance Optimization and Backup/Recovery Acceleration services designed to help enterprise data centers minimize total cost of ownership (TCO) and maximize return on investment (ROI).
IPSTOR'S STORAGE CONSOLIDATION SOLUTIONS consolidate heterogeneous storage environments, centralize storage management under one simple interface, maximize storage capacity utilization, consolidate servers, and/or migrate data.
IPSTOR BUSINESS CONTINUITY SOLUTIONS maintain continuous 24x7 availability and usability of data storage in the event of non-catastrophic unplanned or planned hardware outages and software errors.
IPSTOR DISASTER RECOVERY SOLUTIONS enable rapid recommencement of business in the event of catastrophic outages, for example, a flood in the main data center.
IPSTOR'S I/O PERFORMANCE OPTIMIZATION SOLUTIONS were developed specifically to leverage Solid-State Disk to increase overall storage performance to optimize return on existing investments in IT infrastructure.
IPSTOR'S BACKUP AND RECOVERY ACCELERATION SOLUTIONS enable the customer to leverage the network storage infrastructure to accelerate transparently the performance of third-party backup software, to minimize the risk window, and to shorten the recovery time without impacting the performance of production servers.
IPSTOR'S VIRTUAL TAPE LIBRARY OPTION increases the speed and reliability of off-the-shelf backup and archiving applications by using IPStor-managed disks to emulate tape drives or libraries. With backup windows shrinking and rapid data restoration more critical than ever, IPStor's Virtual Tape Library Option allows users to utilize disk storage to emulate multiple tape libraries concurrently and to accelerate the backup/restore speed.
STORAGE APPLIANCES
FalconStor has entered into agreements with resellers and with OEMs to develop "storage appliances" that combine certain aspects of IPStor functionality with third party hardware to create single purpose turnkey solutions that are easy to deploy. Currently, FalconStor's resellers and/or OEM partners offer the following storage appliances:
REALTIME DATA MIGRATION. Uses fibrechannel SAN to transport data across different vendors' storage subsystems without reconfiguring or shutting down the host.
VIRTUALTAPE LIBRARY. Utilizes rotating disk to emulate tape drive/library to turbo-charge backup/restore and to facilitate vaulting over IP.
ISCSI STORAGE. Aggregates and provisions storage capacity and offers Business Continuity/Disaster Recovery for hosts attached to an iSCSI SAN.
MAINTENANCE, IMPLEMENTATION AND ENGINEERING SERVICES.
FalconStor offers customers a variety of annual maintenance services which entitle customers to periodic software updates and various levels of technical support. Although the implementation of IPStor does not generally require the assistance of FalconStor, the Company offers software implementation services. FalconStor also offers customers software engineering services.
BUSINESS STRATEGY
FalconStor intends to solidify its position as a leading network storage software provider to enterprises and Internet Data Centers worldwide. FalconStor intends to achieve this objective through the following strategies:
o MAINTAIN A LEADERSHIP POSITION IN NETWORK STORAGE SOFTWARE. FalconStor intends to leverage its protocol-agnostic architecture to maintain a leadership position in the network storage software market. The network storage software market is defined by rapid change, and FalconStor plans to continue to focus its research and development efforts to invent and to bring to market innovative solutions.
o EXPAND PRODUCT OFFERINGS. During the past year, FalconStor offered additional options for its IPStor software. In addition, FalconStor expanded its offerings of storage appliances consisting of third-party hardware loaded with IPStor functionality. FalconStor intends to continue to expand the options available for IPStor and to offer additional storage appliances.
o INCREASE MARKET PENETRATION AND BRAND RECOGNITION. FalconStor plans to promote its products and corporate awareness by
o forming strategic partnerships with leading industry players;
o participating in industry events, conferences and trade shows; and
o continuing targeted promotions and public relations campaigns.
FalconStor believes that establishing a strong brand identity as a network storage software solution provider is important to its future success.
o ESTABLISH A GLOBAL PRESENCE. FalconStor believes that significant market share can be achieved in Europe and Asia. FalconStor, through its European headquarters, plans to expand its operational capabilities in Europe. In addition, through its Asia headquarters, FalconStor believes that it is developing a strong business presence in the Asia/Pacific Rim.
o EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND ALLIANCES. FalconStor believes that opportunities exist to expand its technological capabilities, product offerings and services through acquisitions and strategic alliances. When evaluating potential acquisitions and strategic alliances, FalconStor will focus on transactions that enable it to acquire:
o important enabling technology;
o complementary applications;
o marketing, sales, customer and technological synergies; and/or
o key personnel.
As of the date of this filing, FalconStor has no agreements, commitments or understanding with respect to any such acquisitions or strategic alliances, which have not been consummated.
o SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to continue to enter into original equipment manufacturer ("OEM") agreements with strategic switch, storage, appliance and operating system vendors. Besides accelerating overall marketing growth, the OEM relationships should bolster FalconStor's product recognition, corporate credibility and revenue stream.
SALES, MARKETING AND CUSTOMER SERVICE
FalconStor plans to continue to sell its products primarily through agreements with OEMs, value-added resellers and distributors.
o ORIGINAL EQUIPMENT MANUFACTURER RELATIONSHIPS. OEMs collaborate with FalconStor to integrate FalconStor's products into their own product offerings or resell FalconStor's products under their own label.
o VALUE-ADDED RESELLER AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered into value-added reseller and distributor agreements to help sell its product in various geographic areas. FalconStor's value-added resellers and distributors market the entire IPStor product suite and receive a discount off list price on products sold.
o STORAGE APPLIANCES. FalconStor has entered into agreements with strategic partners in which IPStor is adapted to the strategic partner's special-purpose storage appliances to offer Real-Time Data Migration, Data Replication, Storage Consolidation, Virtual Tape Library, and other services specifically for the partner's customers.
FalconStor's marketing department consists of marketing professionals dedicated to advertising, public relations, marketing communications, events and channel partner programs. FalconStor's marketing efforts focus on building brand recognition and developing leads for the sales force.
FalconStor Professional Services personnel are also available to assist customers and partners throughout the product life cycle of IPStor deployments. The Professional Services team includes seasoned "Storage Architects" who can assist in the assessment, planning/design, deployment, and testing phases of an IPStor deployment project, and a Technical Support group for post-deployment assistance and on-going trouble-shooting.
RESEARCH AND DEVELOPMENT
The network storage services industry is subject to rapid technological advancements, changes in customer requirements, developing industry standards, and regular new product introductions and enhancements. As a result, FalconStor's success, in part, depends upon its ability to continue to improve existing solutions and to develop and introduce new products on a cost-effective and timely basis. FalconStor believes its continued investment in research and development is critical to its ability to continue to provide new and enhanced products addressing emerging market needs. There can be no assurance that FalconStor will successfully develop new products to address new customer requirements and technological changes, or that such products will achieve market acceptance. FalconStor's research and development staff consisted of 83 employees as of December 31, 2003. Research and development expenses, primarily consisting of personnel expenses, were, approximately $5.0 million, $6.3 million and $7.1 million in 2001, 2002 and 2003, respectively. FalconStor anticipates that research and development expenses will increase in 2004.
COMPETITION
As the demand for network-based storage products and services increases, more competitors will enter this high-growth market segment. Although there are several companies attempting to offer unified storage services to application hosts attached to CIFS, NFS, iSCSI and Fibre Channel (FC) networks, FalconStor believes it is the only software-based solution capable of accommodating storage devices with industry-standard interfaces and provisioning the virtualized resource over FC, IP/iSCSI, NFS and CIFS with comprehensive storage services and end-to-end manageability. However, some of FalconStor's product capabilities compete with products from a number of companies with substantially greater financial resources, such as Network Appliance, Inc., and Veritas Software Corporation. FalconStor is not aware of any other software company providing unified storage services running on a standard Linux or Solaris based appliance. FalconStor believes that the principal competitive factors affecting its market include product features such as scalability, data availability, ease of use, price, reliability, hardware/platform neutrality, customer service and support.
Additionally, as FalconStor executes upon its Storage Appliance Kit (SAK) initiative, which is based on the advanced network-storage services currently available in the IPStor software suite, the Company may experience supplemental competitive pressures from smaller, niche players in the industry. However, FalconStor believes these potential competitors currently do not offer the depth or breadth of storage services delivered by FalconStor, nor do they possess the experience and technological innovation needed to develop and deliver reliable, fully integrated, and proven storage services.
FalconStor's success will depend largely on its ability to generate market demand and awareness of the IPStor software suite and to develop additional or enhanced products in a timely manner. FalconStor's success will also depend on its ability to convince potential partners of the benefits of licensing its software rather than competing technologies. FalconStor's future and existing competitors could introduce products with superior features, scalability and functionality at lower prices than FalconStor's products and could also bundle existing or new products with other more established products to compete with FalconStor. Increased competition could result in price reductions and reduced gross margins, which could harm FalconStor's business.
INTELLECTUAL PROPERTY
FalconStor's success is dependent in part upon its proprietary technology. Currently, the IPStor software suite is the core of its proprietary technology. FalconStor currently has eighteen pending patent applications, six registered trademarks - including "FalconStor," "FalconStor Software" and "IPStor" - and many pending trademark applications related to FalconStor and the IPStor product.
FalconStor seeks to protect its proprietary rights and other intellectual property through a combination of copyright, trademark and trade secret protection, as well as through contractual protections such as proprietary information agreements and nondisclosure agreements. The technological and creative skills of its personnel, new product developments, frequent product enhancements and reliable product maintenance are essential to establishing and maintaining a technology leadership position.
FalconStor generally enters into confidentiality or license agreements with its employees, consultants and corporate partners, and generally controls access to and distribution of its software, documentation and other proprietary information. Despite FalconStor's efforts to protect its proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use its products or technology. Monitoring unauthorized use of its products is difficult, and there can be no assurance that the steps taken by FalconStor will prevent misappropriation of its technology, particularly in foreign countries where laws may not protect its proprietary rights as fully as do the laws of the United States.
MAJOR CUSTOMERS
For the year ended December 31, 2003, FalconStor did not have any customers that accounted for over 10% of revenues.
EMPLOYEES
As of December 31, 2003, FalconStor had 178 full-time employees, consisting of 42 in sales and marketing, 43 in service, 83 in research and development and 10 in general administration. FalconStor is not subject to any collective bargaining agreements and believes its employee relations are good.
INTERNET ADDRESS AND AVAILABILITY OF FILINGS
FalconStor's internet address is www.falconstor.com. FalconStor makes available free of charge on or through its Internet website, FalconStor's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Sections 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after FalconStor electronically files such material with, or furnishes it to, the SEC. FalconStor complied with this policy for every Securities Exchange Act of 1934 report filed during the year ended December 31, 2003.
ITEM 2.
ITEM 2. PROPERTIES
FalconStor's headquarters are located in an approximately 45,000 square foot facility located in Melville, New York, of which 22,000 square feet is currently being utilized. Offices are also leased for development, sales and marketing personnel, which total an aggregate of approximately 39,900 square feet in Euless, Texas; Le Chesnay, France; Taichung, Taiwan; Tokyo, Japan; Shanghai, China; Munich, Germany; and Seoul, Korea. Initial lease terms range from one to eight years, with multiple renewal options.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There were no material legal proceedings pending or, to our knowledge, threatened against us.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our Common Stock is listed on The Nasdaq National Market ("Nasdaq") under the symbol "FALC". The following table sets forth the range of high and low closing sales prices of our Common Stock for the periods indicated as reported by Nasdaq:
2003 2002 ---- ---- High Low High Low ---- --- ---- --- Fourth Quarter $ 9.15 $ 6.11 $ 4.99 $ 3.61 Third Quarter $ 6.89 $ 4.54 $ 6.20 $ 4.08 Second Quarter $ 7.11 $ 3.56 $ 7.44 $ 4.02 First Quarter $ 4.57 $ 3.47 $11.97 $ 6.20
HOLDERS OF COMMON STOCK
We had approximately 211 holders of record of Common Stock as of March 1, 2004. This does not reflect persons or entities whom hold Common Stock in nominee or "street" name through various brokerage firms.
DIVIDENDS
We have not paid any cash dividends on our common stock since inception. We expect to reinvest any future earnings to finance growth, and therefore do not intend to pay cash dividends in the foreseeable future. Our board of directors may determine to pay future cash dividends if it determines that dividends are an appropriate use of Company capital.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data with respect to our consolidated balance sheets as of December 31, 2003, 2002, 2001 and 2000 and the related consolidated statements of operations data for the years ended December 31, 2003, 2002 and 2001 and the period from inception (February 10, 2000) through December 31, 2000 have been derived from our audited consolidated financial statements. The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto and the information contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Period from Inception Year Ended Year Ended Year Ended (February 10, 2000) December 31, December 31, December 31, through December 31, 2003 2002 2001 2000 -------------------------------- ---------------------------------------- (In thousands, except per share data)
Revenues: Software license revenue ......................... $ 12,251 $ 8,667 $ 4,714 $ -- Maintenance revenue .............................. 2,473 1,297 17 -- Software services and other revenue .............. 2,220 665 861 143 -------- -------- --------- -------- 16,944 10,629 5,592 143 -------- -------- --------- -------- Operating expenses: Amortization of purchased and capitalized software 1,394 899 273 -- Cost of maintenance, software services and other revenue ....................................... 2,580 1,309 897 224 Software development costs ....................... 7,068 6,281 5,004 1,379 Selling and marketing ............................ 10,967 9,856 8,085 327 General and administrative ....................... 2,878 2,592 2,732 534 Lease abandonment charge ......................... 550 -- -- -- Impairment of prepaid royalty .................... -- 483 -- -- -------- -------- --------- -------- 25,437 21,420 16,991 2,464 -------- -------- --------- -------- Operating loss ........................... (8,493) (10,791) (11,399) (2,321) -------- -------- --------- --------
Interest and other income ........................... 1,122 1,585 1,365 225 Impairment of long-lived assets ..................... 35 (2,300) -- -- -------- -------- --------- -------- Loss before income taxes ................... (7,336) (11,506) (10,034) (2,096)
Provision for income taxes ......................... 33 37 22 -- -------- -------- --------- -------- Net loss ................................... $ (7,369) $(11,543) $(10,056) $ (2,096)
Beneficial conversion feature attributable to convertible preferred stock....................... -- -- 3,896 -- -------- -------- --------- -------- Net loss attributable to common shareholders ..................................... $ (7,369) $(11,543) $ (13,952) $(2,096) ======== ======== ========= ======== Basic and diluted net loss per share attributable to common shareholders .............................. $ (0.16) $ (0.26) $ (0.40) $ (0.09) ======== ======== ========= ======== Basic and diluted weighted average common shares outstanding.......................................... 45,968 45,233 35,264 24,383 ======== ======== ========= ========
CONSOLIDATED BALANCE SHEET DATA:
December 31, December 31, December 31, December 31, 2003 2002 2001 2000 ------------------------------------------------------------- (In thousands)
Cash and cash equivalents and marketable securities $36,685 $51,102 $64,527 $ 7,727 Working capital 39,131 47,746 57,518 7,254 Total assets 56,493 64,710 74,471 8,594 Long-term obligations -- -- 283 -- Stockholders' equity 50,556 55,901 63,562 8,057
ITEM 7.
ITEM 7. 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
The year 2003 was a year of growth - and investment in future growth - for our Company. Our revenues increased to $16.9 million from $10.6 million in 2002. We used these revenues and available cash to fund operations and to invest in infrastructure to position the Company for future growth.
The major areas of investment were in our personnel and our facilities.
To continue to create industry-leading cutting-edge network storage solutions, we hired additional development engineers and quality assurance engineers. We also hired engineers to design and test the products that are or will be sold by our OEM partners. Continuing to deliver products to meet the demands of the network storage market is necessary for us to remain competitive and to continue our growth.
We also increased our sales force and our technical support team. An increased sales force should expand the market exposure for our products. The expanded technical support team responds to questions and technical issues from end users of our products and from our resellers and OEM partners. Providing top notch technical support to these groups enhances our ability to continue to make sales. End users who are satisfied with our technical support are more likely to order additional products from us. Resellers and OEM partners who are happy with our technical support, and whose end users are satisfied, will be less likely to look to other providers for future products.
In November 2003, we moved our global headquarters to a larger facility in Melville, New York. Our previous office space had become inadequate for our personnel and equipment needs. Our new headquarters has over 45,000 square feet, of which we are currently utilizing 22,000 square feet. Our lease provides that we take possession and control of the space in stages, allowing us to occupy more space as we grow. Because of work done in the space by the prior tenant, a global computer services provider, we obtained a multi-million dollar technology and office infrastructure at no cost. This pre-built infrastructure includes computer labs and training rooms. The building has dual electrical feeds and diesel-powered generators to assure business continuity during unexpected events.
We also moved our Asia/Pacific headquarters in Taiwan to a larger location. This move provides the space needed for our growing Asia/Pacific presence.
The key factors we look to for our future business prospects are our sales pipeline, our ability to establish relationships with key industry OEMs and resellers, sales by our OEM partners, re-orders from existing customers, additional orders from resellers, and the growth of the overall market for network storage solutions.
Our sales "pipeline" consists of inquiries from end users and resellers for possible purchases of our products. Our overall sales pipeline steadily increased for each quarter of 2003 compared with the same quarter in 2002.
OEM relationships are important to us for two main reasons. First, sales by our OEM partners contribute to our revenues. Second, having our products selected by respected, established industry leaders signals to potential customers, resellers and other potential OEM partners that our products are quality products that add value to their enterprise.
During the past year, we announced strategic OEM relationships with both StorageTek and CNT. Each of these partners undertook broad reviews of all of the competing software solutions available and, after these reviews, each selected IPStor to power network storage solutions for their customers. The choice of IPStor by these major industry participants again validates the design and the capabilities of our products.
In 2003 we signed two additional worldwide OEM agreements with two major technology companies with global presences. These OEMs also conducted in-depth evaluations of all available storage software solutions and chose IPStor.
These four OEM relationships are in addition to the OEM partnerships we already had with companies including Acer, NEC, and Maxxan. We will continue to seek additional OEM opportunities in the future.
Many enterprises look to value added resellers or solution providers to assist them in making their information technology purchases. These resellers typically review an enterprise's needs and suggest a hardware, software, or combined hardware and software solution to fulfill the enterprise's requirements. Resellers have wide choices in fulfilling their customers' needs. We have established strong relationships with many premier resellers. In 2003, we signed agreements with many new resellers worldwide. We also terminated relationships with several resellers who we felt were not properly selling our products. We will continue to enter into relationships with resellers and to discontinue relationships with resellers with whom we are not satisfied.
In 2003, approximately 20% of our sales came from our OEM partners and approximately 80% of our sales came from resellers or distributors. We expect an increase in the percentage of sales attributable to OEMs in 2004 as our OEM relationships mature and expand.
The level of re-orders from existing end users of our products is a significant measure of customer satisfaction. Information technology professionals will only re-order products for their companies if they see that the products have reduced total cost of ownership and have provided a good return on investment. Re-orders are thus an indication that our products are delivering as promised and that our support is meeting the end users' needs. In 2003, we began to see re-orders from some of our end-users. These end-users ordered additional copies of IPStor or ordered additional options. If re-orders decline, it would indicate that future sales might also decline. However, the use of re-orders as an analytical tool is somewhat impaired because our OEM partners typically do not provide us with information identifying the end user for each order.
As service providers to companies, resellers' reputations are dependent on satisfying their customers' needs efficiently and effectively. If resellers determine that a product they have been providing to their customers is not functioning as promised or is not providing adequate return on investment, or if the customers are complaining about the level of support they are receiving from the suppliers, the resellers will move quickly to offer different solutions to their customers. Additional sales by resellers are therefore an important indicator of our business prospects.
The network storage solutions market continues to grow. (Please see the discussion on page 4.) In addition to growth based on the current demand for storage server consolidation and replication, we expect to see growth in backup acceleration.
Some of our strategic industry partners are applying IPStor in different market segments and on additional platforms. The demand for disaster recovery and backup solutions continues to expand. Our partners are offering appliances and other solutions powered by IPStor for replication and for Virtual Tape Library to meet this demand.
We are also seeing growing market acceptance of IP-based Storage Area Networks. Previously, most SANs had been based on fibre-channel. We plan to tap into the growth in this market through sales of our products by our strategic partners.
Another area of growth is dedicated-purpose storage "appliances." Storage appliances combine software with hardware to provide single-purpose turnkey solutions to critical data storage needs. In response to the needs of our customers and our resellers, we offer for sale various storage appliances. (Please see discussion on page 6.) We expect that sales of storage appliances by resellers and OEMs will form a higher percentage of our revenues in 2004 than in 2003.
Our critical accounting policies are those related to revenue recognition and accounts receivable allowances. As described in note 1 to our consolidated financial statements, we recognize revenue in accordance with the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended. Software license revenue is recognized only when pervasive evidence of an arrangement exists and the fee is fixed and determinable, among other criteria. An arrangement is evidenced by a signed customer contract for nonrefundable royalty advances received from OEMs or a customer purchase order for each software license resold by an OEM, distributor or solution provider to an end user. The software license fees are fixed and determinable as our standard payment terms range from 30 to 90 days, depending on regional billing practices, and we have not provided any of our customers extended payment terms. When a customer licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance for its fair value based on the contractual maintenance renewal rate.
We review accounts receivable to determine which are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider specific past due accounts, analysis of our accounts receivable aging, customer payment terms, historical collections, write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. Historically, we have not experienced a high level of write-offs and returns due to our customer relationships, contract provisions and credit assessments. Changes in the credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs, revenues and our general and administrative expenses.
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2003 COMPARED TO THE YEAR ENDED DECEMBER 31, 2002
Revenues for the year ended December 31, 2003 increased 59% to $16.9 million compared to $10.6 million for the year ended December 31, 2002. Our operating expenses increased 19% from $21.4 million in 2002 to $25.4 million in 2003. Net loss decreased 36% from $11.5 million in 2002 to $7.4 million in 2003. The increase in revenues was mainly due to an increase in demand for our network storage solution software. Over 80% of our revenues were generated from resellers and distributors and the remaining revenue was derived from OEM partners. Expenses increased in all departments to support our growth. We invested in additional employees and our headcount increased from 138 employees as of December 31, 2002 to 178 employees as of December 31, 2003. We also invested in infrastructure by purchasing additional computers and equipment and we moved our headquarters to a larger facility.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold through our OEMs, value-added resellers and distributors to end users and, to a lesser extent, directly to end users. These revenues are recognized when, among other requirements, we receive a customer purchase order and the software and permanent key codes are delivered to the customer. We also receive nonrefundable royalty advances and engineering fees from some of our OEM partners. These arrangements are evidenced by a signed customer contract, and the revenue is recognized when the software product master is delivered and accepted, and the engineering services, if any, have been performed.
Software license revenue increased 41% to $12.3 million in 2003 from $8.7 million in 2002. Increased market acceptance and demand for our product were the primary drivers of the increase in software license revenue. A continued increase in the number of our channel partners and OEMs also helped
increase our revenues. We expect our software license revenue to continue to grow and the percentage of software license revenue derived from our OEM partners to increase.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenues are comprised of software maintenance and technical support, professional services primarily related to the implementation of our software, engineering services, and sales of computer hardware. Revenue derived from maintenance and technical support contracts is deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Revenue from engineering services is primarily related to customizing software product masters for some of our OEM partners. Revenue from engineering services is recognized in the period the services are completed. In 2003 and 2002, we had a limited number of transactions in which we purchased hardware and bundled this hardware with our software and sold the bundled solution to a customer. A portion of the contractual fees is recognized as revenue when the hardware or software is delivered to the customer based on the relative fair value of the delivered element(s). Through December 31, 2003, the software and hardware in bundled solutions have almost always been delivered to the customer in the same quarter. Maintenance, software services and other revenue increased 139% to $4.7 million in 2003 from $2.0 million in 2002.
The major factor behind the increase in maintenance, software services and other revenue was an increase in the number of maintenance and technical support contracts we sold. As we are in business longer, and as we license more software, we expect these revenues will continue to increase. The majority of our new customers purchase maintenance and support and most customers renew their maintenance and support after their initial contracts expire. Maintenance revenue increased from $1.3 million for the year ended December 31, 2002 to $2.5 million for the year ended December 31, 2003. Growth in our professional services sales, which increased from $0.4 million in 2002 to $0.9 million in 2003, also contributed to the increase in software services and other revenues. This increase in professional services revenue was related to the increase in our software license customers that elected to purchase professional services. Additionally, our hardware sales increased from $0.2 million in 2002 to $1.3 million in 2003. This increase was the result of an increase in demand from our customers for bundled solutions.
We expect maintenance, software services and other revenues to continue to increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we must continually upgrade our software by enhancing the existing features of our products and by adding new features and products. We often evaluate whether to develop these new offerings in-house or whether we can achieve a greater return on investment by purchasing or licensing software from third parties. Based on our evaluations we have purchased or licensed various software for resale since 2001. Amortization of purchased and capitalized software increased from $0.9 million for the year ended December 31, 2002 to $1.4 million for the year ended December 31, 2003. The increase in amortization expense was due to our purchase of an additional $1.8 million of software licenses in 2003. As of December 31, 2003, we had $4.9 million of purchased software licenses that are being amortized over three years. For the year ended December 31, 2003, we recorded $1.4 million of amortization related to these purchased software licenses. As of December 31, 2002, we had $3.0 million of purchased software licenses and recorded approximately $0.9 million of amortization for the year ended December 31, 2002 related to these purchased software licenses. We will continue to evaluate third party software licenses and may make additional purchases, which would result in an increase in amortization expense.
The Company did not capitalize any software development costs until our initial product reached technological feasibility in March 2001. At that point, we capitalized $0.1 million of software development costs, which are being amortized at the greater of straight line over three years or the ratio of current revenue of the related products to total current and anticipated future revenue of these products. Amortization of capitalized software was $31,523 and $31,524 for the years ended December 31, 2003 and 2002, respectively.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenue consists primarily of personnel costs and other costs associated with providing software implementations, technical support under maintenance contracts, and training. Cost of maintenance, software services and other revenues also includes the cost of hardware purchased for resale. Cost of maintenance, software services and other revenues for the year ended December 31, 2003 increased by 97% to $2.6 million compared to $1.3 million for the year ended December 31, 2002. The increase in cost of maintenance, software services and other revenue was primarily driven by an increase in hardware sales. As we sold more hardware, our hardware costs for resale rose from $0.2 million in 2002 to $1.0 million in 2003. The increase in cost of maintenance, software services and other revenue was also due to an increase in personnel. As a result of our increased sales of maintenance and support contracts and professional services, we required a higher number of employees to provide technical support and to implement our software. Our cost of maintenance, software services and other revenue will continue to grow in absolute dollars as our revenue increases.
Gross profit for the year ended December 31, 2003 was $13.0 million or 77% of revenues compared to $8.4 million or 79% of revenues for the year ended December 31, 2002. The increase in gross profit was directly related to the increase in revenues. The decrease in gross margins was due to the increase in amortization of purchased software licenses and was also partially related to margins on hardware sales, which are typically lower than the margins on software and services.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for product development personnel and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Software development costs increased 13% to $7.1 million in 2003 from $6.3 million in 2002. The increase in software development costs was primarily due to an increase in employees required to enhance and test our core network storage software product, as well as to develop new innovative features and options. In addition, as we negotiated and signed new OEM partners, we required additional employees to test and customize our software with our OEM partners' products. In 2003, we also opened a development office in China to assist in our development work. We intend to continue recruiting and hiring product development personnel to support our development process.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses increased 11% to $11.0 million in 2003 from $9.9 million in 2002. As a result of the increase in revenue and interest in our software, our commission expense and travel expenses increased. In addition, we continued to hire new sales and sales support personnel and expand our worldwide presence to accommodate our revenue growth. We believe that to continue to grow sales, our sales and marketing expenses will continue to increase.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel costs of general and administrative functions, public company related fees, directors and officers insurance, legal and professional fees and other general corporate overhead costs. General and administrative expenses increased 11% to $2.9 million in 2003 from $2.6 million in 2002. One reason for the increase in general and administrative expenses is due to an increase in salaries. As our business grew, we required additional general and administrative personnel to support the growth. Another reason for the increase was due to higher premiums for our directors and officers insurance. We expect general and administrative expenses to continue to increase in order to support the growth of the business.
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in government securities and other low risk investments. Interest and other income decreased 29% to $1.1 million in 2003 from $1.6 million in 2002. This decrease in interest income was due to lower interest rates and lower average cash, cash equivalent and marketable securities balances. We expect interest and other income to decrease until the time we generate positive cash flows.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss incurred from the period from inception (February 10, 2000) through December 31, 2003, as we deemed that it was more likely than not that the deferred tax assets will not be realized based on our early stage of operations. Accordingly, we provided a full valuation allowance against our net deferred tax assets. Our income tax provision consists of tax liabilities related to our foreign subsidiaries.
LEASE ABANDONMENT CHARGE
In November 2003, we relocated our headquarters to a larger facility to accommodate our future growth. As a result of this relocation, we vacated our previous office space and recorded a charge for the estimated loss we expect to incur on the remaining lease obligation. The charge of $0.6 million included the remaining lease rental obligation reduced by cash flows we expect to generate from an agreement to sub-lease the facility as well as the write off of leasehold improvements at our previous facility. This expense is not expected to recur.
IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, we entered into an agreement with Network-1 Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2.8 million was paid to NSSI, of which $2.3 million was for the purchase of convertible preferred stock of NSSI accounted for under the cost method, and $0.5 million was for a non-refundable prepaid royalty recoupable against future product sales of NSSI's product. Primarily due to the decline in the market value of NSSI's common stock underlying the convertible preferred stock significantly below the Company's cost, we concluded in 2002 that the decline in the fair value of our investment in NSSI's preferred stock was other than temporary. Accordingly, in 2002 we recorded an impairment charge to write-off our investment in NSSI preferred stock. In addition, due to the lack of market acceptance of the NSSI product, we concluded that the unrecouped prepaid royalty was not recoverable and it was written off. As a result, in 2002, we recorded a $2.8 million charge for the impairment of long-lived and other assets related to our NSSI agreement, of which $0.5 million was an operating expense. In 2003, we received a payment from NSSI of $35,000 in exchange for all of our preferred stock of NSSI, which was reflected as a reduction to the impairment charge in the statement of operations. While we continue to hold warrants to purchase NSSI common stock, the exercise price of the warrants far exceeds the current market price for NSSI's common stock. We do not expect to incur any additional income or expenses from this investment.
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2002 COMPARED TO THE YEAR ENDED DECEMBER 31, 2001
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue increased 84% to $8.7 million in 2002 from $4.7 million in 2001. The increase in software license revenue was partially due to the release of our principal product at the end of the second quarter of 2001. Therefore in 2001, we only had two full quarters of software license revenue compared to a full year of revenue in 2002. Another reason for the increase in software license revenues was due to increased market acceptance of our product as well as an increase in the number of our channel partners.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 124% to $2.0 million in 2002 from $0.9 million in 2001. The primary reason for the increase in maintenance, software services and other revenue was an increase in the number of our maintenance and technical support contracts. Since our software was only released at the end of the second quarter of 2001, we had limited maintenance and technical support revenue in 2001.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
Amortization of purchased and capitalized software increased from $0.3 million for the year ended December 31, 2001 to $0.9 million for the year ended December 31, 2002. The increase in amortization expense was due to our purchase of an additional $0.8 million of software licenses in 2002. As of December 31, 2002, we had $3.0 million of purchased software licenses that are being amortized over three years. For the year ended December 31, 2002, we recorded $0.9 million of amortization related to these purchased software licenses. As of December 31, 2001, we had $2.2 million of purchased software licenses and recorded approximately $0.3 million of amortization for the year ended December 31, 2001 related to these purchased software licenses. Amortization of capitalized software was $23,643 and $31,524 for the years ended December 31, 2001 and 2002, respectively.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues increased 46% to $1.3 million in 2002 from $0.9 million in 2001. The main reason for the increase in cost of revenues was due to the increase in revenues. As a result of the increase in revenues, we required a higher average number of employees to provide technical support under our maintenance contracts and to help deploy our software. The hardware costs associated with hardware revenue amounted to $0.2 million in 2002. There were no hardware costs in 2001.
Gross profit for the year ended December 31, 2002 was $8.4 million or 79% compared with $4.4 million or 79% for the year ended December 31, 2001. The absolute dollar increase in gross profit was due to the increase in total revenue compared to the prior year.
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 25% to $6.3 million in 2002 from $5.0 million in 2001. The increase in software development costs was mainly due to an increase in development personnel. The increase in employees was required to enhance and test our core network storage software product, as well as to develop new innovative features and options.
SELLING AND MARKETING
Selling and marketing expenses increased 22% to $9.9 million in 2002 from $8.1 million in 2001. This increase in selling and marketing expenses was due to our product being released during the end of the second quarter of 2001. As a result of this release, we expanded our sales force to accommodate our revenue growth and we initiated our marketing efforts to promote our product and create brand awareness. In addition, as a result of the increase in revenues our commission expense increased.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased 5% to $2.6 million in 2002 from $2.7 million in 2001. The decrease in general and administrative expenses was due to a non-cash consulting expense for option grants and higher legal fees in 2001. These amounts were partially offset by a significant increase in premiums for directors and officers insurance in 2002.
INTEREST AND OTHER INCOME
Interest and other income increased 16% to $1.6 million in 2002 from $1.4 million in 2001. This increase in interest income was due to higher average cash, cash equivalent and marketable securities balances as a result of the merger with NPI.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss incurred from the period from inception (February 10, 2000) through December 30, 2002, as we deemed that it was more likely than not that the deferred tax assets will not be realized based on our development and now early stage operations. Accordingly, we provided a full valuation allowance against our net deferred tax assets. Our income tax provision consists of tax liabilities related to our foreign subsidiaries.
IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, we entered into an agreement with Network-1 Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2.8 million was paid to NSSI, of which $2.3 million was for the purchase of convertible preferred stock of NSSI accounted for under the cost method, and $0.5 million was for a non-refundable prepaid royalty recoupable against future product sales of NSSI's product. Primarily due to a decline in the market value of NSSI's common stock underlying the convertible preferred stock significantly below the Company's cost, we concluded the decline in the fair value of our investment in NSSI's preferred stock was other than temporary. Accordingly, in 2002 we recorded an impairment charge to write-off our investment in NSSI preferred stock. In addition, due to the lack of market acceptance of the NSSI product in its current state, we concluded that the unrecouped prepaid royalty is not recoverable and it was written off. As a result, in 2002, we recorded a $2.8 million charge for the impairment of long-lived and other assets related to our NSSI agreement, of which $0.5 million was an operating expense.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents totaled $8.5 million and marketable securities totaled $28.2 million at December 31, 2003. As of December 31, 2002, we had $14.2 million in cash and cash equivalents and $36.9 million in marketable securities. The reasons for this decrease in cash and cash equivalents and marketable securities are discussed below. Because we have not yet been profitable, the major use of our cash has been to fund operations. Until we reach profitability, we will continue to use our cash to fund operations.
In 2003, we made investments in our infrastructure to support our long-term growth. We moved our headquarters to a larger facility and made investments in property and equipment. In addition, we increased the total number of employees in 2003 to support our growth. As we continue to grow, we
will continue to make investments in property and equipment and will need to continue to increase our headcount. In the past, we also used cash to purchase software licenses and to make acquisitions. We will continue to evaluate potential software license purchases and acquisitions and if the right opportunity presents itself we may continue to use our cash in these areas.
We currently do not have any debt and our only commitments are related to our office leases.
In connection with our acquisition of IP Metrics in July 2002, we must make cash payments to the former shareholders of IP Metrics, which are contingent on the level of revenues from IP Metrics products for a period of twenty-four months subsequent to the acquisition. In 2003, we made payments to the former shareholders of IP Metrics totaling $287,130. As of December 31, 2003, the Company has accrued $0.1 million of additional purchase consideration related to sales of IP Metrics products.
In October 2001, our Board of Directors authorized the repurchase of up to two million shares of our outstanding common stock. Since October 2001, 235,000 shares have been repurchased at an aggregate purchase price of $1.4 million. No shares were repurchased in 2003.
Net cash used in operating activities totaled $6.2 million for the year ended December 31, 2003 compared to $7.5 million for the year ended December 31, 2002 and $10.1 million for the year ended December 31, 2001. The trend of decreasing cash used in operations is the result of our decreasing net loss. In 2002, we incurred a non-cash expense of $2.8 million related to an impairment of long-lived and other assets. The decrease in net loss is mainly attributable to our increases in revenues. In addition to the decrease in net loss, our non-cash charges, including depreciation and amortization and equity based compensation increased from $1.5 million in 2001 to $2.5 million in 2002 and $3.3 million in 2003. These increases are mainly due to increases in property and equipment and purchased software licenses. These amounts were partially offset by increases in our accounts receivable balances of $2.5 million in 2001, $1.7 million in 2002 and $2.8 million in 2003. The increases in our accounts receivable balances are due to our revenue growth. We expect cash used in operating activities to continue to decrease as our net loss decreases.
Net cash provided by investing activities was $2.8 million in 2003 and net cash used in investing activities was $15.5 million in 2002. Cash provided by investing activities in 2001 was $34.7 million. In 2001, we acquired $48.2 million in cash related to our acquisition of NPI. We did not have any similar transactions in 2002 or 2003. Included in investing activities for each year are the sales and purchases of our marketable securities. These represent the sales, maturities and reinvesting of our marketable securities. In 2003 the net cash provided from the net sale of securities was $8.5 million, in 2002 and 2001 the cash used from the net purchase of marketable securities was $10.7 and $7.4 million, respectively. These amounts will fluctuate from year to year depending on the maturity dates of our marketable securities. The cash used to purchase property and equipment has increased from $1.3 million in 2001 and 2002 to $3.0 million in 2003. The increase in 2003 was due to our investment in our infrastructure and our relocation of our company headquarters. The cash used to purchase software licenses was $2.2 million in 2001, $0.8 million in 2002 and $1.8 million in 2003. In 2002, we used $2.6 million in cash related to two acquisitions. We did not make any similar acquisitions in 2001 or 2003. We continually evaluate potential software licenses and acquisitions and we may continue to make these investments if we find opportunities that would benefit our business.
Net cash provided by financing activities was $0.9 million in each of 2003 and 2002 and $7.0 million in 2001. In 2001 we received $7.9 million in proceeds from the issuance of preferred stock. In 2003 and 2002 we did not issue any preferred stock. We received proceeds from the exercise of stock options of $0.9 million in 2003, $1.1 million in 2002 and $0.3 million in 2001.
The Company's only contractual obligations relate to its operating leases. The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to a domestic office and offices in foreign countries. The expiration dates for these leases ranges from 2004 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2003:
Year ending December 31,
2004..................................... $ 966,570 2005..................................... 1,174,510 2006..................................... 1,375,952 2007..................................... 1,238,840 2008..................................... 1,121,064 Thereafter............................... 3,778,261 ----------- $ 9,655,197 ===========
For the years ended December 31, 2003, 2002 and 2001, we paid $3.0 million, $2.1 million and $0.8 million, respectively, related to discontinued operations. As of December 31, 2003, all significant payments related to our discontinued operations have been settled.
Based on our increasing revenues, decreasing net loss and decreasing cash burn rate, we believe that our current balance of cash, cash equivalents and marketable securities, and expected cash flows from operations will be sufficient to meet our cash requirements for at least the next twelve months.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board ("FASB") determined that stock-based compensation should be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. The FASB has not as yet determined the methodology for calculating fair value and plans to issue an accounting standard that would become effective in 2005. We will continue to monitor communications on this subject from the FASB to determine the impact on our consolidated financial statements.
In July 2003, the EITF reached a consensus on Issue 03-5, Applicability of AICPA SOP 97-2 to Non-Software Deliverables. The consensus was reached that SOP 97-2 is applicable to non-software deliverables if they are included in an arrangement that contains software that is essential to the non-software deliverables' functionality. The adoption of Issue 03-5 effective October 1, 2003 did not have a material impact on our consolidated financial statements.
RISK FACTORS
WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY.
We have had limited revenues and a history of losses. For the year ended December 31, 2003, we had revenues of $16.9 million. For the period from inception (February 10, 2000) through December 31, 2003 and for the year ended December 31, 2003, we had net losses of $31.1 million and $7.4 million, respectively. We have signed contracts with resellers and original equipment manufacturers, or OEMs, and believe that as a result of these contracts, our revenues should increase in the future, although we are unable to predict whether we will be profitable. Our business model depends upon signing agreements with additional OEM customers, further developing our reseller sales channel, and expanding our sales force. Any difficulty in obtaining these OEM and reseller customers or in attracting qualified sales personnel will hinder our ability to generate additional revenues and achieve or maintain profitability.
FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING RESULTS.
Achieving our anticipated growth will depend on a number of factors, some of which include:
o retention of key management, marketing and technical personnel;
o our ability to increase our customer base and to increase the sales of our products; and
o competitive conditions in the storage networking infrastructure software market.
We cannot assure you that the anticipated growth will be achieved. The failure to achieve anticipated growth could harm our business, financial condition and operating results.
OUR BOARD OF DIRECTORS MAY SELECTIVELY RELEASE SHARES OF OUR COMMON STOCK FROM LOCK-UP RESTRICTIONS.
Currently, approximately 25.5 million shares of our common stock are subject to contractual lock-up restrictions expiring on April 30, 2004. Our board of directors may, in its sole discretion, release any or all of the shares of our common stock from lock-up restrictions at any time with or without notice. Any release of such shares from lock-up restrictions may be applied on a proportionate or selective basis. If the release is selectively applied, the stockholders whose shares are not released will be forced to hold such shares while other stockholders may sell. In addition, the release of any of such shares could depress our stock price.
WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.
During the third quarter of 2003, we signed a lease for new office space that commenced on November 1, 2003 and continues through February, 2012. The lease obligations are substantially greater than our prior lease obligations. This commitment could impact our ability to achieve or to maintain profitability.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage infrastructure software market in which we sell our products and other factors that are beyond our control, reduces our ability to accurately forecast our quarterly and annual revenue. However, we use our forecasted revenue to establish our expense budget. Most of our expenses are fixed in the short term or incurred in advance of anticipated revenue. As a result, we may not be able to decrease our expenses in a timely manner to offset any shortfall in revenue.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall demand for network storage infrastructure software. Because our sales are primarily to major corporate customers, any softness in demand for network storage infrastructure software may result in decreased revenues.
THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT DEVELOP AS WE EXPECT.
The rapid adoption of Storage Area Networks (SAN) and Network Attached Storage (NAS) solutions is critical to our future success. The markets for SAN and NAS solutions are still unproven, making it difficult to predict their potential sizes or future growth rates. Most potential customers have made substantial investments in their current storage networking infrastructure, and they may elect to remain with current network architectures or to adopt new architecture, in limited stages or over extended periods of time. We are uncertain whether a viable market for our products will develop or be sustainable. If these markets fail to develop, or develop more slowly than we expect, our business, financial condition and results of operations would be adversely affected.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE IN THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.
The network storage infrastructure software market continues to evolve and as a result there is continuing demand for new products. Accordingly, we may need to develop and manufacture new products that address additional
network storage infrastructure software market segments and emerging technologies to remain competitive in the data storage software industry. We are uncertain whether we will successfully qualify new network storage infrastructure software products with our customers by meeting customer performance and quality specifications or quickly achieve high volume production of storage networking infrastructure software products. Any failure to address additional market segments could harm our business, financial condition and operating results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN, NAS or Direct Attached Storage ("DAS") system. All components of these systems must comply with the same industry standards in order to operate together efficiently. We depend on companies that provide other components of these systems to conform to industry standards. Some industry standards may not be widely adopted or implemented uniformly, and competing standards may emerge that may be preferred by OEM customers or end users. If other providers of components do not support the same industry standards as we do, or if competing standards emerge, our products may not achieve market acceptance, which would adversely affect our business.
OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.
Our IPStor platform is complex and is designed to be deployed in large and complex networks. Many of our customers have unique infrastructures, which may require additional professional services in order for our software to work within their infrastructure. Because our products are critical to the networks of our customers, any significant interruption in their service as a result of defects in our product within our customers' networks could result in lost profits or damage to our customers. These problems could cause us to incur significant service and warranty costs, divert engineering personnel from product development efforts and significantly impair our ability to maintain existing customer relationships and attract new customers. In addition, a product liability claim, whether successful or not, would likely be time consuming and expensive to resolve and would divert management time and attention. Further, if we are unable to fix the errors or other problems that may be identified in full deployment, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with our resellers and OEM partners to develop storage appliances that combine certain aspects of IPStor functionality with third party hardware to create single purpose turnkey solutions that are designed to be easy to deploy. If the storage appliances are not easy to deploy or do not integrate smoothly with end user systems, the basic premise behind the appliances will not be met and sales would be impacted negatively.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require that each of our products undergo an extensive qualification process, which involves interoperability testing of our product in the OEM's system as well as rigorous reliability testing. This qualification of a product by an OEM does not assure any sales of the product to the OEM. Despite this uncertainty, we devote substantial resources, including sales, marketing and management efforts, toward qualifying our products with OEMs in anticipation of sales to them. If we are unsuccessful or delayed in qualifying any products with an OEM, such failure or delay would preclude or delay sales of that product to the OEM, which may impede our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by our OEM customers and by our resellers. These OEM customers and resellers have limited resources and sales forces and sell many different products, both
in the network storage infrastructure software market and in other markets. The OEM customers and resellers may choose to focus their sales efforts on other products in the network storage infrastructure software market or other markets. The OEM customers might also choose not to continue to develop or to market products which include our products. This would likely result in lower revenues to us and would impede our ability to grow our business.
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR PRODUCTS.
As part of our sales channel, we license our software to OEMs and other partners who install our software on their own hardware or on the hardware of other third parties. If the hardware does not function properly or causes damage to customers' systems, we could lose sales to future customers, even though our software functions properly. Problems with our partners' hardware could negatively impact our business.
THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage infrastructure software market is intensely competitive even during periods when demand is stable. Some of our current and potential competitors have longer operating histories, significantly greater resources, broader name recognition and a larger installed base of customers than we have. Those competitors and other potential competitors may be able to establish or to expand network storage infrastructure software offerings more quickly, adapt to new technologies and customer requirements faster, and take advantage of acquisition and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower their product costs or to otherwise compete more effectively against us; or
o bundle their products with other products to increase demand for their products.
In addition, some OEMs with whom we do business, or hope to do business, may enter the market directly and rapidly capture market share. If we fail to compete successfully against current or future competitors, our business, financial condition and operating results may suffer.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of software and related revenue recognition;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive prices before we do;
o our ability to manage successfully the complex and difficult process of qualifying our products with our customers;
o our customers canceling, rescheduling or deferring significant orders for our products, particularly in anticipation of new products or enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or modify. As a result, the fixed nature of our expenses will magnify any adverse effect of a decrease in revenue on our operating results.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and may be volatile in the future. For example, during the past twelve months ended December 31, 2003, the market price of our common stock as quoted on the NASDAQ National Market System fluctuated between $3.47 and $9.15. The market price of our common stock may be significantly affected by the following factors:
o actual or anticipated fluctuations in our operating results;
o failure to meet financial estimates;
o changes in market valuations of other technology companies, particularly those in the storage networking infrastructure software market;
o announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been unrelated to the performance of particular companies. These market fluctuations may cause our stock price to fall regardless of our performance.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the stockholders, to issue up to 2,000,000 shares of preferred stock on such terms and with such rights, preferences and designations, including, without limitation restricting dividends on our common stock, dilution of the voting power of our common stock and impairing the liquidation rights of the holders of our common stock, as the Board may determine without any vote of the stockholders. Issuance of such preferred stock, depending upon the rights, preferences and designations thereof may have the effect of delaying, deterring or preventing a change in control. In addition, certain "anti-takeover" provisions of the Delaware General Corporation Law, among other things, may restrict the ability of our stockholders to authorize a merger, business combination or change of control. Finally, we have entered into change of control agreements with certain executives.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF OUR COMMON STOCK.
As of December 31, 2003, we had outstanding options and warrants to purchase an aggregate of 10,610,425 shares of our common stock at a weighted average exercise price of $4.42 per share. We also have 1,410,855 shares reserved for issuance under our stock option plans with respect to options that have not been granted.
The exercise of all of the outstanding options would dilute the then-existing stockholders' percentage ownership of common stock, and any sales in the public market of the common stock issuable upon such exercise could adversely affect prevailing market prices for the common stock. Moreover, the terms upon which we would be able to obtain additional equity capital could be adversely affected because the holders of such securities can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms more favorable than those provided by such securities.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.
Our success is dependent upon our proprietary technology. Currently, the IPStor software suite is the core of our proprietary technology. We have eighteen pending patent applications and multiple pending trademark applications related to our IPStor product. We cannot predict whether we will receive patents for our pending or future patent applications, and any patents that we own or that are issued to us may be invalidated, circumvented or challenged. In addition, the laws of certain countries in which we sell and manufacture our products, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States.
We also rely on trade secret, copyright and trademark laws, as well as the confidentiality and other restrictions contained in our respective sales contracts and confidentiality agreements to protect our proprietary rights. These legal protections afford only limited protection.
OUR TECHNOLOGY MAY BE SUBJECT TO INFRINGEMENT CLAIMS THAT COULD HARM OUR BUSINESS.
We may become subject to litigation regarding infringement claims alleged by third parties. If an action is commenced against us, our management may have to devote substantial attention and resources to defend that action. An unfavorable result for the Company could have a material adverse effect on our business, financial condition and operating results and could limit our ability to use our intellectual property.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United States involving patents, trademarks and other intellectual property rights. Legal proceedings could subject us to significant liability for damages or invalidate our intellectual property rights. Any litigation, regardless of its outcome, would likely be time consuming and expensive to resolve and would divert management's time and attention. Any potential intellectual property litigation against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual property;
o obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology or trademark, which license may not be available on reasonable terms, or at all; or
o redesign those products that use infringing intellectual property or cease to use an infringing product or trademark.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key employees, many of whom would be extremely difficult to replace. We do not have key person life insurance on any of our personnel. Worldwide competition for skilled employees in the network storage infrastructure software industry is extremely intense. If we are unable to retain existing employees or to hire and integrate new employees, our business, financial condition and operating results could suffer. In addition, companies whose employees accept positions with competitors often claim that the competitors have engaged in unfair hiring practices. We may be the subject of such claims in the future as we seek to hire qualified personnel and could incur substantial costs defending ourselves against those claims.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM, OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies or their assets. Integration of the acquired products, technologies and businesses, could divert management's time and resources. Further, we may not be able to properly integrate the acquired products, technologies or
businesses, with our existing products and operations, train, retain and motivate personnel from the acquired businesses, or combine potentially different corporate cultures. If we are unable to fully integrate the acquired products, technologies or businesses, or train, retain and motivate personnel from the acquired businesses, we may not receive the intended benefits of the acquisitions, which could harm our business, operating results and financial condition.
LONG TERM CHARACTER OF INVESTMENTS.
Our present and future equity investments may never appreciate in value, and are subject to normal risks associated with equity investments in businesses. These investments may involve technology risks as well as commercialization risks and market risks. As a result, we may be required to write down some or all of these investments in the future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which currently we deem immaterial also may become important factors that affect us.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and marketable securities is subject to interest rate risks. We regularly assess these risks and have established policies and business practices to manage the market risk of our marketable securities.
FOREIGN CURRENCY RISK. We have several offices outside the United States. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. The effect of foreign currency exchange rate fluctuations have not been material since our inception. We do not use derivative financial instruments to limit our foreign currency risk exposure.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements Page
Independent Auditors' Report...........................................31
Consolidated Balance Sheets as of December 31, 2003 and 2002...........32
Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001...................................33
Consolidated Statements of Stockholders' Equity and Comprehensive Loss for the years ended December 31, 2003, 2002 and 2001...................................34
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001...................................35
Notes to Consolidated Financial Statements.............................37
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders FalconStor Software, Inc.:
We have audited the accompanying consolidated balance sheets of FalconStor Software, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FalconStor Software, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Melville, New York February 4, 2004
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
December 31, 2003 2002 ---- ---- Assets Current assets: Cash and cash equivalents ................................................ $ 8,486,144 $ 14,191,075 Marketable securities .................................................... 28,199,242 36,910,448 Accounts receivable, net of allowances of $1,837,934 and $813,645, respectively.................................................. 7,109,922 4,285,892 Prepaid expenses and other current assets ................................ 1,273,125 1,167,174 ------------ ------------ Total current assets ............................................ 45,068,433 56,554,589
Property and equipment, net ................................................. 3,861,069 2,068,001 Goodwill .................................................................... 3,366,642 3,301,599 Other intangible assets, net ................................................ 396,940 309,491 Other assets ................................................................ 3,799,949 2,476,306 ------------ ------------ Total assets .................................................... $ 56,493,033 $ 64,709,986 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ......................................................... $ 562,305 $ 437,088 Accrued expenses ......................................................... 2,777,391 1,987,651 Deferred revenue ......................................................... 2,597,788 2,182,729 Liabilities of discontinued operations ................................... -- 4,201,465 ------------ ------------ Total current liabilities ....................................... 5,937,484 8,808,933 ------------ ------------
Commitments
Stockholders' equity: Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- -- Common stock - $.001 par value, 100,000,000 shares authorized, 46,745,330 and 45,527,590 shares issued, respectively ................ 46,745 45,528 Additional paid-in capital ............................................... 83,277,981 81,423,661 Deferred compensation .................................................... (7,969) (471,445) Accumulated deficit ...................................................... (31,063,589) (23,694,634) Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,435,130) Accumulated other comprehensive (loss) income ............................ (262,489) 33,073 ------------ ------------
Total stockholders' equity ...................................... 50,555,549 55,901,053 ------------ ------------ Total liabilities and stockholders' equity ...................... $ 56,493,033 $ 64,709,986 ============ ============ See accompanying notes to consolidated financial statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2003 2002 2001 ------------------------------------------------
Revenues: Software license revenue ................................ $ 12,250,616 $ 8,666,583 $ 4,713,909 Maintenance revenue ..................................... 2,473,504 1,297,146 16,720 Software services and other revenue ..................... 2,220,015 665,163 861,100 ------------ ------------ ------------ 16,944,135 10,628,892 5,591,729 ------------ ------------ ------------ Operating expenses: Amortization of purchased and capitalized software 1,394,301 899,024 272,532 Cost of maintenance, software services and other revenue 2,580,141 1,309,139 897,145 Software development costs .............................. 7,067,605 6,280,936 5,004,953 Selling and marketing ................................... 10,966,548 9,856,496 8,084,588 General and administrative .............................. 2,878,192 2,591,430 2,731,551 Lease abandonment charge ................................ 550,162 -- -- Impairment of prepaid royalty ........................... -- 482,715 -- ------------ ------------ ------------ 25,436,949 21,419,740 16,990,769 ------------ ------------ ------------ Operating loss .................................. (8,492,814) (10,790,848) (11,399,040) ------------ ------------ ------------
Interest and other income .................................. 1,121,391 1,585,351 1,364,780 Impairment of long-lived assets ............................ 35,000 (2,300,062) -- ------------ ------------ ------------ Loss before income taxes .......................... (7,336,423) (11,505,559) (10,034,260)
Provision for income taxes ................................ 32,532 37,606 21,490 ------------ ------------ ------------ Net loss .......................................... $ (7,368,955) $(11,543,165) $(10,055,750) ------------ ------------ ------------ Beneficial conversion feature attributable to convertible preferred stock .......................... -- -- 3,896,287 ------------ ------------ ------------ Net loss attributable to common shareholders ............................................ $ (7,368,955) $(11,543,165) $(13,952,037) ============ ============ ============ Basic and diluted net loss per share attributable to common shareholders ..................................... $ (0.16) $ (0.26) $ (0.40) ============ ============ ============ Basic and diluted weighted average common shares outstanding ............................................. 45,967,830 45,232,595 35,264,277 ============ ============ ============
See accompanying notes to consolidated financial statements.
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
Accumulated other compre- Convertible Additional Deferred hensive preferred Common paid-in compen- Accumulated Treasury income stock stock capital sation deficit stock (loss) ----------- ----------- ----------- ----------- ------------ ------------ -----------
Balance, December 31, 2000 $ 7,900 $ 10,900 $ 10,625,252 $ (469,351) $ (2,095,719) $ - $ (22,005)
Issuance of 3,193,678 shares of Series C preferred stock 3,194 7,929,141 - - - -
Issuance of stock options and common stock to non-employees - - 450,802 - - - -
Exercise of stock options - 593 254,273 - - - -
Deferred compensation - - 1,028,640 (1,028,640) - - -
Amortization of deferred compensation - - - 471,317 - - -
Net loss - - - - (10,055,750) - -
Conversion of preferred stock into common stock (11,094) 20,207 (9,113) - - - -
Issuance of common stock in connection with NPI merger - 13,349 57,713,001 - - - -
Acquisition of treasury stock - - - - - (1,220,730)
Net unrealized gain on marketable securities - - - - - - 4,533
Foreign currency translation adjustment - - - - - - (59,128) -----------------------------------------------------------------------------------------
Balance, December 31, 2001 $ - $ 45,049 $77,991,996 $(1,026,674) $(12,151,469)$ (1,220,730) $ (76,600)
Issuance of stock options to non-employees - - 32,890 - - - -
Compensation expense for accelerated vesting of stock options - - 231,415 - - - -
Exercise of stock options - 479 1,112,970 - - - -
Amortization of deferred compensation and option forfeitures - - (95,610) 555,229 - - -
Net loss - - - - ( 11,543,165) - -
Acquisition of treasury stock - - - - - (214,400) -
Adjustment to the fair value of the net tangible assets acquired in the NPI merger - - 2,150,000 - - - -
Net unrealized gain on marketable securities - - - - - - 90,904
Foreign currency translation adjustment - - - - - - 18,769 ----------- ----------- ----------- ----------- ------------ ------------ ----------- Balance, December 31, 2002 $ - $ 45,528 $81,423,661 $ (471,445) $ (23,694,634) $ (1,435,130) $ 33,073
Issuance of stock options to non-employees - - 86,875 - - - -
Exercise of stock options - 1,217 850,600 - - - -
Amortization of deferred compensation - - - 463,476 - - -
Net loss - - - - (7,368,955) - -
Adjustment to the fair value of the net tangible assets acquired in the NPI merger - - 916,845 - - - -
Net unrealized loss on marketable securities - - - - - - (214,394)
Foreign currency translation adjustment - - - - - - (81,168) ---------------------------------------------------------------------------- ----------- Balance, December 31, 2003 $ - $ 46,745 $83,277,981 $ (7,969) $(31,063,589) $(1,435,130)$ (262,489) =========================================================================================
Total Compre- stockholders' hensive equity loss ------------ ------------
Balance, December 31, 2000 $ 8,056,977
Issuance of 3,193,678 shares of Series C preferred stock 7,932,335 -
Issuance of stock options and common stock to non-employees 450,802 -
Exercise of stock options 254,866 -
Deferred compensation - -
Amortization of deferred compensation 471,317 -
Net loss (10,055,750) (10,055,750)
Conversion of preferred stock into common stock - -
Issuance of common stock in connection with NPI merger 57,726,350 -
Acquisition of treasury stock (1,220,730) -
Net unrealized gain on marketable securities 4,533 4,533
Foreign currency translation adjustment (59,128) (59,128) -------------------------
Balance, December 31, 2001 $63,561,572 $(10,110,345) ============
Issuance of stock options to non-employees 32,890 -
Compensation expense for accelerated vesting of stock options 231,415 -
Exercise of stock options 1,113,449 -
Amortization of deferred compensation and option forfeitures 459,619 -
Net loss (11,543,165) (11,543,165)
Acquisition of treasury stock (214,400) -
Adjustment to the fair value of the net tangible assets acquired in the NPI merger 2,150,000 -
Net unrealized gain on marketable securities 90,904 90,904
Foreign currency translation adjustment 18,769 18,769 ------------ ------------- Balance, December 31, 2002 $55,901,053 $ (11,433,492) =============
Issuance of stock options to non-employees 86,875 -
Exercise of stock options 851,817 -
Amortization of deferred compensation 463,476 -
Net loss (7,368,955) (7,368,955)
Adjustment to the fair value of the net tangible assets acquired in the NPI merger 916,845 -
Net unrealized loss on marketable securities (214,394) (214,394)
Foreign currency translation adjustment (81,168) (81,168) --------------------------- Balance, December 31, 2003 $ 50,555,549 $ (7,664,517) ===========================
See accompanying notes to consolidated financial statements.
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003 2002 2001 -----------------------------------------------------
Cash flows from operating activities: Net loss ............................................................. $ (7,368,955) $(11,543,165) $(10,055,750) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization .................................. 2,759,030 1,747,380 617,277 Non-cash professional services expenses ........................ 86,875 32,890 450,802 Equity-based compensation expense .............................. 463,476 691,034 471,317 Impairment of long-lived and other assets ...................... -- 2,782,777 -- Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable, net ....................................... (2,824,030) (1,728,305) (2,524,173) Prepaid expenses and other current assets ...................... (137,115) (571,635) (1,029,022) Other assets ................................................... (227,711) (9,119) -- Accounts payable ............................................... 125,217 (121,685) 407,633 Accrued expenses ............................................... 474,697 55,868 1,321,774 Deferred revenue ............................................... 415,059 1,175,735 224,912 ------------ ----------- ---------- Net cash used in operating activities ....................... (6,233,457) (7,488,225) (10,115,230) ------------ ----------- ----------- Cash flows from investing activities: Purchase of marketable securities .................................... (8,537,284) (39,507,257) (9,312,973) Sale of marketable securities ........................................ 17,034,096 28,843,893 1,868,430 Purchase of investment ............................................... (137,710) (75,000) (2,300,062) Purchase of property and equipment ................................... (2,998,908) (1,272,104) (1,340,583) Purchase of software licenses ........................................ (1,821,000) (800,000) (2,240,000) Purchase of intangible assets ........................................ (246,697) (145,534) -- Net cash acquired from acquisition of NPI ............................ -- -- 48,208,649 Net cash paid for acquisition of IP Metrics .......................... -- (2,381,726) -- Net cash paid for acquisition of FarmStor ............................ -- (169,640) -- Security deposits .................................................... (500,000) (35,802) (210,166) ------------ ----------- ----------- Net cash provided by (used in) investing activities ............... 2,792,497 (15,543,170) 34,673,295
Cash flows from financing activities: Net proceeds from issuance of preferred stock ........................ -- -- 7,932,335 Proceeds from exercise of stock options .............................. 851,817 1,113,449 254,866 Payments to acquire treasury stock ................................... -- (214,400) (1,220,730) ------------ ----------- ----------- Net cash provided by financing activities ......................... 851,817 899,049 6,966,471 ------------ ----------- -----------
Cash flows from discontinued operations: Payments of liabilities of discontinued operations (3,034,620) (2,066,285) (821,653) ------------ ----------- -----------
Effect of exchange rate changes ......................................... (81,168) 18,769 (59,128) ------------ ----------- ----------- Net (decrease) increase in cash and cash equivalents (5,704,931) (24,179,862) 30,643,755
Cash and cash equivalents, beginning of year ............................ 14,191,075 38,370,937 7,727,182 ------------ ----------- ----------- Cash and cash equivalents, end of year ................................. $ 8,486,144 $ 14,191,075 $ 38,370,937 ============ =========== =========== In connection with the merger with NPI (note 2) additional paid-in capital increased as follows:
Cash acquired ...................................................... -- -- 57,091,647 Marketable securities acquired ..................................... -- -- 18,707,104 Merger related costs ............................................... -- -- (8,882,998) Fair value of property and equipment acquired ...................... -- -- 50,000 Fair value of accounts receivable acquired ......................... -- -- 92,000 Liabilities of discontinued operations assumed ..................... 916,845 2,150,000 (9,331,403) Par value of common stock issued ................................... -- -- (13,349) ------------ ----------- ----------- Increase in additional paid-in capital ............................. $ 916,845 $ 2,150,000 $ 57,713,001 ------------ ----------- ----------- Cash paid for income taxes ............................................ $ 37,289 $ 34,082 $ -- ============ =========== ===========
The Company did not pay any interest expense for the three years ended December 31, 2003.
See accompanying notes to consolidated financial statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) THE COMPANY AND NATURE OF OPERATIONS
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures and sells network storage infrastructure software solutions and provides the related maintenance, implementation and engineering services.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
(c) CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents, consisting of money market funds and commercial paper, amounted to approximately $8.2 million and $13.6 million at December 31, 2003 and 2002, respectively. Marketable securities at December 31, 2003 and 2002 amounted to $28.2 million and $36.9 million, respectively, and consisted of corporate bonds and government securities, which are classified as available for sale, and accordingly, unrealized gains and losses on marketable securities are reflected as a component of stockholders' equity.
(d) REVENUE RECOGNITION
The Company recognizes revenue from software licenses in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition. Accordingly, revenue for software licenses is recognized when persuasive evidence of an arrangement exists, the fee is fixed and determinable, the software is delivered and collection of the resulting receivable is deemed probable. Software delivered to a customer on a trial basis is not recognized as revenue until a permanent key is delivered to the customer. When a customer licenses software together with the purchase of maintenance, the Company allocates a portion of the fee to maintenance for its fair value based on the contractual maintenance renewal rate. Software maintenance fees are deferred and recognized as revenue ratably over the term of the contract. The cost of providing technical support is included in cost of revenues.
Revenues associated with software implementation and software engineering services are recognized as the services are performed. Costs of providing these services are included in cost of revenues.
The Company has entered into various distribution, licensing and joint promotion agreements with OEMs and distributors, whereby the Company has provided to the reseller a non-exclusive software license to install the Company's software on certain hardware or to resell the Company's software in exchange for payments based on the products distributed by the OEM or distributor. Nonrefundable advances and engineering fees received by the Company from an OEM are recorded as deferred revenue and recognized as revenue when related software engineering services are complete, if any, and the software product master is delivered and accepted.
For the years ended December 31, 2003 and 2002, the Company had a limited number of transactions in which it purchased hardware and bundled this hardware with the Company's software and sold the bundled solution to its customer. Since the software is not essential for the functionality of the equipment included in the Company's bundled solutions, and both the hardware and software have stand
alone value to the customer, a portion of the contractual fees is recognized as revenue when the software or hardware is delivered based on the relative fair value of the delivered element(s).
(e) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets (3 to 7 years).
(f) 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. Consistent with Statement of Financial Accounting Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not amortized goodwill related to its acquisitions, but has instead tested the balance for impairment. The Company's annual impairment assessment is performed on December 31st of each year, and additionally if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. Identifiable intangible assets are amortized over a three-year period using the straight-line method. Amortization expense was $159,248 and $52,893 for 2003 and 2002, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of December 31, 2003 and December 31, 2002 are as follows:
December 31, December 31,
2003 2002 ---------- ----------- Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850 Accumulated amortization (108,425) (36,142) ---------- ----------- Net carrying amount $ 108,425 $ 180,708 ========== ===========
Patents and trademarks:
Gross carrying amount $ 392,231 $ 145,534 Accumulated amortization (103,716) (16,751) ---------- ----------- Net carrying amount $ 288,515 $ 128,783 ========== ===========
As of December 31, 2003, amortization expense on existing identifiable intangible assets, purchased software technology and software development costs will be $1,582,352, $900,675, and $303,626 for the years ended December 31, 2004, 2005 and 2006, respectively. Such assets will be fully amortized at December 31, 2006.
(g) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
Costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company's product development process, technological feasibility is established upon completion of a working model. The Company did not capitalize any software development costs until its initial product reached technological feasibility at the end of March 2001. Until such product was released, the Company capitalized $94,570 of software development costs, of which $31,523, $31,524 and $23,643 was amortized for the years ended December 31, 2003, 2002 and 2001, respectively. Amortization of software development costs is recorded at the greater of straight line over three years or the ratio of current revenue of the related products to total current and anticipated future revenue of these products.
Purchased software technology of $2,381,833 and $1,923,611, net of accumulated amortization of $2,479,167 and $1,116,389, is included in other assets in the balance sheets as of December 31, 2003 and December 31, 2002, respectively. Amortization expense was $1,362,778, $867,499 and 248,889 for the years ended December 31, 2003, 2002 and 2001, respectively.
(h) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
(i) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the sum of the expected future cash flows, undiscounted and without interest, is less than the carrying amount of the asset, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value.
(j) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25 to account for its fixed-plan stock options. Under this method, compensation expense is recorded only if on the date of grant the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the fair value method under SFAS No. 123, the Company's pro forma net loss and diluted net loss per share would have been adjusted to the pro forma amounts indicated below:
2003 2002 2001 ------------ ------------ ------------
Net loss attributable to common shareholders-as reported $ (7,368,955) $(11,543,165) $(13,952,037)
Add stock-based employee compensation expense included in reported net income, net of tax 463,476 691,034 471,317
Deduct total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax (10,480,088) (5,830,622) (3,394,894) ------------ ------------ ------------
Net loss - pro forma $(17,385,567) $(16,682,753) $(16,875,614) ============ ============ ============
Basic net loss per common share-as reported $ (0.16) $ (0.26) $ (0.40)
Basic net loss per common share-pro forma $ (0.38) $ (0.37) $ (0.48)
The per share weighted average fair value of stock options granted during 2003, 2002 and 2001 was $5.60, $2.29 and $4.08, respectively, on the date of grant using the Black-Scholes option-pricing method with the following weighted average assumptions: 2003 - expected dividend yield of 0%, risk free interest rate of 3%, expected stock volatility ranging from 68% to 153% and an expected option life of five years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees;
2002 - expected dividend yield of 0%, risk free interest rate of 3%, expected stock volatility of 44% and an expected option life of five years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees;
2001 - expected dividend yield of 0%, risk free interest rate of 3%, expected stock volatility of 118% and an expected option life of three years for options granted to employees of the Company, and an option life of ten years for options granted to non-employees.
(k) FINANCIAL INSTRUMENTS
As of December 31, 2003 and 2002, the fair value of the Company's financial instruments including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximates book value due to the short maturity of these instruments.
(l) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of exchange at the end of the period, while results of operations are translated at average exchange rates in effect for the period. Unrealized gains and losses from the translation of foreign assets and liabilities are classified as a separate component of stockholders' equity. Realized gains and losses from foreign currency transactions are included in the statements of operations.
(m) EARNINGS PER SHARE (EPS)
Basic EPS is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents. Due to net losses for the periods presented, all common stock equivalents were excluded from diluted net loss per share. As of December 31, 2003, 2002 and 2001, potentially dilutive common stock equivalents included 9,860,425, 9,387,579 and 7,274,717 stock options outstanding, respectively. As of December 31, 2003, potentially dilutive common stock equivalents also included 750,000 warrants outstanding.
(n) COMPREHENSIVE INCOME (LOSS)
Comprehensive loss includes the Company's net loss, foreign currency translation adjustments and unrealized (losses) gains on marketable securities.
(o) USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(p) NEW ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board ("FASB") determined that stock-based compensation should be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. The FASB has not as yet determined the methodology for calculating fair value and plans to issue an accounting standard that would become effective in 2005. The Company will continue to monitor communications on this subject from the FASB to determine the impact on the Company's consolidated financial statements.
In July 2003, the EITF reached a consensus on Issue 03-5, Applicability of AICPA SOP 97-2 to Non-Software Deliverables. The consensus was reached that SOP 97-2 is applicable to non-software deliverables if they are included in an arrangement that contains software that is essential to the non-software deliverables' functionality. The adoption of Issue 03-5 effective October 1, 2003 did not have a material impact on the Company's consolidated financial statements.
(q) RECLASSIFICATIONS
Certain reclassifications have been made to prior years' consolidated financial statements to conform to the current year's presentation.
(2) ACQUISITIONS
On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned subsidiary of the Company, acquired all of the common stock of IP Metrics Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for mission-critical networks, for $2,432,419 in cash plus payments contingent on the level of revenues from IP Metrics' products and services for a period of twenty-four months. The acquisition was accounted for under the purchase method and the results of IP Metrics are included with those of the Company from the date of acquisition. As of December 31, 2003, the Company made contingent acquisition payments totaling $287,130 related to the sale of IP Metrics' products and services and accrued an additional $67,855 of incurred but unpaid contingent consideration. Contingent consideration incurred through December 31, 2003 in excess of the amount accrued at the time of acquisition, of $65,043, was added to goodwill in 2003.
The fair value of the net tangible liabilities of IP Metrics assumed was $898,305, including $289,942 of accrued contingent consideration recorded at the time of acquisition. The Company purchased certain intangible assets, including customer relationships and purchased technology with a fair value of $216,850. These intangible assets are being amortized under the straight-line method over an estimated useful life of 3 years, the expected period of benefit. The purchase price in excess of the fair value of the net tangible and intangible assets acquired and liabilities assumed by the Company amounted to $3,178,917 and has been recorded as goodwill.
On November 12, 2002, FalconStor AC, Inc., acquired all of the common stock of FarmStor, a software sales organization in the Republic of Korea for $180,000 in cash. The fair value of the net tangible liabilities of FarmStor assumed was $7,725. The purchase price in excess of the fair value of the net tangible assets acquired and liabilities assumed by the Company amounted to $187,725 and has been recorded as goodwill.
The following unaudited pro forma consolidated financial information gives effect to the above described acquisitions of IP Metrics and FarmStor, as if they had occurred at the beginning of the period by consolidating the continuing results of operations of the Company, IP Metrics and FarmStor for the year ended December 31, 2002.
Year Ended December 31, ------------------
Revenues $ 11,089,570 Net Loss from continuing operations (11,972,835) Basic and diluted net loss from continuing operations per share $ (0.26) Weighted average basic and diluted shares outstanding 45,232,595
The pro forma information is provided for illustrative purposes only and does not represent what the actual consolidated results of operations would have been had the merger occurred on the dates assumed, nor are they necessarily indicative of future results of operations.
On August 22, 2001, pursuant to an Agreement and Plan of Merger and Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged with Network Peripherals, Inc. ("NPI"), with NPI as the surviving corporation. Under the terms of the Merger Agreement, all of FalconStor's preferred shares were converted into common shares and the stockholders of FalconStor received 0.721858 shares of NPI common stock for each share of FalconStor common stock that they held. Although NPI acquired FalconStor, as a result of the transaction, FalconStor stockholders held a majority of the voting interests in the combined enterprise after the merger. Accordingly, for accounting purposes, the acquisition was a "reverse acquisition" and FalconStor was the "accounting acquirer." Further, as a result of NPI's decision on June 1, 2001 to discontinue its NuWave and legacy business, at the time of the merger NPI was a non-operating public shell with no continuing operations, and no intangible assets associated with NPI were purchased by FalconStor. As a result, the transaction was accounted for as a recapitalization of FalconStor and recorded based on the fair value of NPI's net tangible assets acquired by FalconStor, with no goodwill or other intangible assets being recognized. Costs incurred by FalconStor directly related to the transaction, amounting to $8,882,998, were charged to additional paid-in capital. The conversion of all of FalconStor's preferred stock into common stock resulted in an additional 20,207,460 shares of common stock outstanding and, for accounting purposes, the merger resulted in the issuance of 13,348,605 common shares to NPI's pre-merger shareholders. In connection with the merger, the name of NPI was changed to FalconStor Software, Inc.
(3) PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
December 31, December 31, 2003 2002 Useful Lives ---------------------------------------------
Computer hardware and software $ 5,607,838 $ 2,913,989 3 years
Furniture and equipment 473,774 276,179 5-7 years
Leasehold improvements 231,578 124,115 ----------- ----------- 6,313,190 3,314,283
Less accumulated depreciation (2,452,121) (1,246,282) ----------- ----------- $ 3,861,069 $ 2,068,001 =========== ===========
Depreciation expense was $1,205,839, $826,989, and $368,388 in 2003, 2002, and 2001, respectively.
(4) MARKETABLE SECURITIES
The Company accounts for its short-term investments in accordance with SFAS 115, Accounting for Certain Investments in Debt and Equity Securities ("SFAS 115"). SFAS 115 establishes the accounting and reporting requirements for all debt securities and for investments in equity securities that have a readily determinable fair market value. All short-term marketable securities must be classified as one of the following: held-to-maturity, available-for-sale or trading securities. The Company's short-term investments consist of available-for-sale securities, which are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Unrealized gains and losses are computed on the basis of the specific identification method. Realized gains, realized losses and declines in value judged to be other-than-temporary, are included in other income. The cost of available-for-sale securities sold are based on the specific identification method and interest earned is included in interest and other income.
The cost and fair values of the Company's marketable securities as of December 31, 2003 and 2002 are as follows:
Aggregate Cost Unrealized Unrealized Fair Value Basis Gains Losses ---------- ----- ----- ------
Available-for-sales securities:
December 31, 2003 $ 28,199,242 $ 28,318,199 $ - $ (118,957)
December 31, 2002 $ 36,910,448 $ 36,815,011 $ 95,437 $ -
Marketable securities at December 31, 2003 and 2002 consist of corporate bonds and government securities.
(5) ACCRUED EXPENSES
Accrued expenses are comprised of the following:
December 31, December 31, 2003 2002 -----------------------------
Accrued compensation $ 697,839 $ 826,721
Accrued consulting and professional fees 302,425 327,416
Accrued marketing and promotion 50,000 170,282
Other accrued expenses 965,774 441,654
Accrued IP Metrics contingent purchase price 67,855 221,578
Accrued hardware purchases 253,682 -
Accrued and deferred rent 439,816 - ---------- ---------- $2,777,391 $1,987,651 ========== ==========
(6) INCOME TAXES
The provision for income taxes for the years ended December 31, 2003, 2002 and 2001 are comprised solely of foreign income taxes. The tax effects of temporary differences that give rise to the Company's deferred tax assets (liabilities) as of December 31, 2003 and 2002 are as follows:
2003 2002 ---- ----
U.S. net operating loss carryforwards (FalconStor) $ 12,525,600 $ 8,285,700 U.S. net operating loss carryforwards (NPI) 31,756,000 31,756,000 Start-up costs not currently deductible for taxes 714,300 1,014,200 Depreciation (584,500) (47,200) Compensation 367,900 412,800 Tax credit carryforwards 1,067,100 704,900 Liabilities of discontinued operations -- 2,667,400 Deferred revenue 957,700 783,300 Capital loss carryforward 951,300 -- Lease abandonment charge 231,100 -- Impairment of investment -- 966,000 Allowance for receivables 771,900 341,700 Other 103,600 (44,900) ------------ ------------ 48,862,000 46,839,900 Valuation allowance (48,862,000) (46,839,900) ------------ ------------ $ -- $ -- ============ ============
The difference between the provision for income taxes computed at the Federal statutory rate and the reported amount of tax expense attributable to loss before income taxes for the years ended December 31, 2003, 2002 and 2001, are as follows:
2003 2002 2001 ------------ ----------- ----------- Tax recovery at Federal statutory rate $ (2,494,400) $(3,911,900) $(3,411,700) Increase (reduction) in income taxes resulting from: State and local taxes, net of Federal income tax benefit (318,000) (788,400) (819,400) Non-deductible expenses 41,900 41,400 34,600 Compensation 157,600 389,800 -- Foreign tax credit (90,000) (125,800) (21,490) Net effect of foreign operations (900) 75,700 (610) Research and development credit (272,200) (233,500) (345,600) Increase in valuation allowance 3,008,600 4,590,300 4,585,690 ------------ ----------- ----------- $ 32,600 $ 37,600 $ 21,490 ============ =========== ===========
Income (loss) before provision for income taxes for the years ended December 31, 2003, 2002 and 2001 are as follows:
2003 2002 2001 ------------ ------------ ------------
Domestic loss $ (7,434,000) $(11,393,000) $(10,099,000)
Foreign income (loss) 98,000 (113,000) 65,000 ------------ ------------ ------------ $ (7,336,000) $(11,506,000) $(10,034,000) ============ ============ ============
As of December 31, 2003, the Company has U.S. net operating loss carryforwards of approximately $29,823,000 which expire from 2020 through 2023. In addition, as of the date of the merger, NPI had U.S. net operating loss carryforwards of $93,400,000 that start to expire in December, 2012. At December 31, 2003 and 2002, the Company has established a valuation allowance against its net deferred tax assets due to the Company's pre-tax losses and the resulting likelihood that the deferred tax asset is not realizable. Due to the Company's various equity transactions, which resulted in a change of control, the utilization of certain tax loss carryforwards is subject to annual limitations imposed by Internal Revenue Code Section 382. NPI experienced such ownership change as a result of the merger. As such, the Company's ability to use its NOL carryforwards to offset taxable income in the future may be significantly limited. If the entire deferred tax asset were realized, $4,524,000 would be allocated to paid-in-capital with the remainder reducing income tax expense. Of the amount allocable to paid-in-capital, $2,593,000 related to the tax effect of the deductions that will result from payments of the liabilities of discontinued operations and the balance of $1,931,000 related to the tax effect of compensation deductions from exercises of employee and consultant stock options.
(7) STOCKHOLDERS' EQUITY
In November 2000, in connection with a consulting agreement, the Company, in addition to agreeing to pay a monthly consulting fee, sold 72,185 shares of restricted common stock to a consultant for $25,000 ($0.35 per share). The consultant's rights vested for 23,821 shares on each of November 1, 2001 and 2002 and the remaining 24,543 shares vested on November 1, 2003. As of March 31, 2001, the services related to this consulting agreement were fully performed. The excess of the fair value of the common stock over $0.35 of $122,000 and $32,000 in 2001 and 2000, respectively, was recorded as cumulative consulting expense in each period up until the services were fully performed.
In March 2000, the Company issued 3,000,000 shares of its Series A convertible preferred stock ("Series A"). While outstanding, each share of Series A was convertible, at the option of the holder, into five shares of common stock. The Series A was not redeemable at the option of the holder.
In September 2000, the Company issued 4,900,000 shares of its Series B convertible preferred stock ("Series B"). While outstanding each share of Series B was convertible, at the option of the holder, into two shares of common stock. The Series B was not redeemable at the option of the holder.
On May 4, 2001, the Company issued 3,193,678 shares of its Series C preferred stock ("Series C") at 2.55 per share for net proceeds of $7,932,335. While outstanding, each share of Series C was convertible, at the option of the holder, into one share of common stock. The Series C automatically converted into common stock upon the consummation of a merger or consolidation of the Company with or into another company. The holders of Series C were entitled to receive cumulative cash dividends at the same rate as dividends were paid with respect to the common stock. The Series C was not redeemable at the option of the holder and had a liquidation preference equal to the greater of $2.55 per share plus all accumulated unpaid dividends, or the amount that the Series C holders would have received had they converted all Series C into shares of common stock.
The issuance of the Series C preferred stock resulted in a beneficial conversion feature, which was recorded as a preferred stock dividend in the second quarter of 2001, since the Series C preferred stock was convertible at issuance. The beneficial conversion feature of $3,896,287 was calculated on the
date of issuance, based on the difference between the fair value of the Company's common stock which would be issued upon conversion of the preferred stock and the amount paid for the preferred stock.
In connection with the Company's merger with NPI in August 2001, all of FalconStor's preferred stock was converted into common stock which resulted in an additional 20,207,460 shares of common stock outstanding and, for accounting purposes, the merger resulted in the issuance of 13,348,605 common shares to NPI's pre-merger shareholders.
In September, 2003, the Company entered into a worldwide OEM agreement with a major technology company (the "OEM"), and issued warrants to the OEM to purchase 750,000 shares of the Company's common stock with an exercise price of $6.18 per share. A portion of the warrants will vest annually subject to the OEM's achievement of pre-defined and mutually agreed upon sales objectives over a three-year period. If the OEM generates cumulative revenues to the Company in the mid-eight figure dollar range from reselling the Company's products then all the warrants granted will vest. Any warrants that do not vest by the end of the three-year period will expire. If and when it is probable that all or a portion of the warrants will vest, the then fair value of the warrants earned will be recorded as a reduction of revenue. Subsequently, each quarter the Company will apply variable accounting to adjust such amount to reflect the fair value of the warrants until they vest. The Company expects to begin deriving revenues from sales by the OEM in 2004.
(8) STOCK OPTION PLANS
As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000 Stock Option Plan (the "Plan"). The Plan is administered by the Board of Directors and, as amended, provides for the issuance of up to 12,662,296 options to employees, consultants and non-employee directors. Options may be incentive ("ISO") or non-qualified. Exercise prices of ISOs granted must be at least equal to the fair value of the common stock on the date of grant, and have terms not greater than ten years, except those to an employee who owns stock with greater than 10% of the voting power of all classes of stock of the Company, in which case they must have an option price at least 110% of the fair value of the stock, and expire no later than five years from the date of grant.
Certain of the options granted to employees had exercise prices less than the fair value of the common stock on the date of grant, which resulted in deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively. The amortization of deferred compensation amounted to $463,476, $459,619 and $471,317 in 2003, 2002 and 2001, respectively.
The Company granted options to purchase an aggregate of 5,000, 50,000, and 25,546 shares of common stock to certain non-employee consultants in exchange for professional services during 2003, 2002 and 2001, respectively. The aggregate fair value of these options as determined using the fair value method under SFAS No. 123, is being expensed over the periods the services are provided. The related expense amounted to $86,875, $32,890, and $328,802 in 2003, 2002 and 2001, respectively.
In February 2002, the Company accelerated the vesting of stock options of one employee upon his death. Compensation costs of $231,415 were recorded based on the intrinsic value of the options on the date of acceleration.
As of December 31, 2003, there were outstanding vested options to purchase 186,667 common shares under one of the former NPI stock option plans. The Company does not intend to grant any additional options under the NPI plans except for the 1994 Outside Directors Stock Option Plan which, as amended, has 500,000 shares authorized for issuance upon the exercise of options, of which options to purchase 260,000 shares were outstanding as of December 31, 2003.
Stock option activity for the periods indicated is as follows:
Weighted average Number of exercise Options price ------- -----
Outstanding at December 31, 2000 ............... 4,735,027 $ 0.35 Granted ........................................ 2,591,451 $ 5.37 Assumed in connection with NPI acquisition .... 1,717,040 $ 10.78 Exercised ...................................... (593,297) $ 0.43 Canceled ....................................... (1,175,504) $ 8.46 ---------- Outstanding at December 31, 2001 ............... 7,274,717 $ 3.28 Granted ........................................ 3,088,500 $ 4.60 Exercised ...................................... (478,038) $ 2.32 Canceled ....................................... (497,600) $ 7.53 ---------- Outstanding at December 31, 2002 ............... 9,387,579 $ 3.55 ---------- Granted ........................................ 2,678,300 $ 7.01 Exercised ...................................... (1,224,833) $ .70 Canceled ....................................... (980,621) $ 9.19 ---------- Outstanding at December 31, 2003 ............... 9,860,425 $ 4.29 ========== Vested at December 31, 2001 .................... 2,177,265 $ 4.49 ========== Vested at December 31, 2002 .................... 3,829,793 $ 3.21 ========== Vested at December 31, 2003 .................... 4,950,046 $ 2.47 ========== Options available for grant at December 31, 2003 1,410,855 ==========
During 2003, one employee paid for the exercise price of certain options with 7,094 shares of common stock that were held greater than six months. Such shares which had a market value of $28,744 were retired.
The following table summarizes information about stock options outstanding at December 31, 2003:
Options Outstanding Options Exercisable -------------------------------------------------------- -------------------------------------
Weighted - Average Weighted Range of Number Remaining Contractual Average Exercise Number Weighted - Average Exercise Prices Outstanding Life (Years) Price Exercisable Exercise Price ------------------- ------------ --------------------- ---------------- ----------- ------------------
$0.00 - $1.10 3,059,065 6.50 $0.35 3,045,564 $0.35 $3.29 - $4.38 1,450,130 8.90 $4.03 444,559 $4.04 $4.38 - $5.48 2,377,586 8.10 $5.13 629,118 $4.91 $5.48 - $6.57 1,136,564 7.90 $6.12 563,786 $6.20 $7.67 - $8.76 1,435,300 9.90 $8.46 3,300 $7.98 $8.76 - $9.86 200,923 7.50 $9.69 129,147 $9.70 $9.86 - $10.95 200,857 7.10 $10.95 134,572 $10.95 --------- --------- 9,860,425 7.93 $4.29 4,950,046 $2.47 ========= =========
(9) LEASE ABANDONMENT CHARGE
In November 2003, the Company relocated its headquarters to a larger facility. As a result of this relocation, the Company vacated its previous office space and recorded a lease abandonment charge of $550,162 for the
estimated loss expected to be incurred on the remaining lease obligation through July 2007. The charge included the remaining lease rental obligation reduced by cash flows the Company expects to generate from an agreement to sub-lease the facility, as well as the write-off of leasehold improvements at the Company's previous facility.
(10) IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, the Company entered into an agreement with Network-1 Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2,800,062 was paid to NSSI, of which $2,300,062 was for the purchase of convertible preferred stock accounted for under the cost method and $500,000 was for a nonrefundable prepaid royalty recoupable against future product sales of NSSI's product. Primarily due to the decline since May, 2002 in the market value of NSSI's common stock underlying the convertible preferred stock to a value which was significantly below the Company's cost, the Company concluded the decline in the fair value of its investment in NSSI's preferred stock was other than temporary. Accordingly, in 2002 the Company recorded an impairment charge of $2,300,062 to write down its investment in NSSI to fair value. In addition, due to the lack of market acceptance of the NSSI product in its then current state, the unrecouped prepaid royalty was not recoverable and in 2002 the Company recorded an impairment charge of $482,715 to write off this prepaid royalty. In 2003, the Company sold all its NSSI convertible preferred stock for $35,000, which was reflected as a reduction to the impairment charge in the statement of operations.
(11) LIABILITIES OF DISCONTINUED OPERATIONS
Liabilities of NPI's discontinued operations at December 31, 2002 totaled $4.2 million and consisted of warranty related liabilities, foreign income taxes, severance related payments, professional fees and other related liabilities, including estimated settlement costs for disputes. As of December 31, 2002, the Company had reduced liabilities of discontinued operations and increased additional paid-in-capital by $2,150,000 for its then estimate of the excess of the remaining liabilities for discontinued operations over the amounts estimated to be paid.
On February 14, 2003, the Company settled a claim associated with the liabilities of discontinued operations for $2,850,000. As of December 31, 2003 all significant contingent liabilities related to the discontinued operations of NPI have been resolved and paid. As a result, the excess of the remaining liabilities for discontinued operations over the amounts paid of $916,845 has been reflected as an increase to additional paid-in-capital in the accompanying balance sheet as of December 31, 2003 since this liability was related to the merger with NPI, which was accounted for as a recapitalization.
(12) COMMITMENTS
The Company has an operating lease covering its primary office facility that expires in February, 2012. The Company also has several operating leases related to a domestic office and offices in foreign countries. The expiration dates for these leases ranges from 2004 through 2012. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2003:
Year ending December 31, ------------------------
2004....................................... $ 966,570 2005....................................... 1,174,510 2006....................................... 1,375,952 2007....................................... 1,238,840 2008....................................... 1,121,064 Thereafter................................. 3,778,261 ----------- $ 9,655,197 ===========
These leases require the Company to pay its proportionate share of real estate taxes and other common charges. Total rent expense for operating leases was $673,949, $596,578, and $381,260 for the years ended December 31, 2003, 2002 and 2001, respectively.
The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with SFAS No. 5, Accounting for Contingencies. To date, the Company has not incurred any costs related to warranty obligations.
Under the terms of substantially all of its software license agreements, the Company has agreed to indemnify its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company's software infringes the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with SFAS No. 5. Through December 31, 2003, there have not been any claims under such indemnification provisions.
(13) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors authorized the repurchase of up to two million shares of the Company's outstanding common stock. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company's management. The terms of the stock repurchases will be determined by management based on market conditions. As of December 31, 2003, the Company repurchased a total of 235,000 shares for $1,435,130. The Company did not repurchase any shares in 2003.
(14) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the years ended December 31, 2003, 2002 and 2001 and the location of long-lived assets as of December 31, 2003, 2002 and 2001 are summarized as follows:
2003 2002 2001 --------------------------------------------
Revenues:
United States $ 9,834,526 $ 6,629,147 $ 1,755,823
Asia and other international 7,109,609 3,999,745 3,835,906 ----------- ----------- ----------- Total Revenues $16,944,135 $10,628,892 $ 5,591,729 =========== =========== ===========
Long-lived assets (includes all non-current assets):
United States $10,329,876 $ 7,655,900 $ 5,963,235
Asia and other international 1,094,724 499,497 363,599 ----------- ----------- ----------- Total long-lived assets $11,424,600 $ 8,155,397 $ 6,326,834 =========== =========== ===========
For the year ended December 31, 2003, the Company did not have any customers that accounted for over 10% of revenues. For the year ended December 31, 2002, the Company had one customer that accounted for 16% of revenues. For the year ended December 31, 2001, the Company had one customer that accounted for 13% of revenues.
(15) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR DOUBTFUL ACCOUNTS
Balance at Balance at Beginning of Additions charged End of Period Ended, Period to Expense Deductions Period ------------- ------ ---------- ---------- ------
December 31, 2003 $ 813,645 $ 1,700,100 $ 675,811 $ 1,837,934 December 31, 2002 $ 375,541 $ 930,150 $ 492,046 $ 813,645 December 31, 2001 $ -- $ 375,541 $ -- $ 375,541
(16) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of selected quarterly financial data for the years ended December 31, 2003 and 2002:
Fiscal Quarter First Second Third Fourth ----- ------ ----- ------
Revenue $ 3,678,907 $ 4,090,877 $ 4,082,617 $ 5,091,734 Net loss $ (1,738,853) $ (1,578,925) $ (1,894,198)$ (2,156,979) Basic and diluted net loss per share $ (0.04) $ (0.03) $ (0.04) $ (0.05) Basic and diluted weighted average common shares outstanding 45,499,862 45,848,994 46,134,816 46,376,183
Revenue $ 1,980,842 $ 2,376,618 $ 2,855,522 $ 3,415,910 Net loss $ (2,581,385) $ (2,464,671) $ (3,562,455) $ (2,934,654) Basic and diluted net loss per share $ (0.06) $ (0.05) $ (0.08) $ (0.06) Basic and diluted weighted average common shares outstanding 45,184,257 45,238,657 45,239,977 45,266,504
The sum of the quarterly net loss per share amounts do not always equal the annual amount reported, as per share amounts are computed independently for each quarter and the annual period based on the weighted average common shares outstanding in each such period.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES.
The company maintains "disclosure controls and procedures", as such term is defined in Rules 13a-15e and 15d-15e of the Securities and Exchange Act of 1934, as amended (the "Exchange Act"), that are designed to ensure that information required to be disclosed in its reports, pursuant to the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to its management, including its Chief Executive Officer and Principal Accounting Officer, as appropriate, to allow timely decisions regarding the required disclosures. In designing and evaluating the disclosure controls and procedures, management has recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.
The Company's Chief Executive Officer and Principal Accounting Officer (its principal executive officer and principal accounting officer, respectively) have evaluated the effectiveness of its "disclosure controls and procedures" as of the end of the period covered by this Annual Report on Form 10-K. Based on their evaluation, the principal executive officer and principal financial officer concluded that its disclosure controls and procedures are effective. There were no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date the controls were evaluated.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information called for by Part III, Item 10, regarding the Registrant's directors will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2004, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions "Election of Directors", "Management" and "Committees of the Board of Directors". The Proxy Statement will be filed within 120 days of December 31, 2003, our year-end.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information called for by Part III, Item 11, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2004, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Executive Compensation." The Proxy Statement will be filed within 120 days of December 31, 2003, our year-end.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information called for by Part III, Item 12, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2004, and is incorporated herein by reference. The information appears in the Proxy Statement under the captions "Beneficial Ownership of Shares" and "Equity Compensation Plan
Information." The Proxy Statement will be filed within 120 days of December 31, 2003, our year-end.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding our relationships and related transactions will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2004, and is incorporated by reference. The information appears in the Proxy Statement under the caption "Certain Relationships and Related Transactions." The Proxy Statement will be filed within 120 days of December 31, 2003, our year-end.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information called for by Part III, Item 14, will be included in our Proxy Statement relating to our annual meeting of stockholders scheduled to be held in May 2004, and is incorporated herein by reference. The information appears in the Proxy Statement under the caption "Principal Accounting Fees and Services." The Proxy Statement will be filed within 120 days of December 31, 2003, our year-end.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The information required by subsections (a)(1) and (a)(2) of this item are included in the response to Item 8 of Part II of this annual report on Form 10-K.
(b) Reports on Form 8-K
On November 5, 2003, we filed a Form 8-K under Items 7 and 12.
(c)
2.1 Agreement and Plan of Merger and Reorganization, dated as of May 4, 2001, among FalconStor, Inc., Network Peripherals Inc., and Empire Acquisition Corp, incorporated herein by reference to Annex A to the Registrant's joint proxy/prospectus on Form S-4, filed May 11, 2001.
3.1 Restated Certificate of Incorporation, incorporated herein by reference to Exhibit 3.1 to the Registrant's registration statement on Form S-1 (File no. 33-79350), filed on April 28, 1994.
3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to the Registrant's quarterly report on form 10-Q for the period ended March 31, 2000, filed on May 10, 2000.
3.3 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.3 to the Registrant's annual report on Form 10-K for the year ended December 31, 1998, filed on March 22, 1999.
3.4 Certificate of Amendment to the Certificate of Incorporation, incorporated herein by reference to Exhibit 3.4 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002.
4.1 2000 Stock Option Plan, incorporated herein by reference to Exhibit 4.1 of the Registrant's registration statement on Form S-8, filed on September 21, 2001.
4.2 2000 Stock Option Plan, as amended May 15, 2003, incorporated herein by reference to Exhibit 99 to the Registrant's quarterly report on Form 10-Q for the period ended June 30, 2003, filed on August 14, 2003.
4.3 1994 Outside Directors Stock Plan, as amended May 17, 2002 incorporated herein by reference to Exhibit 4.2 to the Registrant's annual period on Form 10-K for the year ended December 31, 2002, filed on March 17, 2003.
10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and FalconStor Software, Inc., dated August, 2003, incorporated herein by reference to Exhibit 99.1 to the Registrant's quarterly report on Form 10-Q for the period ended September 30, 2003, filed on November 14, 2003.
10.2 ReiJane Huai Employment Agreement, dated September 1, 2001 between Registrant and ReiJane Huai, incorporated herein by reference to Exhibit 10.3 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002.
10.3 Change of Control Agreement dated December 10, 2001 between the Registrant and ReiJane Huai, incorporated herein by reference to Exhibit 10.4 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002.
10.4 Change of Control Agreement dated December 7, 2001 between the Registrant and Wayne Lam, incorporated herein by reference to Exhibit 10.5 to the Registrant's annual report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002.
14 *Code of Conduct
21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor AC, Inc.
23.1 *Consent of KPMG LLP.
31.1 *Certification of the Chief Executive Officer
31.2 *Certification of the Chief Financial Officer
32.1 *Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss.1350)
32.2 *Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss.1350)
*- filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has signed this report by the undersigned, thereunto duly authorized in Melville, State of New York on March 12, 2004.
FALCONSTOR SOFTWARE, INC.
By: /s/ ReiJane Huai Date: March 12, 2004 ----------------------------------------- ReiJane Huai, President, Chief Executive Officer of FalconStor Software, Inc.
POWER OF ATTORNEY
FalconStor Software, Inc. and each of the undersigned do hereby appoint ReiJane Huai and James Weber, and each of them severally, its or his true and lawful attorney to execute on behalf of FalconStor Software, Inc. and the undersigned any and all amendments to this Annual Report on Form 10-K and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission; each of such attorneys shall have the power to act hereunder with or without the other.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
By: /s/ ReiJane Huai March 12, 2004 ---------------------------------------------------- --------------- ReiJane Huai, President, Chief Executive Officer and Date Chairman of the Board (Principal Executive Officer)
By: /s/ James Weber March 12, 2004 ---------------------------------------------------- --------------- James Weber, Chief Financial Officer, Vice President Date and Treasurer (Principal Accounting Officer)
By: /s/ Patrick B. Carney March 12, 2004 ---------------------------------------------------- --------------- Patrick B. Carney, Director Date
By: /s/ Lawrence S. Dolin March 12, 2004 ---------------------------------------------------- --------------- Lawrence S. Dolin, Director Date
By: /s/ Steven R. Fischer March 12, 2004 ---------------------------------------------------- --------------- Steven R. Fischer, Director Date
By: /s/ Steven H. Owings March 12, 2004 ---------------------------------------------------- --------------- Steven H. Owings, Director Date