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TMCNet:  FALCONSTOR SOFTWARE INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

[March 13, 2014]

FALCONSTOR SOFTWARE INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) 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 In 2013, we took significant steps to reposition the Company for future growth and success and to put the problems of the past behind us. Among other things, we made changes to management, reduced expenses, replenished our financial resources, and refocused our product portfolio.

In June, 2013, Gary Quinn was named President and Chief Executive Officer following the voluntary resignation of Jim McNiel. Mr. Quinn had been serving as the Company's Chief Operation Officer after joining the Company as head of sales for North America in 2012. We also hired a Chief Product Officer, and we made a change in leadership in our Europe, Middle East and Africa regions. In January, 2014, we hired a new head of sales for the Americas.

In the third quarter of 2013, we began to implement a reduction in force. This process was completed in the fourth quarter and resulted in a headcount reduction of approximately 30%. We also reviewed each of our office locations worldwide and looked at the size of the market, the economic conditions in the market, and our performance in the market. We determined that there were several locations where we would be better served by reducing or eliminating our physical presence and having our customers serviced by either our partners or other regional FalconStor locations, rather than our own employees. We closed our offices in Australia and in Hong Kong, and we reduced the size of our offices in Singapore, Shanghai, Taichung and in Melville, New York. We have provided notice of the termination of our lease in Toulouse, France and we plan to reduce the size of our office in Le Chesnay, France in 2014. In addition, we closed our research and development operation in Shanghai, although we continue to maintain a sales presence there. Our research and development operation is now located in Melville, New York and in Taichung, Taiwan.

These measures, in conjunction with heightened spending controls, resulted in substantial savings. On an annualized basis, the savings would total over $15 million. We plan to continue to review expenses both to find additional areas of savings and to make sure that the cost savings that have already been realized continue.

While we have reduced our overall headcount, we have not stopped hiring. We continue to recruit for positions where we see value in adding expertise or in replacing underperforming employees.

During 2013, we also strengthened our balance sheet. In September, 2013, an affiliate of Hale Capital Partners purchased 900,000 shares of a newly created class of Series A redeemable convertible preferred stock. The Company received net proceeds of $8,731,677 from this transaction.

In addition, in July, 2013, we entered into a joint development agreement with Violin Memory, Inc., ("Violin") that should provide us with $12.0 million between July 2013 and December 2014, based upon the achievement of certain milestones. During 2013, we reached the first two milestones and we received $6.0 million from Violin. We expect to complete the remaining two milestones in fiscal 2014 and receive the remaining $6.0 million during 2014. However, if we fail to meet certain future obligations under our agreement with Violin, or if we undergo a change of control, some or all of these amounts may need to be refunded to Violin.

Last, in December, 2013, we entered into an agreement to sell our interest in the Chinese joint venture known as Tianjin Zhongke Blue Whale Information Technologies Co., Ltd., and we received a payment of $3.0 million for that asset.

Each of these transactions added cash to our balance sheet both to help us to fund operations if we experience future loses and to assure our current and potential customers that we have resources adequate to allow the Company to provide support to the customers going forward and to develop additional new, innovative products and features.

30 -------------------------------------------------------------------------------- Table of Contents In 2013, we also began to redefine and to refocus our products. At its core, we offer customers "freedom" from the constraints of traditional data management products and the overinflated costs of data protection. We have translated that into a restructured product strategy, which includes a revolutionary redesign of FalconStor solutions into a simplified, single, unified platform which we began to roll out in the beginning of 2014. We plan to continue this evolution in 2014 through both solutions arising from our joint development agreement with Violin and through other internal research and development. One of the reasons that we entered into the agreement with Violin was to help to fund our research and development for new products.

The year also saw the winding down of the legal issues that arose from improper payments made by former Company employees. In December, 2013, the Deferred Prosecution Agreement ("DPA") we had entered into with the United States Attorney's Office for the Eastern District of New York ("USAO") expired. Because we met all of our obligations under the DPA, the charges against the Company were formally dismissed, with prejudice, in the first quarter of 2014. We also made the last payment under our agreement with the USAO and we have no further payment obligations to the government or to the SEC relating to the improper payments.

On the civil side, in January, 2013, we reached an agreement to settle the class action lawsuit filed against the Company and several current and former officers and directors arising out of the improper payments. The court granted preliminary approval of the $5.0 million settlement in the fourth quarter of 2013 and we placed the settlement payment in escrow at that time. At a hearing on March 3, 2014, the Magistrate Judge indicated that she would recommend final approval of the settlement. We recovered $3.9 million of the $5.0 million settlement from our Directors & Officers insurance. Please see Note (14) Litigation to our Consolidated Audited Financial Statements for more information on the insurance recovery.

In March, 2013, the Derivative Action against certain current and former officers and directors of the Company arising out of the improper payments was dismissed. The dismissal has been appealed by the plaintiffs in the Derivative Action.

Taken together, the actions and the events listed above show that we have turned the corner in putting the problems of the past behind us.

Our revenues continue to be generated primarily by our FalconStor-branded gateway appliances and complete turn-key appliances with integrated disks, and licenses of our stand-alone software products. The appliances integrate our software with standard hardware configurations.

Overall, product revenues decreased 34% from $41.4 million for the year ended December 31, 2012 to $27.3 million for the year ended December 31, 2013. We attribute the decline in product revenues to several factors. First, in the first three quarters of the year, potential customers questioned our viability and future direction. We believe that we have removed these issues with the actions we took to strengthen our balance sheet and to reduce expenses, and by previewing our development strategy. Second, we did not release any new products during the year. We do not expect this issue to impact our results in 2014 because we released new versions of our products in the first quarter of 2014 and we anticipate further products releases in 2014.

Support and services revenue decreased 8% from $34.1 million for the year ended December 31, 2012 to $31.3 million for the same period in 2013. The decline resulted solely from the winding up of support contracts from our legacy OEM sales. Our non-legacy OEM support and services maintenance was flat year over year.

Net loss for the year ended December 31, 2013 was $10.9 million, compared with a net loss of $15.0 million for the year ended December 31, 2012. The narrowing of our loss was primarily attributable to the actions we took to reduce expenses, the $1.9 million gain on the sale of our cost-method investment, net of taxes and the $2.3 million tax benefit recorded related to the reversal of unrecognized tax benefits due to the expiration of applicable statute of limitations.

Typically, we look to operating income as another measure of our progress. This number enables us to measure and to compare our results of operations from one year to the next. Operating loss for 2013 was $13.6 million, compared with an operating loss of $13.7 million in 2012.

As stated above, we took major actions to decrease our operating expenses in 2013. Due to employee separation costs, costs for exiting leases and other contracts, and various other expenses related to our headcount reduction and office closings, we did not see the full benefits attributable to our actions until the very end of 2013. However, we expect these savings to be realized in 2014. Overall, our operating expenses decreased 17% or $11.3 million to $57.1 million in 2013 from $68.4 million in 2012. Included in our operating results for 2013 and 2012 were $3.6 million and $0.8 million related to our restructuring expenses.

Our gross margins were 74% for 2013 as compared with 73% in 2012.

31 -------------------------------------------------------------------------------- Table of Contents Operating margin is a measure of operating efficiency. We incur research and development expenses before the product is offered for licensing. These expenses consist primarily of personnel costs for engineering and testing, but also include other items such as the depreciation and amortization of hardware and software used in development. We also have expenses for software support, sales and marketing, and general and administrative functions. Our operating margin decreased to (23%) in 2013 from (18%) in 2012. While our operating margin is not reflective of our recent stabilization efforts, we expect our operating margins to improve as a result of these efforts moving forward.

Our results in 2014 may not be able to be compared directly with prior results of the Company. From the Company's inception through the third quarter of 2013, we used the "up front" revenue model for revenue from nearly all sales of product licenses and hardware. Beginning in the fourth quarter of 2013, we became more flexible in our sales terms and as a result the product revenue for some transactions are being recognized ratably over the contractual maintenance term. We expect to continue this flexibility going forward, which could result in variable periods for recognizing the revenue. Our support and maintenance revenue has always been taken ratably over the term of the support and maintenance agreement and this will not change. Our professional services revenue will continue to be recognized upon delivery of the professional services unless it is sold as part of a bundled arrangement which the Company has not established fair value for all undelivered elements which would require the revenue from the entire arrangement be recognized over the longest service term which would be the maintenance term.

The key factors we look to for our future business prospects are: • our ability to establish and to expand relationships with resellers, and sales and re-orders by those resellers; • growth in deferred revenue; • the development and sales of our new products; • re-orders from existing customers; and • the growth of the overall market for data protection and storage solutions.

We anticipate that in 2014 product bookings by resellers and, to a lesser extent, direct licenses to end users, should grow. We expect to see the results of our investments in new leadership and in revised reseller programs.

Most of our product revenue comes from sales to customers through resellers. As service providers to companies, resellers' reputations are dependent on satisfying their customers' needs efficiently and effectively. Resellers have wide choices in fulfilling their customers' needs. 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 not satisfied with 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.

We continue to enhance our reseller program. Our "Business Partner" program for our resellers was redesigned and refreshed at the end of 2013. This program provides financial incentives, for those resellers that are willing to make a commitment to FalconStor through training, marketing and revenue.

As part of our review of all of our operations to maximize savings without sacrificing sales, and in connection with our redesigned Business Partner program, we reviewed our relationship with each of our resellers in all regions.

We decided to focus on only those resellers who have the expertise, personnel and networks to identify potential customers and to service our end users. For example, beginning in 2014, we terminated agreements with nearly half of our existing North American resellers.

As of today, the majority of our deferred revenues consist of amounts attributable to future support and maintenance of our products. However, as we enter into more flexible business deals, we anticipate deferred revenues will also include increased amounts of product revenues that will be recognized ratably over time. The level of deferred revenue is an important indicator of our success. Maintenance and support for our products is sold for fixed periods of time. Maintenance and support agreements are typically for one year, although some agreements are for terms in excess of one year. If we do not deliver the support needed by end users of our products or by our OEM partners and resellers, then they will not renew their maintenance and support agreements. If end users stop using our products, they also will not renew their maintenance and support agreements. Our deferred revenue increased 23% from $24.1 million in 2012 to $29.8 million in 2013, which includes $6.0 million from our joint development agreement with Violin. Deferred revenue will be an important key metric to measure our success in growing our business from a top line perspective as we anticipate certain product sales in 2014 to be recognized ratably under the terms of the arrangements.

32 -------------------------------------------------------------------------------- Table of Contents Share-based compensation expense continued to have a negative impact on our earnings in 2013. On an on-going basis we weigh the impact of the expense on our consolidated financial statements against the impact of discontinuing the grant of equity-based compensation to our worldwide workforce. It continues to be our view that the opportunity to participate in the growth of our Company is an important motivating factor for our current employees and a valuable recruiting tool for new employees. We will thus continue to apply the criteria and the methodology we have used in the past to determine grants of stock options or other equity-based compensation to our employees. For the management of our business and the review of our progress, we will continue to look to our results excluding share-based compensation expense. We will use these non-GAAP financial measures in making operating decisions because they measure the results of our day-to-day operations and because they provide a more consistent basis for evaluating and comparing our results across different periods.

The primary risks to our success come from product development. For more information on the risks we face, please see Part I, Item 1A, Risk Factors, of this filing.

We need to provide a continuing series of new products and improvements to existing products. Innovation in the data protection market is key to survival.

Customers expect that data protection software will become both more capable and easier to manage over time. If we are unable to deliver new, innovative products in a reasonable time frame, we will fall behind our competitors. Innovation requires adequate resources and the right people. If we do not have enough resources or the right people, we will fall behind.

RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2013 COMPARED WITH THE YEAR ENDED DECEMBER 31, 2012 Total revenues for the year ended December 31, 2013 decreased 22% to $58.6 million, compared with $75.4 million for the year ended December 31, 2012.

Our cost of revenues decreased 27% to $15.2 million for the year ended December 31, 2013, compared with $20.7 million for the year ended December 31, 2012. Our operating expenses decreased 17% from $68.4 million for the year ended December 31, 2012 to $57.1 million for the year ended December 31, 2013. Included in the operating results for the year ended December 31, 2013 and 2012 were $0.4 million and a benefit of $0.3 million, respectively, of investigation, litigation, and settlement related costs. During the second half of 2013, we commenced a restructuring plan to eliminate over 100 positions worldwide, implement tighter expense controls, cease non-core activities and close or downsize several facilities. The 2013 restructuring plan was substantially completed as of December 31, 2013. During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments. The restructuring charges for 2013 and 2012 totaled $3.6 million and $0.8 million, respectively, and have been segregated from each of the respective expense line items and are included within "restructuring costs" in our consolidated statement of operations. In addition, included in our operating expenses for the years ended December 31, 2013 and 2012 were $1.6 million and $4.4 million, respectively, of share-based compensation expense. Net loss for the year ended December 31, 2013 was $10.9 million, compared with a net loss of $15.0 million for the year ended December 31, 2012. Included in our net loss for the year ended December 31, 2013 was an income tax benefit of $1.6 million compared with an income tax provision of $0.8 million for the year ended December 31, 2012 as well as a gain on the sale of a cost-method investment of $2.1 million. The income tax benefit of $1.6 million was primarily attributable to the reversal of $2.3 million of unrecognized income tax benefits due to the expiration of the applicable statutes of limitations, partly offset by withholding taxes on the gain on the sale of our cost-method investment and income taxes related to our foreign operations. The income tax provision of $0.8 million in 2012 was primarily attributable to the impact of our effective tax rate on our then pre-tax loss. No tax benefits were recognized during either period for our domestic losses due to the full valuation allowance over our domestic deferred tax assets. Net loss attributable to common stockholders, which includes the effects of preferred stock dividends and accretion, was $11.3 million for the year ended December 31, 2013, compared to $15.0 million for the year ended December 31, 2012.

The overall decrease in total revenues was primarily due to a decrease in product revenues of 34% for the year ended December 31, 2013, compared with the same period in 2012. Product revenues from OEM partners decreased 75%, while product revenues from non-OEM partners decreased 27% for the year ended December 31, 2013, compared with the same period in 2012. The decrease in product revenues from our non-OEM partners was due to various challenges the business encountered in particular, over the past year. First, prior to our balance sheet strengthening and rebalancing efforts which commenced in the second half of the year, the impact of questions concerning the Company's declining cash balances and ongoing losses significantly impacted our ability to successfully sell our solutions in the marketplace at the level we had historically. Additionally, the Company's product direction and our need to refresh our product offerings also contributed to our overall decline in product revenues on a full-year basis. The decline in OEM product revenues was primarily the result of the disruptions with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which led to a decline in sales 33 -------------------------------------------------------------------------------- Table of Contents volume from this OEM during 2013. However, during the fourth quarter of 2013, the sales volume from this customer returned to a run-rate consistent with the level prior to this OEM's corporate reorganization.

Overall, our total operating expenses decreased $11.3 million or 17%, primarily due to our restructuring efforts and tighter expense controls which we commenced during the second half of 2013 and which resulted in a decrease in salary and personnel costs including share-based compensation expense due to lower headcount. In addition, a decrease in commissions due to the decrease in revenues during the year, partly offset by a $0.7 million increase in investigation, litigation, and settlement related costs and a $2.8 million increase in restructuring costs. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook and to take actions in areas of the Company that are not performing.

Revenues Year ended December 31, 2013 2012 Revenues: Product revenue $ 27,338,557 $ 41,358,621 Support and services revenue 31,297,947 34,052,348 Total Revenues $ 58,636,504 $ 75,410,969 Year-over-year percentage change Product revenue (34)% (16)% Support and services revenue (8)% 2% Total percentage change (22)% (9)% Product revenue Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively "non-OEMs"). These revenues are recognized when all the applicable criteria under Generally Accepted Accounting Principles in the United States are met.

Product revenue decreased 34% from $41.4 million for the year ended December 31, 2012 to $27.3 million for the year ended December 31, 2013. These amounts are net of benefits of less than $0.1 million and $0.7 million recognized during the years ended December 31, 2013 and 2012, respectively, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenue represented 47% and 55% of our total revenues for the years ended December 31, 2013 and 2012, respectively. Product revenues from OEM partners decreased 75%, while product revenues from non-OEM partners decreased 27% for the year ended December 31, 2013, compared with the same period in 2012. The decrease in product revenues from our non-OEM partners was due to various challenges the business encountered in particular, over the past year. First, prior to our balance sheet strengthening and rebalancing efforts which commenced in the second half of the year, the impact of questions concerning the Company's declining cash balances and ongoing losses significantly impacted our ability to successfully sell our solutions in the market place at the level we had historically. Additionally, the Company's product direction and our need to refresh our product offerings also contributed to our overall decline in product revenues on a full-year basis. The decline in OEM product revenues was primarily the result of the disruptions with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which led to a decline in sales volume from this OEM during 2013.

However, during the fourth quarter of 2013, the sales volume from this customer returned to a run-rate consistent with the level prior to this OEM's corporate reorganization. Product revenue from our non-OEM partners represented 96% and 88% of our total product revenue for the years ended December 31, 2013 and 2012, respectively. Product revenue from our OEM partners represented 4% and 12% of our total product revenue for the years ended December 31, 2013 and 2012, respectively.

We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook.

Support and services revenue Support and services revenue is comprised of (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Engineering services are recognized upon customer acceptance 34 -------------------------------------------------------------------------------- Table of Contents or over the remaining contract term if vendor-specific objective evidence ("VSOE") does not exist for remaining deliverables upon acceptance. Support and services revenues decreased 8% from $34.1 million for the year ended December 31, 2012 to $31.3 million for the same period in 2013. The decrease in support and services revenue was attributable to decreases in both maintenance and technical support services revenue and professional services revenues.

Maintenance and technical support services revenue decreased from $31.0 million for the year ended December 31, 2012 to $29.2 million for the same period in 2013. Our maintenance and technical support service revenue is from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the year ended December 31, 2013, the decline in maintenance was attributable to (i) a $1.8 million decline in maintenance revenue from our OEM partners, particularly certain legacy OEM customers due to the continuing wind down in our OEM business, (ii) a decrease from the previous year in revenue from sales of products that are generally sold with maintenance, and (iii) deeper discounts provided on products in the current economic and competitive environments.

Professional services revenues decreased from $3.1 million for the years ended December 31, 2012 to $2.1 million for the year ended December 31, 2013. The professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.

Cost of Revenues Year ended December 31, 2013 2012 Cost of revenues: Product $ 4,155,413 $ 8,215,152 Support and service 11,000,401 12,446,921 Total cost of revenues $ 15,155,814 $ 20,662,073 Total Gross Profit $ 43,480,690 $ 54,748,896 Gross Margin: Product 85% 80% Support and service 65% 63% Total gross margin 74% 73% Cost of revenues, gross profit and gross margin Cost of product revenue consists primarily of the industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the year ended December 31, 2013 decreased $4.1 million, or 49%, to $4.2 million, compared with $8.2 million for the same period in 2012. The decrease in cost of product revenue was primarily attributable to the decline in the number of fully integrated solutions which included hardware appliances as integrated solutions represented a lower percentage of all product revenues compared with the same period in 2012. Our cost of support and service revenues for the year ended December 31, 2013 decreased $1.4 million, or 12%, to $11.0 million, compared with $12.4 million for the same period in 2012. This decrease was primarily attributable to a decrease in personnel costs as a result of lower headcount during 2013 compared with 2012 due to our streamlining of our support facilities globally as part of our rebalancing efforts.

Total gross profit decreased $11.3 million, or 21%, from $54.7 million for the year ended December 31, 2012, to $43.5 million for the year ended December 31, 2013. Total gross margin increased slightly to 74% for the year ended December 31, 2013, compared with 73% for the year ended December 31, 2012. While our total gross profit decreased for the year ended December 31, 2013, compared with 2012, primarily due to the 22% decrease in our total revenues, we improved our gross margin by reducing our expenses in response to declining revenues and due to the decline in the number of fully integrated solutions which included hardware appliances as integrated solutions represented a lower percentage of all product revenues compared with the same period in 2012. Generally, our total gross profits and total gross margins fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.

35 -------------------------------------------------------------------------------- Table of Contents Share-based compensation expense included in both cost of product revenue and cost of support and service was less than 1% of total revenue for each of the years ended December 31, 2013 and 2012.

Operating Expenses Research and Development Costs Research and development costs consist primarily of personnel costs for product development personnel, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $3.3 million, or 18%, to $15.6 million for the year ended December 31, 2013, from $19.0 million in 2012. The decrease in research and development costs was primarily the result of a decline in personnel related costs, including share-based compensation expense, due to the reduction in headcount as we discontinued our development efforts on our small-to-medium business product line and re-focused our engineering efforts on our core enterprise class solutions as part of our rebalancing efforts. This decrease is also attributable to higher capitalization of software development costs in the year ended December 31, 2013 of $1.0 million compared with $0.5 million during the year ended December 31, 2012. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.4 million from $0.7 million for the years ended December 31, 2013 and December 31, 2012, respectively.

Share-based compensation expense included in research and development costs was equal to 1% of total revenues for the years ended December 31, 2013 and 2012, respectively.

Selling and Marketing Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses decreased $10.5 million, or 29%, to $25.2 million for the year ended December 31, 2013, from $35.7 million for the year ended December 31, 2012. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 34% decline in product revenue compared with 2012, and (ii) a decrease in personnel related costs, including share-based compensation expenses, as a result of lower sales and marketing headcount as we closed or downsized several of our foreign office locations. We are now servicing our customers through our partners or other regional locations in order to be more cost effective. Share-based compensation expense included in selling and marketing expenses decreased to $0.4 million for the year ended December 31, 2013 from $1.7 million for the year ended December 31, 2012, primarily due to the reversal of previously accrued share-based compensation expense related to the resignations of certain former sales and marketing professionals. Share-based compensation expense included in selling and marketing expenses was equal to 1% and 2% of total revenues for the years ended December 31, 2013 and 2012, respectively.

General and Administrative General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers insurance, legal and professional fees, bad debt expense and other general corporate overhead costs. General and administrative expenses decreased $1.1 million, or 8%, to $12.3 million for the year ended December 31, 2013, from $13.3 million for 2012. The decrease in general and administrative expenses was primarily due to (i) a decrease in personnel related costs as a result of the decrease in headcount as a result of streamlining our consolidation and reporting process through the implementation of a global ERP system as part of our rebalancing efforts, (ii) a decrease in bad debt expense of approximately $1.3 million to a benefit of $0.3 million for 2013 from a provision of $1.0 million for 2012 due to the improvement in the Company's bad debt experience during 2013 compared with 2012, and (iii) a decrease of $1.2 million in share-based compensation expense from $2.0 million in 2012 to $0.8 million in 2013, mainly attributable to the reversal of previously accrued share-based compensation related to the resignation of the Company's former CEO. These decreases were partially offset by an increase in professional fees, severance costs related to the resignation of the Company's former CEO, and other administrative costs. Share-based compensation expense included in general and administrative expenses was equal to 1% of total revenue for the year ended December 31, 2013 and to 3% of total revenue for the year ended December 31, 2012.

36 -------------------------------------------------------------------------------- Table of Contents Investigation, Litigation and Settlement Related Costs During 2013, our total investigation, litigation, and settlement related costs totaled $0.4 million, which was comprised of $0.9 million of legal expenses related to the class action and derivative lawsuits and legal fees associated with other settlement related activities, partially offset by $0.5 million of expenses that are expected to be recoverable through insurance. During 2012, our total investigation, litigation, and settlement related costs resulted in a net benefit of $0.3 million, which was comprised of (i) $1.7 million of legal fees, (ii) a $0.3 million recovery of legal expenses previously incurred related to the class action and derivative lawsuits, and (iii) a $1.7 million accrual reduction. Refer to Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, for a more detailed description of the investigations.

To a much lesser extent then previous years our operating expenses may continue to be adversely impacted during 2014 due to professional and service provider fees, and other costs, resulting from the finalizing of the stockholder lawsuits and settlement related activities.

Restructuring costs From time to time, the Company has undertaken restructuring and expense control measures to support its business performance and to align the Company's cost structure with its resources. In the third quarter of 2013, the Company adopted a restructuring plan intended to better align the Company's cost structure with the skills and resources required to more effectively execute the Company's long-term growth strategy and to support revenue levels we expect to achieve on a go forward basis. In connection with the 2013 Plan the Company eliminated over 100 positions worldwide, implemented tighter expense controls, ceased non-core activities and closed or downsized several facilities. The total amount incurred under the 2013 Plan was $3.6 million, of which $2.3 million was paid during 2013. Actions under the 2013 Plan were substantially completed as of December 31, 2013; however, this is an ongoing initiative and the Company expects to incur additional restructuring costs in the first half of 2014.

During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments.

These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy, to drive operational efficiencies and to support the anticipated revenue levels we expect to achieve on a go forward basis. The total amount incurred with respect to severance under the 2012 Plan was $0.8 million. Actions under the 2012 Plan were substantially completed by the end of the third quarter of 2012. As of December 31, 2013, there were no remaining payments related to the 2012 Plan.

Interest and Other Income (Loss) We invest our cash primarily in money market funds, commercial paper, government securities, and corporate bonds. As of December 31, 2013, our cash, cash equivalents, and marketable securities totaled $28.1 million, compared with $29.9 million as of December 31, 2012. Interest and other income (loss) increased $1.6 million to income of $1.1 million for the year ended December 31, 2013, compared with a loss of $0.5 million for 2012. Interest and other income was comprised of a gain on the sale of a cost-method investment of $2.1 million and foreign currency losses of $1.1 million for the year ended December 31, 2012, compared with foreign currency losses of $0.6 million and interest income of $0.1 million for the year ended December 31, 2012.

Income Taxes Our provision for income taxes consists of federal, state and local, and foreign taxes. For the year ended December 31, 2013, we recorded an income tax benefit of $1.6 million on our pre-tax loss of $12.5 million, consisting primarily of a $2.3 million reversal of unrecognized tax benefits due to the expiration of applicable statutes of limitations partly offset by withholding taxes recorded on the gain of our investment in Blue Whale and state and local and foreign taxes. For the year ended December 31, 2012, we recorded an income tax provision of $0.8 million on our pre-tax loss of $14.2 million, consisting primarily of state and local and foreign taxes. Our domestic deferred tax assets are not realizable on a more-likely-than-not basis and, therefore, we recorded a full valuation allowance against our domestic deferred tax assets. During the years ended December 31, 2013 and 2012, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our net domestic deferred tax assets for the full years of 2013 and 2012.

37 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2012 COMPARED WITH THE YEAR ENDED DECEMBER 31, 2011 Total revenues for the year ended December 31, 2012 decreased 9% to $75.4 million, compared with $82.9 million for the year ended December 31, 2011.

During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments. The restructuring charges related to the 2012 reduction totaled approximately $0.8 million. During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 positions worldwide from various departments and the closing of a satellite facility. The restructuring charges related to the 2011 reduction totaled approximately $0.8 million. The restructuring charges for both 2012 and 2011 have been segregated from each of the respective expense line items and are included within "restructuring costs" in our consolidated statement of operations. Our cost of revenues decreased 4% to $20.7 million for the year ended December 31, 2012, compared with $21.5 million for the year ended December 31, 2011. Included in our cost of revenues for the years ended December 31, 2012 and 2011 were $0.2 million and $0.5 million, respectively, of share-based compensation expense. Our operating expenses decreased 18% from $83.6 million for the year ended December 31, 2011 to $68.4 million for the year ended December 31, 2012. Included in the operating results for the year ended December 31, 2012, was a net reduction of $0.3 million of investigation, litigation and settlement costs and $0.8 million of restructuring costs. Included in the operating results for the year ended December 31, 2011 was $10.3 million of investigation, litigation, and settlement related costs and $0.8 million of restructuring costs. The $10.3 million was comprised of $2.8 million of legal fees and an accrual of $7.5 million for certain costs associated with the then outstanding resolution of the investigations. In addition, included in our operating expenses for the years ended December 31, 2012 and 2011 were $4.4 million and $5.1 million, respectively, of share-based compensation expense. Net loss for the year ended December 31, 2012 was $15.0 million, compared with a net loss of $23.4 million for the year ended December 31, 2011. Included in our net loss for the year ended December 31, 2012 was an income tax provision of $0.8 million compared with an income tax provision of $1.2 million for the year ended December 31, 2011. The income tax provisions of $0.8 million and $1.2 million were primarily attributable to the impact of our effective tax rate on our then pre-tax losses for the years ended December 31, 2012 and 2011, respectively. No tax benefits were recognized during either period for our domestic losses due to the full valuation allowance over our domestic deferred tax assets.

The overall 9% decrease in total revenues was primarily due to a 16% decrease in product revenue for the year ended December 31, 2012, compared with the same period in 2011. This was partially offset by a 2% increase in support and services revenue for the year ended December 31, 2012, compared with the same period in 2011. Product revenues from OEM partners decreased 25%, while product revenues from non-OEM partners decreased 15% for the year ended December 31, 2012, compared with the same period in 2011. As we had previously reported over the past several years, product revenues from our legacy OEM partners continued to decline due to consolidation within the industry and end-of-life programs implemented by these legacy OEM partners. During 2012, we continued our focus and emphasis on the FalconStor-branded business.

Overall, our total operating expenses have decreased, primarily due to a decline in (i) our overall salary and personnel costs as part of our cost savings initiatives and our focus on improved operational efficiencies , and (ii) a $10.6 million decrease in costs associated with the government investigations, litigation, and settlement related costs incurred during the year ended December 31, 2012, compared with the same period in 2011.

Revenues Year ended December 31, 2012 2011 Revenues: Product revenue $ 41,358,621 $ 49,470,139 Support and services revenue 34,052,348 33,400,463 Total Revenues $ 75,410,969 $ 82,870,602 Year-over-year percentage change Product revenue (16)% (5)% Support and services revenue 2% 8% Total percentage change (9)% 0% Product revenue Product revenue decreased 16% from $49.5 million for the year ended December 31, 2011 to $41.4 million for the year ended December 31, 2012. These amounts are net of a benefit of $0.7 million recognized during the years ended December 31, 2012 38 -------------------------------------------------------------------------------- Table of Contents and 2011, respectively, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenues from OEM partners decreased 25%, while product revenues from non-OEM partners decreased 15% for the year ended December 31, 2012, compared with the same period in 2011. As we had previously reported over the past several years, product revenues from our legacy OEM partners continued to decline due to consolidation within the industry and end-of-life programs implemented by these legacy OEM partners.

During 2012, we continued our focus and emphasis on the FalconStor-branded business.

Support and services revenue Support and services revenue increased 2% from $33.4 million for the year ended December 31, 2011 to $34.1 million for the same period in 2012. The increase in support and services was primarily attributable to an increase in maintenance and technical support services.

Maintenance and technical support services increased from $30.3 million for the year ended December 31, 2011 to $31.0 million for the same period in 2012. As we are in business longer, and as we license more integrated solutions and stand-alone software applications to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. The anticipated growth in our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the year ended December 31, 2012, the growth in maintenance revenue in the non-OEM channel business was primarily offset by (i) a decline in maintenance revenue from certain legacy OEM customers due to consolidation in the industry, (ii) the decrease from non-OEM product revenues during the current year, which are generally sold with maintenance, and (iii) deeper discounts provided on product in the then current economic and competitive environment.

Professional services revenues remained consistent at $3.1 million for the years ended December 31, 2012 and December 31, 2011. The professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that are performed during the period. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.

Cost of Revenues Year ended December 31, 2012 2011 Cost of revenues: Product $ 8,215,152 $ 8,386,864 Support and service 12,446,921 13,130,045 Total cost of revenues $ 20,662,073 $ 21,516,909 Total Gross Profit $ 54,748,896 $ 61,353,693 Gross Margin: Product 80% 83% Support and service 63% 61% Total gross margin 73% 74% Cost of revenues, gross profit and gross margin Cost of product revenue for the year ended December 31, 2012 decreased $0.2 million, or 2%, to $8.2 million, compared with $8.4 million for the same period in 2011. The overall decrease in cost of product revenue was attributable to a decrease in hardware costs as a result of fewer appliance units being sold, compared with the same period in 2011. Our cost of support and service revenues for the year ended December 31, 2012 decreased $0.7 million, or 5%, to $12.4 million, compared with $13.1 million for the same period in 2011. The decrease in cost of support and service revenue was primarily related to a decrease in compensation costs due to the overall change in the mix of our headcount within support and services as compared to the same period in 2011 and a decrease in share-based compensation expenses which decreased to $0.2 million for the year ended December 31, 2012, compared with $0.5 million for the year ended December 31, 2011.

39 -------------------------------------------------------------------------------- Table of Contents Total gross profit decreased $6.6 million, or 11%, from $61.4 million for the year ended December 31, 2011, to $54.7 million for the year ended December 31, 2012. Total gross margin decreased slightly to 73% for the year ended December 31, 2012, compared with 74% for the year ended December 31, 2011. The decrease in our total gross profit for the year ended December 31, 2012, compared with the same period in 2011, was primarily due to a 9% decrease in our total revenues. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and service mix of sales.

Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for each of the years ended December 31, 2012 and 2011. Share-based compensation expense included in the cost of support and service revenue decreased to $0.2 million from $0.5 million for the years ended December 31, 2012 and December 31, 2011, respectively. Share-based compensation expense related to cost of support and service revenue was less than 1% for the year ended December 31, 2012 and 1% for the year ended December 31, 2011.

Operating Expenses Research and Development Costs Research and development costs decreased $2.6 million, or 12%, to $19.0 million for the year ended December 31, 2012, from $21.5 million in the same period in 2011. The decrease in research and development costs was primarily the result of a decline in salary and personnel costs as the result of lower research and development headcount. Share-based compensation expense included in research and development costs decreased to $0.7 million from $1.3 million for the years ended December 31, 2012 and December 31, 2011, respectively. Share-based compensation expense included in research and development costs was equal to 1% and 2% of total revenue for the years ended December 31, 2012 and 2011, respectively.

Selling and Marketing Selling and marketing expenses decreased $3.6 million, or 9%, to $35.7 million for the year ended December 31, 2012, from $39.3 million for the year ended December 31, 2011. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 16% decline in product revenue compared with the same period in 2011, (ii) a decrease in salary and personnel costs, including share-based compensation expenses, as a result of lower sales and marketing headcount, and (iii) a decrease in costs associated with the recruitment and hiring of additional sales personnel in 2011.

Share-based compensation expense included in selling and marketing was $1.7 million for the year ended December 31, 2012 and $2.0 million for the year ended December 31, 2011. Share-based compensation expense included in selling and marketing expenses was equal to 2% of total revenue for the years ended December 31, 2012 and 2011, respectively.

General and Administrative General and administrative expenses increased $1.6 million, or 14%, to $13.3 million for the year ended December 31, 2012, from $11.7 million for the same period in 2011. The overall increase within general and administrative expenses related to increases in (i) personnel related costs including share-based compensation expense, (ii) bad debt expense, (iii) professional fees, and (iv) various administrative costs. Share-based compensation expense included in general and administrative expenses was $2.0 million for the year ended December 31, 2012, compared with $1.7 million for the year ended December 31, 2011.

Share-based compensation expense included in general and administrative expenses was equal to 3% of total revenue for the year ended December 31, 2012 and to 2% of total revenue for the year ended December 31, 2011.

Investigation, Litigation and Settlement Related Costs During 2012, we recorded a $0.3 million reduction of investigation, litigation and settlement related costs. The reduction was comprised of (i) a $1.7 million reduction in the accrual for certain costs associated with the resolution of the government investigations and (ii) a recovery of $0.3 million of legal expenses previously incurred related to the class action and derivative lawsuits, partially offset by (i) $1.5 million of legal expenses related to the class action and derivative lawsuits as well as for the potential settlement of the class action lawsuit that are not or may not be recoverable through insurance and (ii) $0.2 million of legal fees incurred related to the resolution of the government investigations. Investigation costs for the year ended December 31, 2011, totaled $10.3 million, which consisted of $2.8 million of legal and professional fees and an accrual of $7.5 million for certain costs associated with the then possible resolution of the government investigations.

Restructuring costs 40 -------------------------------------------------------------------------------- Table of Contents During 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 positions worldwide from various departments.

These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy, to drive operational efficiencies and to support the anticipated revenue levels we expect to achieve on a go forward basis. The total amount incurred with respect to severance under the 2012 Plan was $0.8 million. Actions under the 2012 Plan were substantially completed by the end of the third quarter of 2012. During 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 positions worldwide from various departments and the closing of a satellite facility. The total amounts incurred with respect to severance and facilities abandonment under the 2011 Plan were $0.8 million and less than $0.1 million, respectively. Actions under the 2011 Plan were substantially completed by the end of the third quarter of 2011.

Interest and Other (Loss) Income We invest our cash primarily in money market funds, commercial paper, government securities, and corporate bonds. As of December 31, 2012, our cash, cash equivalents, and marketable securities totaled $29.9 million, compared with $37.8 million as of December 31, 2011. Interest and other income (loss) decreased $0.6 million to a loss of ($0.5) million for the year ended December 31, 2012, compared with $0.1 million of income for the same period in 2011. The decrease in interest and other income was primarily due to foreign currency losses of ($0.6) million and interest income of $0.1 million during the year ended December 31, 2012, compared with $0.1 million of interest income partially offset by $0.1 million of foreign currency losses.

Income Taxes Our provision for income taxes consists of federal, state and local, and foreign taxes. For the year ended December 31, 2012, we recorded an income tax provision of $0.8 million on our pre-tax loss of $14.2 million, consisting primarily of state and local and foreign taxes. For the year ended December 31, 2011, we recorded an income tax provision of $1.2 million on our pre-tax loss of $22.2 million, consisting of primarily state and local and foreign taxes. During 2010, we concluded that our domestic deferred tax assets were no longer realizable on a more-likely-than-not basis and, therefore, we recorded a full valuation allowance against our domestic deferred tax assets. During the years ended December 31, 2012 and 2011, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our net domestic deferred tax assets for the full years of 2012 and 2011.

LIQUIDITY AND CAPITAL RESOURCES Cash flow information is as follows: Years Ended December 31, 2013 2012 2011 Cash provided by (used in): Operating activities $ (11,134,925 ) $ (5,268,470 ) $ 3,138,766 Investing activities 2,572,090 7,235,301 (5,400,465 ) Financing activities 9,429,177 738,184 920,106 Effect of exchange rate changes (229,470 ) (311,241 ) (243,268 ) Net increase (decrease) in cash and cash equivalents $ 636,872 $ 2,393,774 $ (1,584,861 ) Our principal sources of liquidity are our cash, cash equivalents, and marketable securities balances generated from operating, investing and financing activities. We also received proceeds from the issuance of our Series A redeemable convertible preferred stock and our joint development agreement with Violin Memory as discussed below. Our cash, cash equivalents and marketable securities balance as of December 31, 2013 totaled $28.1 million, compared with $29.9 million as of December 31, 2012. Cash and cash equivalents totaled $19.3 million, restricted cash totaled $0.8 million, and marketable securities totaled $8.1 million at December 31, 2013. Cash and cash equivalents totaled $18.7 million, restricted cash totaled $0.8 million, and marketable securities totaled $10.5 million at December 31, 2012.

As of December 31, 2013 and 2012, we had $0.8 million of restricted cash. The restricted cash serves as collateral related to deposit service indebtedness with our commercial bank. As of each of December 31, 2013 and 2012, we did not have any debt service indebtedness with our bank.

Over the past several years, we have been through multiple transitions, which included various senior management changes, new sales leadership in all of our regions, changes within our North American sales force structure, and restructuring. Most recently, 41 -------------------------------------------------------------------------------- Table of Contents during the third quarter of 2013, we commenced a restructuring which included a workforce reduction of more than 100 positions worldwide from various departments as well as the closure of certain facilities. These actions were intended to better align our cost structure with the skills and resources required to more effectively execute our long-term growth strategy, to drive operational efficiencies and to support the anticipated revenue levels we expect to achieve on a go-forward basis. The total amount incurred under the 2013 Plan, during 2013, was $3.6 million of which $2.3 million was paid during 2013.

Actions under the 2013 Plan were substantially completed as of December 31, 2013; however, this is an ongoing initiative and we expect to incur additional restructuring costs in the first half of 2014. For further information, refer to Note (15) Restructuring Costs, to our consolidated financial statements.

During the second half of 2013 we met the first two milestones related to our joint development agreement with Violin Memory and we have received payments of $6.0 million under the agreement. We expect to complete the remaining two milestones in fiscal 2014 and receive the remaining $6.0 million during 2014.

However, if we fail to meet certain future obligations under our agreement with Violin, or if we undergo a change of control, some or all of these amounts may need to be refunded to Violin.

In addition, during 2013 we received $1.3 million of insurance reimbursements related to the class action lawsuit. Finally, we sold our interest in Tianjin Zhongke Blue Whale Information Technologies Co., Ltd. ("Blue Whale") for $3.0 million and recorded a gain of $1.9 million, net of tax.

On September 16, 2013, we issued to Hale Capital Partners, LP 900,000 shares of the Company's newly created Series A redeemable convertible preferred stock, par value $0.001 per share, at a price of $10 per share, for an aggregate purchase consideration of $9.0 million. We received net proceeds of approximately $8.7 million from the issuance of the Series A redeemable convertible preferred stock, net of transaction costs.

Upon certain triggering events, such as bankruptcy, insolvency, a material adverse effect, failure to achieve minimum financial covenants or failure by us to issue shares upon conversion of the Series A redeemable convertible preferred stock in accordance with its obligations, the Series A redeemable convertible preferred stockholders may require us to redeem all or some of the redeemable convertible preferred stock at a price equal to the greater of 100% of the stated value plus accrued and unpaid dividends or the product of the number of shares of common stock underlying the Series A redeemable convertible preferred stock and the closing price as of the occurrence of the triggering event. On or after August 5, 2017, each Series A redeemable convertible preferred stockholder can require us to redeem its Series A redeemable convertible preferred stock in cash at a price equal to 100% of the stated value being redeemed plus accrued and unpaid dividends. As of December 31, 2013, there were no triggering events that would allow the Series A redeemable convertible preferred stockholders to require us to redeem any of the Series A redeemable convertible preferred stock and we do not expect to incur any triggering events in fiscal 2014. However, if certain financial covenants are not met over the next twelve months, the Company would work on addressing any financial measures needed to remedy the failed covenants as well as work with the holders of the Series A redeemable convertible preferred stock on obtaining waivers as applicable.

In addition, as of December 31, 2013, our liability for dividends to preferred stockholders totaled $216,379. Holders of the redeemable convertible preferred stock are entitled to receive quarterly dividends at the Prime Rate (Wall Street Journal Eastern Edition) plus 5% (up to a maximum amount of 10%). These dividends were paid using cash on hand during January 2014.

As discussed further in Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, in June 2012, we settled charges arising from investigations conducted by the United States Attorney's Office and the Securities and Exchange Commission for a total of $5.8 million. During 2013, we paid the remaining $1.7 million of the $5.8 million investigation settlement. We have no further obligations, for payment or otherwise, under our agreements with the USAO and with the SEC.

In addition, as discussed further in in Part I, Item 3 - Legal Proceedings of this annual report on Form 10-K, we are among the defendants named in class action and derivative lawsuits. In accordance with our by-laws and Delaware law, we have been paying for the costs of defense of these actions for the other named defendants. If liability is ultimately assessed some of the other named defendants may be entitled to claim indemnification from us. We have incurred, and continue to incur significant expenses, primarily for legal counsel, due to the class action and derivative lawsuits. In January, 2013, the parties to the Class Action reached an agreement in principle to settle the Class Action. In the fourth quarter of 2013, following preliminary approval of the settlement by the district court, we deposited $5.0 million into an escrow account, where it was held pending final settlement. On March 3, 2014 a final settlement hearing was held. There were no objections to the proposed settlement. The Magistrate Judge indicated that she would be filing a report and recommendation that the settlement be approved. However, there can be no assurance regarding if or when final approval of the settlement will be granted.

At various times from October 2001 through February 2009 our Board of Directors has authorized the repurchase of up to 14 million shares of our outstanding common stock in the aggregate. We did not repurchase any of our outstanding common stock 42 -------------------------------------------------------------------------------- Table of Contents during the years ended December 31, 2013, 2012 and 2011. Since October 2001, we have repurchased a total of 8,005,235 shares at an aggregate purchase price of $46.9 million. As of December 31, 2013, we had the authority to repurchase 5,994,765 shares of our common stock based upon our judgment and market conditions. See Note (9) Stockholders' Equity to our consolidated financial statements for further information.

Net cash (used in) provided by operating activities totaled ($11.1) million, ($5.3) million and $3.1 million for the years ended December 31, 2013, 2012 and 2011, respectively. The changes in net cash (used in) provided by operating activities for each of the years ended December 31, 2013, 2012 and 2011 is the result of recording a net loss of $10.9 million, $15.0 million and $23.4 million, respectively, adjusted for: (i) the impact of non-cash charges, particularly relating to depreciation, amortization, stock-based compensation, provision for returns and doubtful accounts and deferred income taxes; and (ii) adjustments for net changes in operating assets and liabilities, primarily changes in our accounts receivable, prepaid expenses, inventory, accounts payable, accrued expenses and deferred revenues. During 2013 we received $6.0 million related to our agreement with Violin Memory which was recorded as long-term deferred revenue as of December 31, 2013, which was more than offset by cash payments of $1.7 million and $5.0 million related to the settlement of the shareholder litigation and final DPA payment which were incurred in prior years.

Net cash provided by (used in) investing activities totaled $2.6 million, $7.2 million and ($5.4) million for the years ended December 31, 2013, 2012 and 2011, respectively. Included in investing activities for each year are the sales and purchases of our marketable securities, which include the sales, maturities and reinvestment of our marketable securities. The net cash provided by (used in) investing activities from the net sales of securities was $2.5 million, $11.1 million and ($2.0) million for the years ended December 31, 2013, 2012 and 2011, 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 was $1.5 million, $2.5 million and $2.2 million for the years ended December 31, 2013, 2012 and 2011, respectively. The cash used in the capitalization of software development costs was $1.0 million, $0.5 million and $1.0 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Proceeds from the sale of our interest in Blue Whale was $3.0 million for the year ended December 31, 2103. The cash used in restricted cash was $0.8 million for the year ended December 31, 2012. We continually evaluate potential software license purchases and acquisitions, and we may continue to make such investments if we find opportunities that would benefit our business. We anticipate continued capital expenditures, including capitalized software costs, as we continue to invest in our infrastructure and expand and enhance our product offerings. As of the date of this filing, we have no agreements, commitments or understandings with respect to any such license purchases or acquisitions.

Net cash provided by financing activities totaled $9.4 million, $0.7 million and $0.9 million for the years ended December 31, 2013, 2012 and 2011, respectively.

The primary cash inflow from financing activities for 2013 related to the $8.7 million of proceeds from the issuance of the Series A redeemable convertible preferred stock, net of issuance costs. Additionally, cash inflows from financing activities represent proceeds received from the exercise of stock options.

We currently do not have any debt and our only significant commitments are related to our employment agreement with Gary Quinn, our President and Chief Executive Officer, our office leases, and the potential redemption of the Series A redeemable convertible preferred stock as discussed above.

During 2013, we signed a new operating lease covering its corporate office facility that expires in April 2021. We also have several operating leases related to offices in both the United States and foreign countries. The expiration dates for these leases range from 2014 through 2017. The following is a schedule of future minimum lease payments for all operating leases as of December 31, 2013: 2014 $ 2,595,765 2015 1,793,759 2016 1,520,711 2017 1,465,118 2018 1,459,190 Thereafter 3,577,335 $ 12,411,878 In addition, as of December 31, 2013, our liability for uncertain tax positions totaled $0.3 million. Due to the uncertainty relating to the timing of future payments, such amounts are not presented in the above schedule.

43 -------------------------------------------------------------------------------- Table of Contents We believe that our current balance of cash, cash equivalents, restricted cash and marketable securities, and our expected cash flows from operations, will be sufficient to meet our cash requirements for at least the next twelve months.

However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See Part I, Item 1A - Risk Factors.

Off-Balance Sheet Arrangements As of December 31, 2013 and 2012, we had no off-balance sheet arrangements.

Critical Accounting Policies and Estimates Our critical accounting policies and estimates are those related to revenue recognition, accounts receivable allowances, deferred income taxes, accounting for share-based payments, goodwill and other intangible assets, software development costs, fair value measurements and litigation.

Revenue Recognition. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we recognize revenue in accordance with the authoritative guidance issued by the FASB on revenue recognition. Product 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, a customer purchase order, and/or a royalty report summarizing software licenses sold for each software license resold by an OEM, distributor, or reseller to an end user.

Product fees are fixed and determinable as our standard payment terms range from 30 to 90 days, depending on regional billing practices. Although we may provide extended or flexible payment terms to our customers in the future; we have not provided any of our customers with extended payment terms during 2013. When a customer purchases our integrated solutions and/or licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance based upon VSOE of the fair value of the contractual optional maintenance renewal rate. If professional services are included in our multi-element software arrangements, we allocate a portion of the fee to these services based on its VSOE of fair value which is established using rates charged when sold on a stand-alone basis. If VSOE does not exist for all undelivered elements of an arrangement, we recognize total revenue from the arrangement ratably over the term of the maintenance agreement.

Revenues associated with maintenance services are deferred and recognized as revenue ratably over the term of the contract. Revenues associated with software implementation and software engineering services are recognized when the services are performed. Costs of providing these services are included in cost of support and services.

The Company has entered into various distribution, licensing and joint promotion agreements with OEMs, whereby the Company has provided to the OEM a non-exclusive software license to install the Company's software on certain hardware or to resell the Company's software in exchange for payments based on the products distributed by these OEMs. Such payments from the OEM or distributor are recognized as revenue in the period reported by the OEM.

From time to time the Company will enter into funded software development arrangements. Under such arrangements, revenue recognition will not commence until final delivery and/or acceptance of the product. For arrangements where the Company has VSOE for the undelivered elements, the Company will follow the residual method and recognize product revenue upon final delivery and/or acceptance of the product. For arrangements where the Company does not have VSOE for the undelivered elements, the Company will recognize the entire arrangement fee ratably commencing at the time of final delivery and/or acceptance through the end of the service period in the arrangement.

Accounts Receivable. We review accounts receivable to determine which receivables are doubtful of collection. In making the determination of the appropriate allowance for uncollectible accounts and returns, we consider (i) historical return rates, (ii) specific past due accounts, (iii) analysis of our accounts receivable aging, (iv) customer payment terms, (v) historical collections, write-offs and returns, (vi) changes in customer demand and relationships, (vii) actual cash collections on our accounts receivables and (viii) concentrations of credit risk and customer credit worthiness. When determining the appropriate allowance for uncollectable accounts and returns each period, the actual customer collections of outstanding account receivable balances impact the required allowance for returns. We recorded a benefit of $0.3 million and expenses of approximately $0.4 million and $0.1 million for the years ended December 31, 2013, 2012 and 2011, respectively. These amounts are included within our consolidated statement of operations in each respective year. Changes in the product return rates, 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.

Income Taxes. As discussed further in Note (6) Income Taxes, to our consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on income taxes, we regularly evaluate our ability to recover deferred tax assets, 44 -------------------------------------------------------------------------------- Table of Contents and report such deferred tax assets at the amount that is determined to be more-likely-than-not recoverable. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In determining the period in which related tax benefits are realized for financial reporting purposes, excess share-based compensation deductions included in net operating losses are realized after regular net operating losses are exhausted.

We account for uncertain tax positions in accordance with the authoritative guidance issued by the FASB on income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return, should be recorded in the financial statements. Pursuant to the authoritative guidance, we may recognize the tax benefit from an uncertain tax position only if it meets the "more likely than not" threshold that the position will be sustained on examination by the taxing authority, based on the technical merits of the position or under statute expirations. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. In addition, the authoritative guidance addresses de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures.

Accounting for Share-Based Payments. As discussed further in Note (10) Share-Based Payment Arrangements, to our consolidated financial statements, we account for share-based awards in accordance with the authoritative guidance issued by the FASB on stock compensation.

We have used and expect to continue to use the Black-Scholes option-pricing model to compute the estimated fair value of share-based compensation expense.

The Black-Scholes option-pricing model includes assumptions regarding dividend yields, expected volatility, expected option term and risk-free interest rates.

The assumptions used in computing the fair value of share-based compensation expense reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. We estimate expected volatility based primarily on historical daily price changes of our stock and other factors. The expected option term is the number of years that we estimate that the stock options will be outstanding prior to exercise. The estimated expected term of the stock awards issued has been determined pursuant to SEC Staff Accounting Bulletin SAB No. 110. Additionally, we estimate forfeiture rates based primarily upon historical experience, adjusted when appropriate for known events or expected trends. We may adjust share-based compensation expense on a quarterly basis for changes to our estimate of expected equity award forfeitures based on our review of these events and trends and recognize the effect of adjusting the forfeiture rate for all expense amortization in the period in which we revised the forfeiture estimate. If other assumptions or estimates had been used, the share-based compensation expense that was recorded for the years ended December 31, 2013, 2012 and 2011 could have been materially different. Furthermore, if different assumptions or estimates are used in future periods, share-based compensation expense could be materially impacted in the future.

Goodwill and Other Intangible Assets. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we account for goodwill and other intangible assets in accordance with the authoritative guidance issued by the FASB on goodwill and other intangibles. The authoritative guidance requires an impairment-only approach to accounting for goodwill and other intangibles with an indefinite life. Absent any prior indicators of impairment, we perform an annual impairment analysis during the fourth quarter of each of our fiscal years.

As of each of December 31, 2013 and 2012, we had $4.2 million of goodwill. As of each of December 31, 2013 and 2012, we had $0.2 million (net of accumulated amortization), of other identifiable intangible assets. We do not amortize goodwill, but we assess for impairment at least annually and more often if a trigger event occurs. We amortize identifiable intangible assets over their estimated useful lives. We evaluate the recoverability of goodwill using a two-step process based on an evaluation of the reporting unit. The first step involves a comparison of a reporting unit's fair value to its carrying value. In the second step, if the reporting unit's carrying value exceeds its fair value, we compare the goodwill's implied fair value and its carrying value. If the goodwill's carrying value exceeds its implied fair value, we recognize an impairment loss in an amount equal to such excess. We evaluate the recoverability of other identifiable intangible assets whenever events or changes in circumstances indicate that its carrying value may not be recoverable. Such events include significant adverse changes in business climate, several periods of operating or cash flow losses, forecasted continuing losses or a current expectation that an asset or asset a group will be disposed of before the end of its useful life. As of December 31, 2013 and 2012, we did not record any impairment charges on either our goodwill or other identifiable intangible assets.

Software Development Costs. As discussed further in Note (1) Summary of Significant Accounting Policies, to our consolidated financial statements, we account for software development costs in accordance with the authoritative guidance issued by the FASB on costs of software to be sold, leased or marketed.

45 -------------------------------------------------------------------------------- Table of Contents As of December 31, 2013 and 2012, we had $1.8 million and $1.2 million, respectively, of software development costs, net of amortization. The authoritative guidance requires that the costs associated with the development of new software products and enhancements to existing software products be expensed as incurred until technological feasibility of the product has been established. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers.

Judgment is required in determining when technological feasibility of a product is established and assumptions are used that reflect our best estimates. If other assumptions had been used in the current period to estimate technological feasibility, the reported product development and enhancement expense could have been affected. Annual amortization of capitalized software costs is the greater of the amount computed using the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life of the software product, generally estimated to be five years from the date the product became available for general release to customers. Software development costs are reported at the lower of amortized cost or net realizable value. Net realizable value is computed as the estimated gross future revenues from each software solution less the amount of estimated future costs of completing and disposing of that product. Because the development of projected net future revenues related to our software solutions used in our net realizable value computation is based on estimates, a significant reduction in our future revenues could impact the recovery of our capitalized software development costs. We amortize software development costs using the straight-line method.

Fair Value Measurement. As discussed further in Note (4) Fair Value Measurements, to our consolidated financial statements, we determine fair value measurements of both financial and nonfinancial assets and liabilities in accordance with the authoritative guidance issued by the FASB on fair value measurements and disclosures. The FASB authoritative guidance establishes three levels of inputs that may be used to measure fair value. Each level of input has different levels of subjectivity and difficulty involved in determining fair value.

Level 1 - instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult.

Level 2 - instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments.

Level 3 - instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. All of our derivative instruments classified as Level 3 are valued using a Black-Scholes pricing model and adjusted for probability assumptions. Most inputs to the Black-Scholes model are observable while the probability and volatility assumptions are unobservable.

The Company's embedded derivatives were classified as Level 3 as of December 31, 2013. There were no instruments classified as Level 3 as of December 31, 2012.

Other-Than-Temporary Impairment After determining the fair value of our available-for-sale debt instruments, gains or losses on these investments are recorded to other comprehensive income, until either the investment is sold or we determine that the decline in value is other-than-temporary. Determining whether the decline in fair value is other-than-temporary requires management judgment based on the specific facts and circumstances of each investment. For investments in debt instruments, these judgments primarily consider the financial condition and liquidity of the issuer, the issuer's credit rating, and any specific events that may cause us to believe that the debt instrument will not mature and be paid in full; and our ability and intent to hold the investment to maturity.

Litigation. As discussed further in Note (14) Litigation, to our consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on contingencies, the Company accrues anticipated costs of settlement, damages and losses for claims to the extent specific losses are probable and estimable. The Company records a receivable for insurance recoveries when such amounts are probable and collectable. In such cases, there may be an exposure to loss in excess of any amounts accrued. If, at the time of evaluation, the loss contingency related to a litigation is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable and, the Company will expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, the Company will accrue the minimum amount of the range.

46 -------------------------------------------------------------------------------- Table of Contents Impact of Recently Issued Accounting Pronouncements See Item 8 of Part II, Consolidated Financial Statements - Note (1) Summary of Significant Accounting Policies - New Accounting Pronouncements.

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