XNAS:FALC FalconStor Software Inc Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012
 
or
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                 to                                

Commission File Number:  000-23970
 
 
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
77-0216135
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

2 Huntington Quadrangle
Melville, New York
11747
(Address of principal executive offices)
(Zip Code)

631-777-5188
(Registrant’s telephone number, including area code)
 
 
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes x  No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes x     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large accelerated filer ¨
Accelerated filer x
   
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o    No x
 
The number of shares of Common Stock outstanding as of July 31, 2012 was 47,526,276.
 
 
1

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
FORM 10-Q
 
INDEX
 
   
Page
     
3
     
3
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
26
     
43
     
43
     
44
     
44
 
   
45
     
48
     
49

 
 
2

 
PART I.         FINANCIAL INFORMATION
 
Item 1.     Condensed Consolidated Financial Statements

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
June 30, 2012
   
December 31, 2011
 
Assets
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 16,484,132     $ 16,257,694  
Marketable securities
    16,622,687       20,894,328  
Accounts receivable, net of allowances of $1,073,041 and $1,723,679, respectively
    10,428,659       19,314,789  
Prepaid expenses and other current assets
    1,860,686       1,912,831  
Inventory
    1,100,644       1,769,007  
Deferred tax assets, net
    169,089       177,798  
Total current assets
    46,665,897       60,326,447  
                 
Property and equipment, net of accumulated depreciation of $19,307,534 and $17,797,835, respectively
    4,472,535       4,364,180  
Long-term marketable securities
    464,999       611,082  
Deferred tax assets, net
    209,843       217,771  
Software development costs, net
    1,325,948       1,001,530  
Other assets, net
    2,243,466       2,183,973  
Goodwill
    4,150,339       4,150,339  
Other intangible assets, net
    177,932       191,572  
                 
Total assets
  $ 59,710,959     $ 73,046,894  
                 
Liabilities and Stockholders' Equity
               
Current liabilities:
               
Accounts payable
  $ 2,656,205     $ 2,883,844  
Accrued expenses
    9,569,410       17,609,766  
Deferred revenue, net
    19,358,548       19,450,966  
Total current liabilities
    31,584,163       39,944,576  
                 
Other long-term liabilities
    4,396,320       2,587,327  
Deferred revenue, net
    6,919,380       7,698,053  
                 
Total liabilities
    42,899,863       50,229,956  
                 
Commitments and contingencies
               
Stockholders' equity:
               
Preferred stock - $.001 par value, 2,000,000 shares authorized
    -       -  
Common stock - $.001 par value, 100,000,000 shares authorized,  55,546,497 and 54,931,397 shares issued, respectively and 47,541,262 and 46,926,162 shares outstanding, respectively
    55,546       54,931  
Additional paid-in capital
    160,483,485       157,321,564  
Accumulated deficit
    (94,995,792 )     (85,925,798 )
Common stock held in treasury, at cost (8,005,235 and 8,005,235 shares, respectively)
    (46,916,339 )     (46,916,339 )
Accumulated other comprehensive loss, net
    (1,815,804 )     (1,717,420 )
                 
Total stockholders' equity
    16,811,096       22,816,938  
Total liabilities and stockholders' equity
  $ 59,710,959     $ 73,046,894  
                 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
3

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Revenues:
                       
Product revenues
  $ 7,835,568     $ 11,609,760     $ 18,498,521     $ 22,868,775  
Support and services revenues
    8,630,633       8,018,248       17,335,752       15,718,495  
Total  revenues
    16,466,201       19,628,008       35,834,273       38,587,270  
                                 
Cost of revenues:
                               
Product
    1,787,186       2,266,040       3,807,672       3,989,045  
Support and service
    3,091,055       3,418,589       6,252,411       6,537,808  
Total cost of revenues
    4,878,241       5,684,629       10,060,083       10,526,853  
                                 
Gross profit
  $ 11,587,960     $ 13,943,379     $ 25,774,190     $ 28,060,417  
                                 
Operating expenses
                               
Research and development costs
    4,771,691       5,245,119       9,472,286       11,350,107  
Selling and marketing
    9,266,762       10,521,307       19,029,987       18,995,399  
General and administrative
    3,018,154       2,957,460       6,129,029       5,558,995  
Investigation, litigation, and settlement related costs
    851,123       1,188,671       (439,797 )     3,799,791  
Total operating expenses
    17,907,730       19,912,557       34,191,505       39,704,292  
                                 
Operating loss
    (6,319,770 )     (5,969,178 )     (8,417,315 )     (11,643,875 )
                                 
Interest and other (loss) income , net
    (105,533 )     150,007       (244,864 )     450,956  
                                 
Loss before income taxes
    (6,425,303 )     (5,819,171 )     (8,662,179 )     (11,192,919 )
                                 
Provision for income taxes
    195,283       69,868       407,815       662,384  
                                 
Net loss
  $ (6,620,586 )   $ (5,889,039 )   $ (9,069,994 )   $ (11,855,303 )
                                 
Basic net loss per share
  $ (0.14 )   $ (0.13 )   $ (0.19 )   $ (0.26 )
                                 
Diluted net loss per share
  $ (0.14 )   $ (0.13 )   $ (0.19 )   $ (0.26 )
                                 
Weighted average basic shares outstanding
    47,472,909       46,643,349       47,258,696       46,453,196  
                                 
Weighted average diluted shares outstanding
    47,472,909       46,643,349       47,258,696       46,453,196  
 
See accompanying notes to unaudited condensed consolidated financial statements
 
 
4

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(UNAUDITED)
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                                 
Net loss
  $ (6,620,586 )   $ (5,889,039 )   $ (9,069,994 )   $ (11,855,303 )
                                 
Other comprehensive  loss:
                               
Foreign currency translation
    (34,261 )     (117,798 )     (163,860 )     (270,157 )
Net unrealized gains on marketable securities
    13,513       47,568       58,357       48,592  
Net minimum pension liability
    1,669       6,391       7,120       7,166  
Total other comprehensive loss
    (19,079 )     (63,839 )     (98,383 )     (214,399 )
                                 
Total comprehensive loss
  $ (6,639,665 )   $ (5,952,878 )   $ (9,168,377 )   $ (12,069,702 )

 

 

 

 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
5

 
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
Six Months Ended
June 30,
 
   
2012
   
2011
 
Cash flows from operating activities:
           
Net loss
  $ (9,069,994 )   $ (11,855,303 )
Adjustments to reconcile net loss to net cash from operating activities:
               
Depreciation and amortization
    1,702,187       2,224,070  
Share-based payment compensation
    2,508,448       2,529,229  
Non-cash professional services expenses
    29,930       126,071  
Realized gain on marketable securities
    (546 )     -  
Provision for returns and doubtful accounts
    (325,591 )     (317,809 )
Deferred income tax provision
    7,928       14,912  
Changes in operating assets and liabilities:
               
Accounts receivable
    9,248,544       6,060,390  
Prepaid expenses and other current assets
    43,214       (263,610 )
Inventory
    668,363       190,831  
Other assets
    (20,718 )     11,854  
Accounts payable
    (222,903 )     936,232  
Accrued expenses and other liabilities
    (6,202,916 )     431,453  
Deferred revenue
    (837,581 )     2,248,781  
                 
Net cash (used in) provided by operating activities
    (2,471,635 )     2,337,101  
                 
                 
Cash flows from investing activities:
               
Sales of marketable securities
    11,818,443       10,284,132  
Purchases of marketable securities
    (7,341,816 )     (12,231,093 )
Purchases of property and equipment
    (1,612,104 )     (1,289,194 )
Capitalized software development costs
    (461,555 )     (700,084 )
Security deposits
    (41,746 )     (8,522 )
Purchase of intangible assets
    (44,610 )     (35,220 )
                 
Net cash provided by (used in) investing activities
    2,316,612       (3,979,981 )
                 
                 
Cash flows from financing activities:
               
Proceeds from exercise of stock options
    624,155       552,774  
                 
Net cash provided by financing activities
    624,155       552,774  
                 
Effect of exchange rate changes on cash and cash equivalents
    (242,694 )     (135,803 )
                 
Net increase (decrease) in cash and cash equivalents
    226,438       (1,225,909 )
                 
Cash and cash equivalents, beginning of period
    16,257,694       17,842,555  
                 
Cash and cash equivalents, end of period
  $ 16,484,132     $ 16,616,646  
                 
Cash paid for income taxes
  $ 528,714     $ 278,871  

The Company did not pay any interest for the six months ended June 30, 2012 and 2011.





See accompanying notes to unaudited condensed consolidated financial statements.
 
 
6


FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
 
Notes to Unaudited Condensed Consolidated Financial Statements
 
 
(1) Summary of Significant Accounting Policies
 
(a) The Company and Nature of Operations
 
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures and sells data protection solutions and provides the related maintenance, implementation and engineering services.
 
(b)  
Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.
 
(c)  Reclassifications
 
Certain prior year’s amounts have been reclassified to conform to the current year presentation. Software development costs are now presented separately from “other assets, net.”  Certain costs previously recorded within “cost of revenues – support and services” are now presented within “research and development” to better align these costs with functions performed.
 
 (d)  Use of Estimates
 
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company’s significant estimates include those related to revenue recognition, accounts receivable allowances, share-based payment compensation, cost-based investments, marketable securities, software development costs, goodwill and other intangible assets and the recoverability of deferred tax assets. Actual results could differ from those estimates.
 
The financial market volatility, both in the U.S. and in many other countries where the Company operates, has impacted and may continue to impact the Company’s business. Such conditions could have a material impact to the Company’s significant accounting estimates discussed above.
 
 (e) Unaudited Interim Financial Information
 
The accompanying unaudited interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.
 
In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at June 30, 2012, and the results of its operations for the three and six months ended June 30, 2012 and 2011. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year.
 
 
7

 
(f) Cash Equivalents and Marketable Securities
 
The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. The Company records its cash equivalents and marketable securities at fair value in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”) on fair value measurements and disclosures. As of both June 30, 2012 and December 31, 2011, the Company’s cash equivalents consisted of money market funds.  At June 30, 2012 and December 31, 2011, the fair value of the Company’s cash equivalents amounted to approximately $6.5 million and $8.1 million, respectively. As of June 30, 2012 and December 31, 2011, the Company’s marketable securities consisted of corporate bonds, auction rate securities, and government securities. As of June 30, 2012 and December 31, 2011, the fair value of the Company’s current marketable securities was approximately $16.6 million and $20.9 million, respectively. In addition, as of both June 30, 2012 and December 31, 2011, the Company had an additional $0.5 million and $0.6 million, respectively, of long-term marketable securities that required a higher level of judgment to determine the fair value. All of the Company’s marketable securities are classified as available-for-sale, and accordingly, unrealized gains and losses on marketable securities, net of tax, are reflected as a component of accumulated other comprehensive loss in stockholders’ equity. Any other-than-temporary impairments are recorded within interest and other loss, net in the condensed consolidated statement of operations. See Note (5) Marketable Securities for additional information.
 
(g)  Fair Value of Financial Instruments
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To increase the comparability of fair value measurements, a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies, is as follows:
 
Level 1—Valuations based on quoted prices for identical assets and liabilities in active markets.
 
Level 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.
 
Level 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment.
 
As of both June 30, 2012 and December 31, 2011, the fair value of the Company’s financial instruments including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated carrying value due to the short maturity of these instruments. See Note (4) Fair Value Measurements for additional information.
 
 (h) Revenue Recognition
 
The Company derives its revenue from sales of its products, support and services. Product revenue consists of the Company’s software integrated with industry standard hardware and sold as complete turn-key integrated solutions. Product revenue also consists of stand-alone software applications. Support and services revenue consists of both maintenance revenues and professional services revenues. Revenue is recorded net of applicable sales taxes.
 
In accordance with the authoritative guidance issued by the FASB on revenue recognition, the Company recognizes revenue from product sales when persuasive evidence of an arrangement exists, the fee is fixed and determinable, the product is delivered, and collection of the resulting receivable is deemed probable. Products delivered to a customer on a trial basis are not recognized as revenue until a permanent key code is delivered to the customer. Reseller customers typically send the Company a purchase order when they have an end user identified. For bundled arrangements that include either maintenance or both maintenance and professional services, the Company uses the residual method to determine the amount of product revenue to be recognized. Under the residual method, consideration is allocated to the undelivered elements based upon vendor-specific objective evidence (“VSOE”) of the fair value of those elements, with the residual of the arrangement fee allocated to and recognized as product revenue. The long-term portion of deferred revenue relates to maintenance contracts with terms in excess of one year. The Company provides an allowance for product returns as a reduction of revenue, based upon historical experience and known or expected trends.
 
 
8

 
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 and distributors, whereby the Company has provided to the reseller a non-exclusive software license to install the Company’s software on certain hardware or to resell the Company’s software in exchange for payments based on the products distributed by the OEM or distributor. Such payments from the OEM or distributor are recognized as revenue in the period reported by the OEM or distributor.
 
 (i)      Property and Equipment
 
Property and equipment are recorded at cost. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets (3 to 7 years). For the three months ended June 30, 2012 and 2011, depreciation expense was $709,241 and $984,639, respectively. For the six months ended June 30, 2012 and 2011, depreciation expense was $1,506,800 and $1,928,887, respectively. Leasehold improvements are amortized on a straight-line basis over the term of the respective leases or over their estimated useful lives, whichever is shorter.
 
(j)      Goodwill and Other Intangible Assets
 
Goodwill represents the excess of the purchase price over the estimated fair value of net tangible and identifiable intangible assets acquired in business combinations. The Company has not amortized goodwill related to its acquisitions, but instead tests the balance for impairment. The Company evaluates goodwill for impairment annually or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. The Company tests goodwill for impairment by first comparing the book value of net assets to the fair value of the reporting unit. If the fair value is determined to be less than the book value or qualitative factors indicate that it is more likely than not that goodwill is impaired, a second step is performed to compute the amount of impairment as the difference between the estimated fair value of goodwill and the carrying value.
 
The Company’s annual impairment assessment is performed during the fourth quarter of each year, and the Company has determined there to be no impairment for any of the periods presented. Identifiable intangible assets include (i) assets acquired through business combinations, which include customer contracts and intellectual property, and (ii) patents amortized over three years using the straight-line method.
 
For the three months ended June 30, 2012 and 2011, amortization expense was $29,862 and $126,553, respectively. For the six months ended June 30, 2012 and 2011, amortization expense was $58,249 and $260,755, respectively. The gross carrying amount and accumulated amortization of other intangible assets as of June 30, 2012 and December 31, 2011 are as follows:
 
 
9

 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
Goodwill
  $ 4,150,339     $ 4,150,339  
Other intangible assets:
               
Gross carrying amount
  $ 3,071,554     $ 3,026,945  
Accumulated amortization
    (2,893,622 )     (2,835,373 )
Net carrying amount
  $ 177,932     $ 191,572  
 
(k) Software Development Costs and Purchased Software Technology
 
In accordance with the authoritative guidance issued by the FASB on costs of software to be sold, leased, or marketed, costs associated with the development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. Based on the Company’s product development process, technological feasibility is established upon completion of a working model. Amortization of software development costs is recorded at the greater of the straight-line basis over the product’s estimated life, or the ratio of current revenue of the related products to total current and anticipated future revenue of these products.  During the three months ended June 30, 2012 and 2011 the Company capitalized approximately $74,000 and $578,000, respectively, related to software development projects. During the six months ended June 30, 2012 and 2011 the Company capitalized approximately $462,000 and $700,000, respectively, related to software development projects. During the three months ended June 30, 2012 and 2011, the Company recorded $78,983 and $17,525, respectively, of amortization expense related to capitalized software costs. During the six months ended June 30, 2012 and 2011, the Company recorded $137,138 and $34,428, respectively, of amortization expense related to capitalized software costs.
 
Purchased software technology is included within “other assets, net” in the condensed consolidated balance sheets. As of June 30, 2012 and 2011, purchased software technology had been fully amortized.
 
(l) Income Taxes
 
The Company records income taxes under the liability method. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In determining the period in which related tax benefits are realized for financial reporting purposes, excess share-based compensation deductions included in net operating losses are realized after regular net operating losses are exhausted.
 
The Company accounts for uncertain tax positions in accordance with the authoritative guidance issued by the FASB on income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return, should be recorded in the financial statements. Pursuant to the authoritative guidance, the Company may recognize the tax benefit from an uncertain tax position only if it meets the “more likely than not” threshold that the position will be sustained on examination by the taxing authority, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. In addition, the authoritative guidance addresses de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures. The Company includes interest and penalties related to its uncertain tax positions as part of income tax expense within its consolidated statement of operations. See Note (3) Income Taxes for additional information.
 
 
10

 
 (m) 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.
 
(n) Share-Based Payments
 
The Company accounts for share-based payments in accordance with the authoritative guidance issued by the FASB on share-based compensation, which establishes the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Under the provisions of the authoritative guidance, share-based compensation expense is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the requisite employee service period (generally the vesting period), net of estimated forfeitures. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model. The estimation of share-based awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical experience. Additionally, share-based awards to non-employees are expensed over the period in which the related services are rendered at their fair value. All share-based awards are expected to be fulfilled with new shares of common stock. See Note (2) Share-Based Payment Arrangements for additional information.
 
(o) Foreign Currency

Assets and liabilities of foreign operations are translated at rates of exchange at the end of the period, while results of operations are translated at average exchange rates in effect for the period. Gains and losses from the translation of foreign assets and liabilities from the functional currency of the Company’s subsidiaries into the U.S. dollar are classified as accumulated other comprehensive loss in stockholders’ equity. Gains and losses from foreign currency transactions are included in the condensed consolidated statements of operations within interest and other (loss) income, net.

During the three months ended June 30, 2012 and 2011, foreign currency transactional (loss) gain totaled approximately ($126,000) and $107,000, respectively. During the six months ended June 30, 2012 and 2011, foreign currency transactional (loss) gain totaled approximately ($301,000) and $341,000, respectively.

(p) Earnings Per Share (EPS)
 
Basic EPS is computed based on the weighted average number of shares of common stock outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding increased by dilutive common stock equivalents, attributable to stock option awards, restricted stock awards and restricted stock unit awards outstanding. Due to the net loss for both the three and six months ended June 30, 2012 and 2011, all common stock equivalents, totaling 12,377,225 and 14,811,235, respectively, were excluded from diluted net loss per share because they were anti-dilutive.
 
 
11

 
The following represents a reconciliation of the numerators and denominators of the basic and diluted EPS computation:
 
 
   
Three Months Ended June 30, 2012
   
Three Months Ended June 30, 2011
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
 
Amount
   
(Numerator)
   
(Denominator)
 
Amount
 
Basic EPS
  $ (6,620,586 )     47,472,909     $ (0.14 )   $ (5,889,039 )     46,643,349     $ (0.13 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (6,620,586 )     47,472,909     $ (0.14 )   $ (5,889,039 )     46,643,349     $ (0.13 )
                                                 
                                                 
                                                 
   
Six Months Ended June 30, 2012
   
Six Months Ended June 30, 2011
 
   
Net Loss
   
Shares
   
Per Share
   
Net Loss
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
 
Amount
   
(Numerator)
   
(Denominator)
 
Amount
 
Basic EPS
  $ (9,069,994 )     47,258,696     $ (0.19 )   $ (11,855,303 )     46,453,196     $ (0.26 )
                                                 
Effect of dilutive securities:
                                               
      Stock options and restricted stock
            -                       -          
                                                 
Diluted EPS
  $ (9,069,994 )     47,258,696     $ (0.19 )   $ (11,855,303 )     46,453,196     $ (0.26 )
 
(q)  Investments
 
As of both June 30, 2012 and December 31, 2011, the Company maintained certain cost-method investments aggregating approximately $932,000, which are included within other assets, net in the accompanying condensed consolidated balance sheets. During the three and six months ended June 30, 2012 and 2011, the Company did not recognize any impairment charges related to any of its cost-method investments.
 
(r) Treasury Stock

The Company accounts for treasury stock under the cost method and includes treasury stock as a component of stockholders’ equity.
 
 (s) New Accounting Pronouncements
 
In September 2011, the FASB issued guidance for intangibles – goodwill and other, related to goodwill impairment guidance. The guidance gives an option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If after assessing all events and circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, the performance of the existing two-step impairment test is unnecessary. The guidance is effective for the Company for annual periods beginning after December 15, 2011. The implementation of the guidance did not have a material impact on the Company’s condensed consolidated financial statements and disclosures.

In June 2011, the FASB issued guidance that modified how comprehensive income is presented in an entity’s financial statements. The guidance issued requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements and eliminates the option to present the components of other comprehensive income as part of the statement of equity. The revised financial statement presentation for comprehensive income is effective for the Company for annual periods beginning after December 15, 2011. The Company has included an additional statement as a result of applying this guidance.
 
 
12


In May 2011, the FASB issued new guidance for fair value measurements intended to achieve common fair value measurement and disclosure requirements. The amended guidance provides a consistent definition of fair value to ensure that the fair value measurement and disclosure requirements are similar between U.S. generally accepted accounting principles and International Financial Reporting Standards. The amended guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for Level 3 fair value measurements. The amended guidance is effective for the Company for annual periods beginning after December 15, 2011. The implementation of the guidance did not have a material impact on the Company’s condensed consolidated financial statements and disclosures.

 (2) Share-Based Payment Arrangements

The following table summarizes the plans under which the Company was able to grant equity compensation as of June 30, 2012:
 
 
   
Shares
 
Shares Available
 
Shares
 
Last Date for
Name of Plan
 
Authorized
 
for Grant
 
Outstanding
 
Grant of Shares
                 
FalconStor Software, Inc., 2006 Incentive Stock Plan
 
12,044,957
 
2,197,887
 
7,336,713
 
May 17, 2016
                 
FalconStor Software, Inc., 2010 Outside Directors Equity Compensation Plan
 
400,000
 
280,000
 
90,300
 
May 8, 2020
 
On July 1, 2012, the total shares available for issuance under the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006 Plan”) totaled 2,197,887. Pursuant to the 2006 Plan, if, on July 1st of any calendar year in which the 2006 Plan is in effect, the number of shares of stock as to which options, restricted shares and restricted stock units may be granted under the 2006 Plan is less than five percent (5%) of the number of outstanding shares of stock, then the number of shares of stock available for issuance under the 2006 Plan is automatically increased so that the number equals five percent (5%) of the shares of stock outstanding. In no event shall the number of shares of stock subject to the 2006 Plan in the aggregate exceed twenty million shares, subject to adjustment as provided in the 2006 Plan. On July 1, 2012, the total number of outstanding shares of the Company’s common stock totaled 47,541,262. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan thus increased by 179,176 shares from 2,197,887 to 2,377,063 shares available for issuance as of July 1, 2012.

The following table summarizes the Company’s equity plans that have expired but that still have equity awards outstanding as of June 30, 2012:
 
   
Shares Available
 
Shares
Name of Plan
 
for Grant
 
Outstanding
         
FalconStor Software, Inc., 2000 Stock Option Plan
 
--
 
3,265,212
         
1994 Outside Directors Stock Option Plan
 
--
 
40,000
         
2004 Outside Directors Stock Option Plan
 
--
 
250,000
         
FalconStor Software, Inc., 2007 Outside Directors Equity Compensation Plan
 
--
 
175,000
         
Stand-Alone Stock Option Agreement between the Company and James P. McNiel
 
--
 
1,220,000
 
All options granted under the Company’s equity plans have terms of ten years.
 
 
13

 
The following table summarizes stock option activity during the six months ended June 30, 2012:
 
               
Weighted
       
         
Weighted
   
Average
       
         
Average
   
Remaining
   
Aggregate
 
   
Number of
   
Exercise
   
Contractual
   
Intrinsic
 
   
Options
   
Price
   
Life (Years)
   
Value
 
                         
Options Outstanding at December 31, 2011
    14,456,722       $4.95              
                             
Granted
    521,200       $2.94              
Exercised
    (82,900 )     $2.45              
Canceled
    (10,000 )     $7.98              
Forfeited
    (428,290 )     $6.88              
                             
Options Outstanding at March 31, 2012
    14,456,732       $4.83       6.12     $ 5,497,712  
                                 
Granted
    408,000       $3.21                  
Exercised
    (187,680 )     $2.24                  
Canceled
    (666,380 )     $5.09                  
Forfeited
    (1,846,570 )     $4.28                  
                                 
Options Outstanding at June 30, 2012
    12,164,102       $4.89       6.46     $ 453,155  
                                 
Options Exercisable at June 30, 2012
    4,146,502       $5.69       5.20     $ 432,455  
 
Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended June 30, 2012 and 2011 was $421,290 and $85,421, respectively. The total cash received from stock option exercises for the six months ended June 30, 2012 and 2011 was $624,155 and $552,774, respectively. The total intrinsic value of stock options exercised during the three months ended June 30, 2012 and 2011 was $188,609 and $56,526, respectively. The total intrinsic value of stock options exercised during the six months ended June 30, 2012 and 2011 was $266,862 and $314,822, respectively.
 
 
14

 
 The Company recognized share-based compensation expense for all awards issued under the Company’s stock equity plans in the following line items in the condensed consolidated statements of operations:
 
   
Three months ended June 30,
 
   
2012
   
2011
 
Cost of revenues - Product
  $ 49     $ 741  
Cost of revenues - Support and Service
    (21,124 )     129,714  
Research and development costs
    125,231       329,369  
Selling and marketing
    398,031       462,555  
General and administrative
    587,889       417,974  
                 
    $ 1,090,076     $ 1,340,353  
                 
                 
   
Six months ended June 30,
 
      2012       2011  
Cost of revenues - Product
  $ 99     $ 1,473  
Cost of revenues - Support and Service
    49,844       273,201  
Research and development costs
    444,188       808,411  
Selling and marketing
    884,656       885,279  
General and administrative
    1,159,591       686,936  
                 
    $ 2,538,378     $ 2,655,300  
 
The Company has the ability to issue both restricted stock and restricted stock units. The fair value of the restricted stock awards and restricted stock units are expensed at either (i) the fair value per share at date of grant (directors, officers and employees), or (ii) the fair value per share as of each reporting period (non-employee consultants). A summary of the total stock-based compensation expense related to restricted stock awards and restricted stock units, which is included in the Company’s total share-based compensation expense for each respective period, is as follows:
 
   
Three months ended June 30,
 
   
2012
   
2011
 
Directors, officers and employees
  $ 130,164     $ 326,964  
Non-employee consultants
    -       19,290  
                 
    $ 130,164     $ 346,254  
                 
                 
   
Six months ended June 30,
 
      2012       2011  
Directors, officers and employees
  $ 407,580     $ 721,498  
Non-employee consultants
    -       21,882  
                 
    $ 407,580     $ 743,380  
 
As of June 30, 2012, an aggregate of 2,871,054 shares of restricted stock had been issued, of which, 2,193,552 had vested and 464,889 had been canceled. As of June 30, 2011, an aggregate of 2,803,554 shares of restricted stock had been issued, of which, 1,776,429 had vested and 444,645 had been canceled.
 
As of June 30, 2012, an aggregate of 90,412 restricted stock units had been issued, of which 78,555 had vested and 11,347 had been canceled. As of June 30, 2011, an aggregate of 90,412 restricted stock units had been issued, of which 70,890 had vested and 2,500 had been canceled.
 
 
15


The following table summarizes restricted stock and restricted stock units activity during the six months ended June 30, 2012:
 
     
Number of Restricted
     
Stock Awards / Units
       
Non-Vested at December 31, 2011
   
525,889
       
Granted
   
-
Vested
   
(290,105)
Forfeited
   
(11,496)
       
Non-Vested at March 31, 2012
   
224,288
       
Granted
   
50,000
Vested
   
(54,415)
Forfeited
   
(6,750)
       
Non-Vested at June 30, 2012
   
213,123
 
Restricted stock and restricted stock units are fulfilled with new shares of common stock. The total intrinsic value of restricted stock for which the restrictions lapsed during the three months ended June 30, 2012 and 2011 was $178,592 and $266,019, respectively. The total intrinsic value of restricted stock for which the restrictions lapsed during the six months ended June 30, 2012 and 2011 was $1,038,739 and $1,635,512, respectively.
 
Options granted to officers, employees and directors during fiscal 2012 and 2011 have exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, and a vesting period generally of three years.
 
Options granted to non-employee consultants have exercise prices equal to the fair market value of the stock on the date of grant and a contractual term of ten years. Restricted stock awards granted to non-employee consultants have a contractual term equal to the lapse of restriction(s) of each specific award. Vesting periods for share-based awards granted to non-employee consultants range from immediate vesting to three years depending on service requirements. A summary of the total stock-based compensation expense/(benefit) related to share-based awards granted to non-employee consultants, which is included in the Company’s total share-based compensation expense for each respective period, is as follows:
 
   
Three months ended June 30,
 
   
2012
   
2011
 
Non-qualified stock options
  $ (25,262 )   $ 17,286  
Restricted stock awards
    -       19,290  
                 
    $ (25,262 )   $ 36,576  
                 
                 
   
Six months ended June 30,
 
      2012       2011  
Non-qualified stock options
  $ 29,930     $ 104,189  
Restricted stock awards
    -       21,882  
                 
    $ 29,930     $ 126,071  
 
 
16

 
The Company estimates expected volatility based primarily on historical daily volatility of the Company’s stock and other factors, if applicable. The risk-free interest rate is based on the United States treasury yield curve in effect at the time of grant. The expected option term is the number of years that the Company estimates that options will be outstanding prior to exercise. The expected term of the awards was determined based upon an estimate of the expected term of “plain vanilla” options as prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110.
 
As of June 30, 2012, there was approximately $6,958,152 of total unrecognized compensation cost related to the Company’s unvested options, restricted shares and restricted stock units granted under the Company’s equity plans.
 
 (3) Income Taxes
 
The Company’s provision for income taxes consists of federal, state and local, and foreign taxes, as applicable, in amounts necessary to align the Company’s year-to-date tax provision with the effective rate that it expects to achieve for the full year.  The Company’s 2012 annual effective tax rate (excluding discrete items) is estimated to be approximately (4.7%) based upon its anticipated results both in the U.S. and in its foreign subsidiaries.
 
For the six months ended June 30, 2012, the Company recorded an income tax provision of $0.4 million on its pre-tax loss of $8.7 million, consisting of primarily state and local and foreign taxes. Additionally, the Company recorded an adjustment to its accrual for certain legal matters during the six months ended June 30, 2012, which the Company believes will be non-deductible for US income tax purposes. The tax impact related to this accrual was recorded as a discrete item during the six months ended June 30, 2012. As of June 30, 2012, the Company’s conclusion did not change with respect to the realizability of its domestic deferred tax assets and, therefore, the Company has not recorded any benefit for its expected net domestic deferred tax assets for the full year 2012 estimated annual effective tax rate. As of June 30, 2012, the valuation allowance totaled approximately $35.4 million.
 
For the six months ended June 30, 2011, the Company recorded an income tax provision of $0.7 million on its pre-tax loss of $11.2 million, consisting of primarily state and local and foreign taxes.
 
The Company’s total unrecognized tax benefits for both June 30, 2012 and December 31, 2011 were approximately $5.1 million, which if recognized, would affect the Company’s effective tax rate. As of June 30, 2012 and December 31, 2011, the Company recorded an aggregate of approximately $301,000 and $232,000, respectively, of accrued interest and penalties.
 
(4) Fair Value Measurements
 
The Company measures its cash equivalents and marketable securities at fair value. Fair value is an exit price, representing the amount that would be received on the sale of an asset or that would be paid to transfer a liability in an orderly transaction between market participants. As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:
 
  Fair Value Hierarchy
 
The methodology for measuring fair value specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs). As a result, observable and unobservable inputs have created the following fair value hierarchy:
 
 
17

 
·  
Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities. The Level 1 category includes money market funds, which at June 30, 2012 and December 31, 2011 totaled $6.5 million and $8.1 million, respectively, which are included within cash and cash equivalents in the condensed consolidated balance sheets.

·  
Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly. The Level 2 category includes government securities and corporate debt securities, which at June 30, 2012 and December 31, 2011 totaled $16.6 million and $20.9 million, respectively, which are included within cash and cash equivalents and marketable securities in the condensed consolidated balance sheets.

·  
Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. The Level 3 category includes auction rate securities, which at June 30, 2012 and December 31, 2011 totaled $0.5 million and $0.6 million, respectively, which are included within long-term marketable securities in the condensed consolidated balance sheets.
 
Measurement of Fair Value
 
The Company measures fair value as an exit price using the procedures described below for all assets and liabilities measured at fair value. When available, the Company uses unadjusted quoted market prices to measure fair value and classifies such items within Level 1. If quoted market prices are not available, fair value is based upon financial models that use, when possible, current market-based or independently-sourced market parameters such as interest rates and currency rates. Items valued using financial generated models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be inputs that are readily observable. If quoted market prices are not available, the valuation model used generally depends on the specific asset or liability being valued. The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments.
 
As of June 30, 2012 and December 31, 2011, the Company held certain assets that are required to be measured at fair value on a recurring basis. Included within the Company’s marketable securities portfolio are investments in auction rate securities, which are classified as available-for-sale securities and are reflected at fair value. The Company has determined the estimated fair values of these securities utilizing a discounted cash flow analysis or other type of valuation model. These analyses consider, among other items, the collateral underlying the security, the creditworthiness of the issuer, the timing of the expected future cash flows, including the final maturity, and an assumption of when the next time the security is expected to have a successful auction. These securities were also compared, when possible, to other observable and relevant market data, which is limited at this time.
 
As of June 30, 2012, the Company recorded a cumulative temporary decline in fair value of approximately $35,000 in accumulated other comprehensive loss. As of December 31, 2011, the Company recorded a cumulative temporary decline in fair value of approximately $89,000 in accumulated other comprehensive loss. During the second quarter of 2012, $100,000 of the Company’s auction rate notes were called by the issuer at par value. During the first six months of 2012, $200,000 of the Company’s auction rate securities were called by the issuer at par value. The Company believes that the temporary declines in fair value are primarily due to liquidity concerns and are not due to the creditworthiness of the remaining underlying assets, because the majority of the underlying securities are almost entirely backed by the U.S. Government. However, if at any time in the future a determination that a valuation adjustment is other-than-temporary, the Company will record a charge to earnings in the period of determination.
 
 
18

 
The Company measures its cash equivalents and marketable securities at fair value. Fair value is an exit price, representing the amount that would be received on the sale of an asset or that would be paid to transfer a liability in an orderly transaction between market participants. As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:
 
Items Measured at Fair Value on a Recurring Basis
 
       The following table presents the Company’s assets that are measured at fair value on a recurring basis at June 30, 2012:
 
         
Fair Value Measurements at Reporting Date Using
 
                         
         
Quoted Prices in
         
Significant
 
         
Active Markets for
   
Significant other
   
Unobservable
 
         
Identical Assets
   
Inputs
   
Inputs
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Cash equivalents:
                       
 Money market funds
  $ 6,452,560     $ 6,452,560     $ -     $ -  
Total cash equivalents
    6,452,560       6,452,560       -       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    16,622,687       -       16,622,687       -  
 Auction rate securities
    464,999       -       -       464,999  
Total marketable securities
    17,087,686       -       16,622,687       464,999  
                                 
Total assets measured at fair value
  $ 23,540,246     $ 6,452,560     $ 16,622,687     $ 464,999  

The following table presents the Company’s assets that are measured at fair value on a recurring basis at December 31, 2011:
 
         
Fair Value Measurements at Reporting Date Using
 
                         
         
Quoted Prices in
         
Significant
 
         
Active Markets for
   
Significant other
   
Unobservable
 
         
Identical Assets
   
Inputs
   
Inputs
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Cash equivalents:
                       
 Money market funds
  $ 8,129,960     $ 8,129,960     $ -     $ -  
Total cash equivalents
    8,129,960       8,129,960       -       -  
                                 
Marketable securities:
                               
 Corporate debt and government securities
    20,894,328       -       20,894,328       -  
 Auction rate securities
    611,082       -       -       611,082  
Total marketable securities
    21,505,410       -       20,894,328       611,082  
                                 
Total assets measured at fair value
  $ 29,635,370     $ 8,129,960     $ 20,894,328     $ 611,082  
 
 
19


The Company’s valuation methodology for auction rate securities includes a discounted cash flow analysis. The following table presents the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of January 1st through June 30th of each of the respective years:

   
Fair Value Measurements Using
 
   
Significant Unobservable Inputs
 
   
(Level 3)
 
             
   
Auction Rate Securities
 
             
   
June 30, 2012
   
June 30, 2011
 
Beginning Balance
  $ 611,082     $ 578,643  
Total unrealized gains in accumulated
               
 other comprehensive loss
    53,917       41,491  
Securities called by issuer
    (200,000 )     -  
Ending Balance
  $ 464,999     $ 620,134  

(5) Marketable Securities
 
The Company’s marketable securities consist of available-for-sale securities, which are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity. Unrealized gains and losses are computed on the specific identification method. Realized gains, realized losses and declines in value judged to be other-than-temporary, are included in interest and other income, net. The cost of available-for-sale securities sold is based on the specific identification method and interest earned is included in interest and other income.
 
The cost and fair values of the Company’s available-for-sale marketable securities as of June 30, 2012, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 464,999     $ 500,000     $ (35,001 )
                         
Government securities
    13,603,098       13,593,019       10,079  
                         
Corporate debt securities
    3,019,589       3,020,100       (511 )
                         
    $ 17,087,686     $ 17,113,119     $ (25,433 )
 
The cost and fair values of the Company’s available-for-sale marketable securities as of December 31, 2011, are as follows:
 
   
Aggregate
   
Cost or Amortized
   
Net Unrealized
 
   
Fair Value
   
Cost
   
Gains / (loss)
 
                   
Auction rate securities
  $ 611,082     $ 700,000     $ (88,918 )
                         
Government securities
    17,303,207       17,286,598       16,609  
                         
Corporate debt securities
    3,591,121       3,602,602       (11,481 )
                         
    $ 21,505,410     $ 21,589,200     $ (83,790 )
 
 
20

 
(6) Inventories
 
Inventories consist of component materials and finished systems. Inventories are stated at the lower of cost (first-in, first-out) or market, not in excess of net realizable value. Component material consists of certain key replacement parts for the finished systems. Inventories are as follows:
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
   Component materials
  $ 148,605     $ 63,179  
   Finished systems
    952,039       1,705,828  
                 
Total Inventory
  $ 1,100,644     $ 1,769,007  
 
As of June 30, 2012 and December 31, 2011, the Company has not recorded any reserve for excess and/or obsolete inventories in arriving at estimated net realizable value of its inventory.
 
 (7) Stockholders’ Equity
 
Stock Repurchase Activity
 
At various times from October 2001 through February 2009, the Company’s Board of Directors has authorized the repurchase of up to 14 million shares of the Company’s outstanding common stock in the aggregate. The repurchases may be made from time to time in open market transactions in such amounts as determined at the discretion of the Company’s management. The terms of the stock repurchases are determined by management based on market conditions.
 
During each of the three and six months ended June 30, 2012 and 2011, the Company did not repurchase any shares of its common stock. Since October 2001, the Company has repurchased a total of 8,005,235 shares of its common stock at an aggregate purchase price of $46,916,339. As of June 30, 2012, the Company had the authorization to repurchase an additional 5,994,765 shares of its common stock based upon its judgment and market conditions.
 
Preferred Stock
 
The Company is authorized to issue two million shares of $0.001 par value preferred stock. No preferred stock has been issued or outstanding for any period presented.
 
 
21

 
 (8) Commitments and Contingencies
 
As of June 30, 2012, the Company has an operating lease covering its corporate office facility that expires in February 2017. The Company has the option to terminate the lease as of the last date of each month between August 31, 2013 and February 28, 2014, on nine months’ prior written notice. The Company also has several operating leases related to offices in the United States and foreign countries. The expiration dates for these leases range from 2012 through 2017. The following is a schedule of future minimum lease payments for all operating leases as of June 30, 2012:
 
2012
$1,507,222
2013
2,315,174
2014
2,022,509
2015
1,729,941
2016
1,634,274
Thereafter
296,643
 
$9,505,763
 
 
The Company typically provides its customers a warranty on its software products for a period of no more than 90 days. Such warranties are accounted for in accordance with the authoritative guidance issued by the FASB on contingencies. To date, the Company has not incurred any costs related to warranty obligations.
 
Under the terms of substantially all of its software license agreements, the Company has agreed to indemnify its customers for all costs and damages arising from claims against such customers based on, among other things, allegations that the Company’s software infringes the intellectual property rights of a third party. In most cases, in the event of an infringement claim, the Company retains the right to (i) procure for the customer the right to continue using the software; (ii) replace or modify the software to eliminate the infringement while providing substantially equivalent functionality; or (iii) if neither (i) nor (ii) can be reasonably achieved, the Company may terminate the license agreement and refund to the customer a pro-rata portion of the license fee paid to the Company. Such indemnification provisions are accounted for in accordance with the authoritative guidance issued by the FASB on guarantees. As of June 30, 2012 and June 30, 2011, there were no claims outstanding under such indemnification provisions.
 
On January 11, 2011, the Company entered into an Employment Agreement (“McNiel Employment Agreement”) with James P. McNiel. Pursuant to the McNiel Employment Agreement, the Company agreed to employ Mr. McNiel as President and Chief Executive Officer of the Company effective January 1, 2011 through December 31, 2013, at an annual salary of $400,000 per annum for calendar years 2011, 2012 and 2013. Pursuant to the McNiel Employment Agreement, Mr. McNiel’s base salary is subject to review annually by the Board of Directors and may be increased but not decreased as determined by the Board of Directors based on job performance. The McNiel Employment Agreement also provides for certain equity based awards as previously disclosed in the Company’s quarterly reports on Form 10-Q during 2011 and its Annual Report on Form 10-K for the year ended December 31, 2011.
 
As of June 30, 2012, the Company had a total of $2.9 million payable outstanding relating to its settlement with the United States Attorney’s Office, of which $1.2 million was paid in July 2012, and the remaining $1.7 million is to be paid in December 2013.
 
(9) Litigation

The Internal and Government Investigations
 
As previously disclosed, both the United States Attorney’s Office for the Eastern District of New York (“USAO”) and the Securities and Exchange Commission (“SEC”) commenced investigations of the Company in October, 2010, in response to the Company’s announcement that it had accepted the resignation of ReiJane Huai, its President and Chief Executive Officer, and the Chairman of its Board of Directors, following his disclosure to the Company that certain improper payments allegedly were made in connection with the Company’s licensing of software to one customer.
 
The Company conducted its own investigation into the matter and cooperated with the USAO and SEC investigations.
 
 
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On June 27, 2012, the Company announced that it had entered into settlements with the USAO and the SEC.
 
The Company entered into a Deferred Prosecution Agreement (DPA) with the USAO.  Under the DPA, the USAO agrees that it will defer prosecution of the Company in connection with the matter, and ultimately not prosecute the Company if the Company satisfies its obligations during the 18 month term of the DPA.  The DPA acknowledges the remedial actions taken by the Company in response to its discovery of the improper payments and does not require the Company to make any additional control or compliance changes.  Under the DPA, the Company will forfeit $2.9 million over eighteen months.
 
The Company agreed with the SEC to the entry of a Consent Judgment (CJ) to settle a civil action filed by the SEC.  Pursuant to the CJ, the Company agreed not to violate the anti-fraud and registration provisions of Sections 17(a)(2), 5(a) and 5(c) of the Securities Act of 1933, and the books and records provisions of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934.  The Company further agreed to pay a civil penalty of $2.9 million to the SEC.
 
As of June 30, 2012, the Company has paid a total of $2.9 million of the total $5.8 million, for which the Company had previously accrued. In addition, in July 2012, the Company paid another $1.2 million with the balance of $1.7 million payable in December 2013.
 
Stockholder Litigation
 
The Company is a defendant in a class action lawsuit brought in United Stated District Court for the Eastern District of New York, by Company shareholders (the “Class Action”).  The other defendants are James Weber, our former CFO and Vice President for Operations, and the estate of ReiJane Huai.  Mr. Huai was the Company’s former Chairman, President and CEO.
 
The Class Action complaint alleges that the defendants defrauded shareholders by falsely certifying in the Company’s SEC filings that they had disclosed any fraud, whether or not material, that involved management or other employees who had a significant role in the registrant’s internal control over financial reporting.  The Class Action complaint alleges that the defendants were in fact aware of fraud.
 
The Company has filed a motion to dismiss the complaint.  That motion is now fully briefed.
 
Certain of the defendants may be entitled to indemnification by the Company under the laws of Delaware and/or our by-laws.
 
The Company cannot predict when the Class Action will be resolved or its outcome. While the Company has insurance policies that it believes covers the Company, at least in part, for the allegations of the Class Action, there can be no assurance that the amount of insurance will be adequate to cover the costs of its defense of the Class Action or any damages that might be awarded against the Company or any defendant(s) to whom we owe indemnification. The Company’s insurers may deny coverage under the policies. If the plaintiffs are awarded damages and the Company’s insurance is not adequate to cover the amounts, or its insurers deny coverage, the amounts to be paid by the Company could have a significant negative impact on our financial results, our cash flow and our cash reserves. As a result, the Company recorded an accrual of $0.4 million in the second quarter of 2012 for certain costs associated with the possible resolution of the Class Action.
 
Company shareholders filed actions in the Suffolk County Division of the Supreme Court of the State of New York, putatively derivatively on behalf of the Company, against the Company, each of the Company’s Directors, Mr. Weber, Wayne Lam, a former Vice president of the Company, the estate of Mr. Huai, and Jason Lin, a former employee of the Company (the “Derivative Action”). The consolidated amended Derivative Action complaint alleges that the defendants breached their duties to the Company by: (1) causing or allowing the dissemination of false and misleading information; (2) failing to maintain internal controls; (3) failing to manage the Company properly; (4) unjustly enriching themselves; (5) abusing their control of the Company; and (6) wasting Company assets.
 
 
23

 
The Company has filed a motion to dismiss the Derivative Action.
 
Certain of the defendants may be entitled to indemnification by the Company under the laws of Delaware and/or the Company’s by-laws.
 
The Company cannot predict when the Derivative Action will be resolved or its outcome. While the Company has insurance policies that it believes covers the Company for the allegations of the Derivative Action, there can be no assurance that the amount of insurance will be adequate to cover the costs of the Company’s defense of the Derivative Action or any damages that might be awarded against it or any defendant(s) to whom the Company owes indemnification. The Company’s insurers may deny coverage under the policies. If the plaintiffs are awarded damages and the Company’s insurance is not adequate to cover the amounts, or the Company’s insurers deny coverage, the amounts to be paid by the Company could have a significant negative impact on its financial results, cash flow and cash reserves.
 
The Company is subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. While the outcome of any such matters cannot be predicted with certainty, such matters are not expected to have a material adverse effect on the Company’s financial condition or operating results.
 
(10) Segment Reporting
 
The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. Revenues from the United States to customers in the following geographical areas for the three months ended June 30, 2012 and 2011, and the location of long-lived assets as of June 30, 2012 and December 31, 2011, are summarized as follows:
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
Revenues:
 
2012
   
2011
   
2012
   
2011
 
                         
North America
  $ 7,085,505     $ 8,468,250     $ 15,201,737     $ 16,810,779  
Asia Pacific
    4,833,526       5,662,096       10,744,801       10,987,277  
Europe, Middle East, Africa and Other
    4,547,170       5,497,662       9,887,735       10,789,214  
                                 
  Total Revenues
  $ 16,466,201     $ 19,628,008     $ 35,834,273     $ 38,587,270  
                                 
                                 
     
June 30,
     
December 31,
                 
Long-lived assets:
     2012       2011                  
                                 
North America
  $ 11,644,706     $ 11,271,525                  
Asia Pacific
    1,014,980       1,122,487                  
Europe, Middle East, Africa and Other
    385,376       326,435                  
                                 
  Total long-lived assets
  $ 13,045,062     $ 12,720,447                  
 
      For the three months ended June 30, 2012 and 2011, the Company did not have any customers that accounted for 10% or more of total revenues. As of June 30, 2012, the Company had one customer that accounted for 10% of the accounts receivable balance. As of December 31, 2011, the Company had one customer that accounted for 11% of the accounts receivable balance.
 
 
24

 
The Company recorded an expense of approximately $0.3 million during the three months ended June 30, 2012, and due to cash collections of previously reserved accounts receivable balances, a benefit of approximately $0.3 million during the six months ended June 30, 2012. The Company recorded an expense of approximately $0.2 million during the three months ended June 30, 2011, and due to cash collections of previously reserved accounts receivable balances, a benefit of approximately $0.7 million during the six months ended June 30, 2011. These amounts are included within revenues in each respective period in the accompanying condensed consolidated statements of operations.

(11) Restructuring Costs
 
In July 2011, the Company undertook certain restructuring activities that included a workforce reduction of approximately 25 global positions and the closing of a satellite facility (the “2011 Plan”). These actions were 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. 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 during the third quarter of 2011.
 
Accrued restructuring costs associated with the 2011 Plan are as follows:
 
   
Reconciliation of Aggregate Liability Recorded for
 
   
Restructuring Costs
 
                         
   
December 31,
               
June 30,
 
   
2011
   
Provisions
   
Payments
   
2012
 
                         
   Severance related costs
  $ 94,844     $ -     $ 94,844     $ -  
   Facility abandonment costs
  $ 25,200     $ -     $ 25,200     $ -  
                                 
Total Restructuring Costs
  $ 120,044     $ -     $ 120,044     $ -  
 
Both the severance related liabilities and facility abandonment liabilities are included within “accrued expenses” in the accompanying condensed consolidated balance sheets. The expenses to the 2011 Plan are included within “restructuring costs” in the accompanying condensed consolidated statements of operations. The accrued payments were completed as of June 30, 2012.
 
(12) Subsequent Events
 
In July 2012, the Company undertook additional restructuring activities that included a workforce reduction of approximately 7% of our existing global workforce (the “2012 Plan”). Actions under the 2012 Plan are expected to be substantially completed during the third quarter of 2012 and the Company’s termination and other associated costs are expected to be between $650,000 and $850,000.
 
 
25

 
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “plans,” “may,” “intends,” “will,” or similar terms.  Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report..
 
OVERVIEW
 
The most significant event of our second quarter was the settlement of the investigations commenced by the United States Attorney’s Office for the Eastern District of New York (“USAO”) and by the Securities and Exchange Commission (“SEC”) in October, 2010.  We agreed to pay a total of $5.8 million to settle the investigations.  $2.9 million was paid to the SEC in the second quarter of 2012.  $1.2 million was paid to the Department of Justice in July 2012, and the remaining $1.7 million will be paid to the Department of Justice in December, 2013.  We had previously accrued for these amounts in our condensed consolidated financial statements.
 
In addition to the monetary relief, we entered into a Deferred Prosecution Agreement with the USAO and we entered into a consent judgment with the SEC.
 
These settlements remove an element of uncertainty that was being exploited by our competitors and which negatively impacted our sales efforts.  While the fact that we were investigated may have some lingering effect on sales , we believe that the certainty brought by the settlement, combined with the fact that the settlement confirmed that any improper payments were confined to one customer and to three employees, should ultimately benefit us.
 
Our revenues for the second quarter of 2012 fell well short of what we had budgeted and during July 2012 we began to take steps to better align expected revenues and expenses.  These expense reductions include the elimination of the positions of 7% of our workforce in July, 2012, and a decision not to fill job vacancies created by attrition and select other open positions, among others.  While the Company’s termination and other associated costs are expected to be between $650,000 and $850,000, we expect the cost reductions to result in approximately $10 million in annualized savings.  Our goal is to be at a break-even run rate by the end of 2012, while not sacrificing the investment necessary to develop our next generation of products.
 
Revenues totaled $16.5 million, a decline of $3.2 million from the same period in 2011.  We attribute the softer than expected product revenue from all of our regions, particularly our EMEA region, to the global economic malaise, which resulted in many sales that we expected to close in the quarter being postponed or lost due to either customer budget freezes or to deeply discounted competitive pricing.

In Asia Pacific, total product revenue was down compared to the previous year, primarily due to disruptions with one of our larger OEM partners during the quarter.  The OEM partner was involved in a reorganization as it was absorbed into its parent company, which caused a lack of focus on the partner’s business with us.  While we will continue to monitor the situation carefully and to push for renewed focus, we cannot guarantee when or if the business with this OEM partner will return to its previous levels.  Although our non-OEM product revenue from Asia Pacific continued to grow, it still did not meet our expectations.

Non-OEMs contributed 96% of our product revenues in the second quarter of 2012 and OEMs contributed 4%.   No customer accounted for 10% or more of our revenues in the quarter.
 
 
26

 
The one bright spot in our revenues for the second quarter was support and services revenue.  Support and services revenue grew 8% on a year-over-year basis from $8.0 million in the second quarter of 2011 to $8.6 million in the second quarter of 2012.  The maintenance fee portion of our support and services revenue, which is more consistent than our professional services revenue, grew 6% to $7.7 million in the second quarter of 2012, from $7.3 million in the second quarter of 2011.  The continuing growth of our maintenance revenue shows that our customers believe that they get value from our products.
 
Our net loss for the second quarter of 2012 was $6.6 million, compared with a net loss of $5.9 million for the same period a year ago. Included in the operating results for the second quarter of 2012 was $0.9 million of costs associated with the ongoing class actions and with the finalizing of the government investigations. The $0.9 million was comprised of $0.4 million for certain costs associated with the possible resolution of the class action and $0.5 million in overall related legal fees. During the same period in 2011, the Company had recorded $1.2 million of costs associated with the government investigations and related class action, comprised of $0.5 million of legal fees and an accrual of $0.7 million for certain costs associated with the possible resolution of the then outstanding government investigations.
 
Operating expenses for the second quarter of 2012 decreased $2 million from the second quarter of 2011.  The decrease in our operating expenses was primarily attributable to declines in salary and personnel costs, including commissions and share-based compensation due to lower headcount and a decrease in investigation, litigation, and settlement related costs as compared with the same period in 2011. Our operating expenses for these periods were affected by accruals and costs related to the government.
 
Our cash flow for the six months of 2012 was down significantly from the six months of 2011, primarily due to the significant declines in our accrued expenses and decline in deferred revenues when compared with December 31, 2011, as opposed to increases in both accrued expenses and deferred revenues for prior year periods.  Additionally, our cash flows in 2012 reflect the $2.9 million payment we made to the SEC as we have previously discussed.
 
Deferred revenue at June 30, 2012 was $26.3 million a decrease of 3%, compared with the balance at December 31, 2011, and an increase of 2% when compared with the balance at June 30, 2011.
 
RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED JUNE 30, 2012 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2011.
 
Our primary sales focus is on selling turn-key solutions, whereby our software is integrated with industry standard hardware and sold as one complete integrated solution. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Product revenue consists of both integrated solutions and stand-alone software revenues. Support and services revenues consists of both maintenance revenues and professional services revenues.
 
Total revenues for the three months ended June 30, 2012 decreased 16% to $16.5 million, compared with $19.6 million for the three months ended June 30, 2011. Our cost of revenues decreased 14% to $4.9 million for the three months ended June 30, 2012, compared with $5.7 million for the three months ended June 30, 2011. Included in our cost of revenues was less than $0.1 million of share-based compensation expense for each of the three months ended June 30, 2012 and 2011. Our operating expenses decreased 10% from $19.9 million for the three months ended June 30, 2011 to $17.9 million for the three months ended June 30, 2012. Included in the operating results for the three months ended June 30, 2012 and June 30, 2011 was $0.9 million and $1.2 million, respectively, of investigation, litigation and settlement related costs. In addition, included in our operating expenses for the three months ended June 30, 2012 and 2011 was $1.1 million and $1.2 million, respectively, of share-based compensation expense. Net loss for the three months ended June 30, 2012 was $6.6 million, compared with a net loss of $5.9 million for the three months ended June 30, 2011. Included in our net loss for the three months ended June 30, 2012 was an income tax provision of $0.2 million, compared with an income tax provision of $0.1 million for the three months ended June 30, 2011. The income tax provision of $0.2 million was primarily attributable to the impact of our estimated 2012 full year effective tax rate on our pre-tax losses for the three months ended June 30, 2012. The income tax provision of $0.1 million was primarily attributable to the impact of our estimated 2011 full year effective tax rate on our pre-tax losses for the three months ended June 30, 2011. No tax benefits were recognized during either period for our domestic losses due to the full valuation allowance over our domestic deferred tax assets.
 
 
27

 
Overall, the decrease in total revenues was primarily due to a decrease in product revenues for the three months ended June 30, 2012, compared with the same period in 2011. In total, our product revenues decreased 33%. Product revenues from our OEM partners decreased 82%, while product revenues from our non-OEM partners decreased 23% for the three months ended June 30, 2012, compared with the same period in 2011. The decline in OEM product revenues was primarily the result of disruption with one of our largest OEM partners in China which was part of a significant corporate reorganization during the second quarter of 2012. In addition, as anticipated, our OEM product revenues from historical OEM partners continued to decline, as a result of merger and acquisition activity that began in 2009, and more recently, end-of-life programs implemented by some of those OEM partners, which we have previously reported. We do not anticipate that any of our historical OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the overall decrease in our non-OEM product revenues was primarily attributable to the weak macroeconomic environment around the globe. In addition, the recently concluded government investigation has also contributed to the challenges and disruptions we faced in our business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding the overall product revenue growth within our non-OEM business.
 
Overall, our total operating expenses decreased $2.0 million, or 10%, to $17.9 million for the three months ended June 30, 2012, as compared with $19.9 million for the same period in 2011. The decrease in total operating expenses was primarily attributable to a decrease in salary and personnel costs including share-based compensation due to lower headcount and to a decrease in investigation, litigation, and settlement related costs as compared with the same period in 2011. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 481 employees as of June 30, 2012, compared with 527 employees as of June 30, 2011. In July 2012, we began to take cost-savings initiatives and announced a plan whereby we reduced our worldwide headcount by approximately 7%.
 
Revenues
 
   
Three months ended June 30,
 
   
2012
   
2011
 
Revenues:
           
   Product revenue
  $ 7,835,568     $ 11,609,760  
   Support and services revenue
    8,630,633       8,018,248  
                 
Total Revenues
  $ 16,466,201     $ 19,628,008  
                 
Year-over-year percentage growth
               
   Product revenue
    -33%       -5%  
   Support and services revenue
    8%       -1%  
                 
Total percentage growth
    -16%       -3%  
 
Product revenue
 
Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively “non-OEMs”). These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing stand-alone software applications sold, integrated solutions sold and/or permanent key codes are delivered to the customer.
 
 
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Product revenue decreased 33% from $11.6 million for the three months ended June 30, 2011 to $7.8 million for the three months ended June 30, 2012. Product revenue represented 48% and 59% of our total revenues for the three months ended June 30, 2012 and 2011, respectively. Product revenues from our OEM partners decreased 82%, while product revenues from our non-OEM partners decreased 23% for the three months ended June 30, 2012, compared with the same period in 2011. The decline in OEM product revenues was primarily the result of disruption with one of our largest OEM partners in China which was part of a significant corporate reorganization during the second quarter of 2012. In addition, as anticipated, our OEM product revenues from historical OEM partners continued to decline, as a result of merger and acquisition activity that began in 2009, and more recently, end-of-life programs implemented by some of these OEM partners, which we have previously reported. We do not anticipate that any of our historical OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the overall decrease in our non-OEM product revenues was primarily attributable to the weak macroeconomic environment around the globe. In addition, the recently concluded government investigation also contributed to the challenges and disruptions we faced in our business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding the overall product revenue growth within our non-OEM business. Product revenue from our non-OEM partners represented 96% and 84% of our total product revenue for the three months ended June 30, 2012 and 2011, respectively. Product revenue from our OEM partners represented 4% and 16% of our total product revenue for the three months ended June 30, 2012 and 2011, 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. We anticipate that our investments in the FalconStor-branded business will result in our non-OEM generated product revenue growing at a greater rate in future years when compared to our OEM generated product revenue.

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. Support and services revenue increased 8% from $8.0 million for the three months ended June 30, 2011 to $8.6 million for the three months ended June 30, 2012. The increase in support and services revenue was attributable to increases in both (i) maintenance and technical support services and (ii) professional services.

Maintenance and technical support services increased from $7.3 million for the three months ended June 30, 2011 to $7.7 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.
 
Professional services revenues increased from $0.7 million for the three months ended June 30, 2011 to $0.9 million for the same period in 2012. The professional services revenue varies from period to period based upon (i) the number of integrated solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that were 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 integrated solutions.
 
 
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Cost of Revenues
 
   
Three months ended June 30,
 
   
2012
   
2011
 
Cost of revenues:
           
   Product
  $ 1,787,186     $ 2,266,040  
   Support and service
    3,091,055       3,418,589  
Total cost of revenues
  $ 4,878,241     $ 5,684,629  
                 
Total Gross Profit
  $ 11,587,960     $ 13,943,379  
                 
Gross Margin:
               
   Product
    77%       80%  
   Support and service
    64%       57%  
Total gross margin
    70%       71%  
 
Cost of revenues, gross profit and gross margin
 
Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of purchased and capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the three months ended June 30, 2012 decreased $0.5 million, or 21%, to $1.8 million, compared with $2.3 million for the same period in 2011. The decrease in cost of product revenue was primarily attributable to decreased hardware costs due to the fewer appliance units being sold. Hardware costs will vary from period to period based upon the mix of deals whereby our software is integrated on industry standard hardware creating a turn-key solution or integrated solution. Our cost of support and service revenues for the three months ended June 30, 2012 decreased $0.3 million, or 10%, to $3.1 million, compared with $3.4 million for the same period in 2011. The decrease in cost of support and service revenue is primarily related to personnel costs related to the mix of our headcount within support and services as compared with the same period in 2011 as well as to share-based compensation expense.
 
Total gross profit decreased $2.4 million, or 17%, to $11.6 million for the three months ended June 30, 2012 from $13.9 million for the same period in 2011. Total gross margin decreased slightly to 70% for the three months ended June 30, 2012, from 71% for the same period in 2011. 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 mix of sales.
 
Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for both the three months ended June 30, 2012 and June 30, 2011. Share-based compensation expense included in the cost of support and service revenue decreased to less than $0.1 million for the three months ended June 30, 2012 from $0.1 million for the three months ended June 30, 2011. Share-based compensation expense related to cost of support and service revenue was less than 1% for the three months ended June 30, 2012 and 2011.
 
 
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Operating Expenses
 
Research and Development Costs
 
Research and development costs consist primarily of personnel costs for product development, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.5 million, or 9%, to $4.8 million for the three months ended June 30, 2012 from $5.2 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, including share-based compensation expense, as a result of lower research and development headcount. These declines were partially offset by a decrease in the total capitalized costs associated with software development of approximately $0.6 million. 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 $0.1 million from $0.3 million for the three months ended June 30, 2012 and June 30, 2011, respectively. Share-based compensation expense included in research and development costs was equal to 1% and 2% of total revenue for the three months ended June 30, 2012 and 2011, 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 $1.3 million, or 12%, to $9.3 million for the three months ended June 30, 2012 from $10.5 million for the same period in 2011. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the decline in revenue as compared to 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.  Share-based compensation expense included in selling and marketing decreased to $0.4 million from $0.5 million for the three months ended June 30, 2012 and 2011, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 2% for the three months ended June 30, 2012 and 2011.
 
General and Administrative
 
General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers insurance, legal and professional fees, and other general corporate overhead costs. General and administrative expenses increased less than $0.1 million, or 2%, to $3.0 million for the three months ended June 30, 2012 compared with the same period in 2011. The overall increase within general and administrative expenses related to increases in personnel related costs including share-based compensation partially offset by a decrease in bad debt expense due to improved collections of receivables. Share-based compensation expense included in general and administrative expenses increased to $0.6 million from $0.4 million for the three months ended June 30, 2012 and 2011, respectively. Share-based compensation expense included in general and administrative expenses was equal to 4% and 2% of total revenue for the three months ended June 30, 2012 and 2011, respectively.
 
Investigation, Litigation and Settlement Related Costs
 
During the three months ended June 30, 2012, our total investigation, litigation, and settlement related costs of $0.9 million were comprised of (i) $0.5 million of legal fees, and (ii) a $0.4 million accrual associated with the possible resolution of the class action lawsuit. During the three months ended June 30, 2011, our total investigation, litigation, and settlement related costs of $1.2 million were comprised of (i) $0.5 million in legal fees, and (ii) a $0.7 million accrual for certain costs associated with the possible resolution of the investigations. See Part II, Item 1 – Legal Proceedings of this quarterly report on Form 10-Q, for a more detailed description of the investigations.
 
We expect that our operating expenses will continue to be adversely impacted during 2012 due to professional and service provider fees and other costs, resulting from the ongoing stockholder lawsuits.
 
 
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Interest and Other (Loss) Income
 
We invest our cash primarily in money market funds, government securities, and corporate bonds. As of June 30, 2012, our cash, cash equivalents, and marketable securities totaled $33.6 million, compared with $38.1 million as of June 30, 2011. Interest and other (loss) income decreased $0.3 million to ($0.1) million for the three months ended June 30, 2012 compared with $0.2 million for the same period in 2011. The decrease in interest and other (loss) income was primarily due to a foreign currency loss of ($0.1) million incurred during the three months ended June 30, 2012 as compared with a foreign currency gain of $0.1 million for the same period in 2011.
 
Income Taxes
 
Our provision for income taxes consists of state, local, and foreign taxes. For the three months ended June 30, 2012, we recorded an income tax provision of $0.2 million on our pre-tax loss of $6.4 million, consisting of primarily state and local and foreign taxes. For the three months ended June 30, 2011, we recorded an income tax provision of $0.1 million. 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 three months ended June 30, 2012, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our expected net domestic deferred tax assets for the full year 2012 estimated annual effective tax rate. As of June 30, 2012, the valuation allowance totaled approximately $35.4 million.
 
RESULTS OF OPERATIONS – FOR THE SIX MONTHS ENDED JUNE 30, 2012 COMPARED WITH THE SIX MONTHS ENDED JUNE 30, 2011.
 
Total revenues for the six months ended June 30, 2012 decreased 7% to $35.8 million, compared with $38.6 million for the six months ended June 30, 2011. Our cost of revenues decreased 4% to $10.1 million for the six months ended June 30, 2012, compared with $10.5 million for the six months ended June 30, 2011. Included in our cost of revenues for the six months ended June 30, 2012 and 2011 was less than $0.1 million and $0.3 million, respectively, of share-based compensation expense. Our operating expenses decreased 14% from $39.7 million for the six months ended June 30, 2011 to $34.2 million for the six months ended June 30, 2011.  Included in the operating results for the six months ended June 30, 2012 was a net reduction of $0.4 million of investigation, litigation and settlement costs. The net reduction of $0.4 million was comprised of a $1.7 million reduction in the accrual for certain costs associated with the resolution of the investigations, less $0.9 million in legal fees, and a $0.4 million accrual related to the possible resolution of the class action lawsuits. Included in the operating results for the six months ended June 30, 2011 was $3.8 million of investigation, litigation, and settlement related costs. The $3.8 million was comprised of a $2.2 million accrual for certain costs associated with the resolution of the investigations and $1.6 million in legal fees. In addition, included in our operating expenses for the six months ended June 30, 2012 and 2011 was $2.5 million and $2.4 million, respectively, of share-based compensation expense. Net loss for the six months ended June 30, 2012 was $9.1 million, compared with a net loss of $11.9 million for the six months ended June 30, 2011. Included in our net loss for the six months ended June 30, 2012 was an income tax provision of $0.4 million compared with an income tax provision of $0.7 million for the six months ended June 30, 2011. The income tax provision of $0.4 million and $0.7 million were primarily attributable to the impact of our estimated full year effective tax rate on our pre-tax losses for the six months ended June 30, 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.
 
Our overall 7% decrease in total revenues was primarily due to a 19% decrease in product revenue for the six months ended June 30, 2012, compared with the same period in 2011. This was partially offset by a 10% increase in support and services revenue for the six months ended June 30, 2012, compared with the same period in 2011. Product revenues from OEM partners decreased 67%, while product revenues from non-OEM partners decreased 11% for the six months ended June 30, 2012, compared with the same period in 2011. The decline in our OEM product revenues was primarily the result of disruptions with one of our largest OEM partners in China which was part of a significant corporate reorganization during the second quarter of 2012, as compared with the same period in 2011. In addition, as anticipated, our OEM product revenues from historical OEM partners continued to decline as a result of merger and acquisition activity that began in 2009, and more recently, end-of-life programs implemented by some of those OEM partners, which we have previously reported. We do not anticipate that any of our historical OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During the first half of 2012, we continued our focus and emphasis on the FalconStor-branded business. However, the overall decrease in our non-OEM product revenues was primarily attributable to the weak macroeconomic environment around the globe. In addition, the recently concluded government investigation also contributed to the challenges and disruptions we faced in our business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding the overall product revenue growth within our non-OEM business.
 
Overall, our total operating expenses have decreased, primarily due to a decline in overall salary and personnel costs as the result of lower headcount and a $4.2 million decrease in costs associated with the government investigations, litigation, and settlement related costs incurred during the six months ended June 30, 2012 as compared with the same period in 2011. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 481 employees as of June 30, 2012, compared with 527 employees as of June 30, 2011.In July 2012, we began to take cost-savings initiatives and announced a plan whereby we reduced our worldwide headcount by approximately 7%.
 
 
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Revenues