sec document

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Fy3SJPEhOQlUEnpGUifwvA9TUFDv3SFkXAw/2SXp7OxSlw26ADy9MJ2D5U1me7uR JgQAwMr8O05grMjh2GJ+1w== 0000921895-05-001851.txt : 20051108 0000921895-05-001851.hdr.sgml : 20051108 20051108171610 ACCESSION NUMBER: 0000921895-05-001851 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20050930 FILED AS OF DATE: 20051108 DATE AS OF CHANGE: 20051108 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FALCONSTOR SOFTWARE INC CENTRAL INDEX KEY: 0000922521 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 770216135 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-23970 FILM NUMBER: 051187069 BUSINESS ADDRESS: STREET 1: 125 BAYLIS ROAD CITY: MELVILLE STATE: NY ZIP: 11747 BUSINESS PHONE: 631 777 5188 MAIL ADDRESS: STREET 1: 125 BAYLIS ROAD CITY: MELVILLE STATE: NY ZIP: 11747 FORMER COMPANY: FORMER CONFORMED NAME: NETWORK PERIPHERALS INC DATE OF NAME CHANGE: 19940502 10-Q 1 form10q04637_09302005.htm sec document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

/X/ QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended September 30, 2005
---------------------------------------------

/_/ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to to
---------------- ---------------------

COMMISSION FILE NUMBER 0-23970

FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 77-0216135

(State of Incorporation) (I.R.S. Employer Identification No.)

2 HUNTINGTON QUADRANGLE

MELVILLE, NEW YORK 11747

(Address of principal executive offices) (Zip code)

Registrant's telephone number,including area code: 631-777-5188

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 is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes v No

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes No v

The number of shares of Common Stock issued and outstanding as of October
26, 2005 was 48,219,098 and 47,719,498, which includes redeemable common shares.

-1-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

Page

PART I. Financial Information 3

Item 1. Consolidated Financial Statements 3

Consolidated Balance Sheets at September 30, 2005
(unaudited) and December 31, 2004 3

Unaudited Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2005 and 2004 4

Unaudited Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2005 and 2004 5

Notes to the Unaudited Condensed Consolidated
Financial Statements 6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13

Item 3. Qualitative and Quantitative Disclosures about Market Risk 28

Item 4. Controls and Procedures 28

PART II. Other Information 29

Item 1. Legal Proceedings 29

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29

Item 5. Other Information 29

Item 6. Exhibits 29

-2-

PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, 2005 December 31, 2004
------------------ -----------------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents ............................................................... $ 16,388,518 $ 15,484,573
Marketable securities ................................................................... 18,786,873 18,488,616
Accounts receivable, net of allowances of $3,902,557 and
$2,551,616, respectively .............................................................. 11,436,107 10,269,822
Prepaid expenses and other current assets ............................................... 688,810 629,036
------------ ------------

Total current assets ........................................................... 47,300,308 44,872,047

Property and equipment, net of accumulated depreciation of $6,478,466 and
$4,698,025, respectively ................................................................ 5,208,574 4,662,269
Goodwill ................................................................................... 3,512,796 3,512,796
Other intangible assets, net ............................................................... 232,504 307,620
Other assets ............................................................................... 2,093,413 2,719,460
------------ ------------

Total assets ................................................................... $ 58,347,595 $ 56,074,192
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable ........................................................................ $ 1,317,709 $ 821,433
Accrued expenses ........................................................................ 3,218,653 3,501,034
Deferred revenue ........................................................................ 5,731,717 4,097,279
------------ ------------
Total current liabilities .................................................... 10,268,079 8,419,746

Deferred revenue ........................................................................... 1,854,303 1,290,496
------------ ------------

Total liabilities ............................................................ 12,122,382 9,710,242

Commitments and contingencies

Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized .............. -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
48,219,098 and 47,768,755 shares issued, respectively and 47,719,498
and 47,491,655 shares outstanding, respectively ...................................... 48,219 47,769
Additional paid-in capital .............................................................. 86,349,501 85,400,740
Accumulated deficit ..................................................................... (36,315,281) (36,952,436)
Common stock held in treasury, at cost (499,600 and 277,100 shares,
respectively) ........................................................................ (3,258,406) (1,714,775)
Accumulated other comprehensive loss .................................................... (598,820) (417,348)
------------ ------------

Total stockholders' equity ..................................................... 46,225,213 46,363,950
------------ ------------
Total liabilities and stockholders' equity ..................................... $ 58,347,595 $ 56,074,192
============ ============

See accompanying notes to unaudited consolidated financial statements.

-3-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
Revenues:
Software license revenue ......................................... $ 7,007,075 $ 5,430,010 $ 19,940,026 $ 13,893,339
Maintenance revenue .............................................. 1,972,037 1,332,179 5,293,478 3,197,234
Software services and other revenue .............................. 1,077,553 707,810 2,710,784 2,121,361
------------ ------------ ------------ ------------
10,056,665 7,469,999 27,944,288 19,211,934
------------ ------------ ------------ ------------

Operating expenses:
Amortization of purchased and capitalized software............. 189,472 347,027 605,472 1,171,325
Cost of maintenance, software services and other revenue....... 1,666,459 1,112,662 4,462,542 3,080,622
Software development costs .................................... 3,007,337 2,271,437 8,438,473 6,612,280
Selling and marketing ......................................... 3,814,540 3,532,531 11,298,883 10,247,147
General and administrative .................................... 1,103,778 1,358,833 3,121,089 3,566,885
Litigation settlement ......................................... -- 1,300,000 -- 1,300,000
------------ ------------ ------------ ------------
9,781,586 9,922,490 27,926,459 25,978,259
------------ ------------ ------------ ------------
Operating income (loss) ............................... 275,079 (2,452,491) 17,829 (6,766,325)
------------ ------------ ------------ ------------

Interest and other income ........................................ 245,218 162,146 668,713 553,923
------------ ------------ ------------ ------------

Income (loss) before income taxes ....................... 520,297 (2,290,345) 686,542 (6,212,402)

Provision for income taxes ....................................... 37,418 2,738 49,387 15,279
------------ ------------ ------------ ------------

Net income (loss) ....................................... $ 482,879 $ (2,293,083) $ 637,155 $ (6,227,681)
------------ ------------ ------------ ------------

Basic net income (loss) per share ................................ $ 0.01 $ (0.05) $ 0.01 $ (0.13)
============ ============ ============ ============

Diluted net income (loss) per share .............................. $ 0.01 $ (0.05) $ 0.01 $ (0.13)
============ ============ ============ ============

Weighted average basic shares
outstanding ................................................... 47,720,496 47,054,294 47,615,182 46,852,779
============ ============ ============ ============

Weighted average diluted shares
outstanding ................................................... 50,531,012 47,054,294 50,715,162 46,852,779
============ ============ ============ ============

See accompanying notes to unaudited consolidated financial statements.

-4-

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Nine Months Ended
September 30,
2005 2004
------------ ------------
Cash flows from operating activities:
Net income (loss) ........................................................ $ 637,155 $ (6,227,681)
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation and amortization ...................................... 2,560,186 2,813,772
Non-cash professional services ..................................... (89,765) 23,738
Equity-based compensation expense .................................. -- 7,969
Provision for returns and doubtful accounts ....................... 2,825,430 2,268,067
Changes in operating assets and liabilities:
Accounts receivable, net ........................................... (3,991,715) (3,875,073)
Prepaid expenses and other current assets .......................... (59,774) 254,412
Other assets ....................................................... 128,575 (18,543)
Accounts payable ................................................... 496,276 515,387
Accrued expenses ................................................... (282,381) 490,981
Deferred revenue ................................................... 2,198,245 1,616,871
------------ ------------
Net cash provided by (used in) operating activities ............. 4,422,232 (2,130,100)
------------ ------------
Cash flows from investing activities:
Sale of marketable securities ............................................ 44,853,759 30,053,292
Purchase of marketable securities ........................................ (45,164,822) (20,963,131)
Purchase of property and equipment ....................................... (2,326,747) (1,827,752)
Purchase of software licenses ............................................ (108,000) (50,000)
Purchase of intangible assets ............................................ (99,156) (101,875)
Security deposits ........................................................ -- (4,501)
Net cash paid for acquisition of IP Metrics .............................. -- (146,155)
------------ ------------

Net cash (used in) provided by investing activities ................... (2,844,966) 6,959,878
------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options .................................. 1,038,976 942,771
Payments to acquire treasury stock ....................................... (1,543,631) (279,645)
------------ ------------

Net cash (used in) provided by financing activities ................... (504,655) 663,126
------------ ------------

Effect of exchange rate changes on cash and cash equivalents ................ (168,666) (69,361)
------------ ------------

Net increase in cash and cash equivalents ................................... 903,945 5,423,543

Cash and cash equivalents, beginning of period .............................. 15,484,573 8,486,144
------------ ------------

Cash and cash equivalents, end of period .................................... $ 16,388,518 $ 13,909,687
============ ============

Cash paid for income taxes .................................................. $ 6,320 $ 321
============ ============

The Company did not pay any interest expense for the nine months ended September 30, 2005 and 2004.

See accompanying notes to unaudited condensed consolidated financial statements.

-5-

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 network storage software solutions and provides
the related maintenance, implementation and engineering services.

(B) PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

The unaudited interim consolidated financial statements of the Company as
of September 30, 2005 and for the three and nine months ended September 30, 2005
and 2004, included herein 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 September 30, 2005, and the results of its operations for the
three and nine months ended September 30, 2005 and 2004.

(D) CASH EQUIVALENTS AND MARKETABLE SECURITIES

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$11.3 million and $10.9 million at September 30, 2005 and December 31, 2004,
respectively. Marketable securities at September 30, 2005 and December 31, 2004
amounted to $18.8 million and $18.5 million, respectively, and consisted of
corporate bonds and government securities, which are classified as available for
sale, and accordingly, unrealized gains and losses on marketable securities are
reflected as a component of accumulated other comprehensive loss in
stockholders' equity.

(E) REVENUE RECOGNITION

The Company recognizes revenue from software licenses in accordance
with Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION.
Accordingly, revenue for software licenses is recognized when persuasive
evidence of an arrangement exists, the fee is fixed and determinable and the
software is delivered and collection of the resulting receivable is deemed
probable. Software delivered to a customer on a trial basis is not recognized as
revenue until a permanent key is delivered to the customer. Reseller customers
typically send the Company a purchase order only when they have an end user
identified. When a customer licenses software together with the purchase of
maintenance, the Company allocates a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate. Software
maintenance fees are deferred and recognized as revenue ratably over the term of
the contract. The long-term portion of deferred revenue relates to maintenance
contracts with terms in excess of one year. The cost of providing technical
support is included in cost of revenues. The Company provides an allowance for
software product returns as a reduction of revenue.

Revenues associated with software implementation and software
engineering services are recognized as the services are completed. Costs of
providing these services are included in cost of revenues.

-6-

The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.

For the quarters ended September 30, 2005 and 2004, the Company had a
limited number of transactions in which it purchased hardware and bundled this
hardware with the Company's software and sold the bundled solution to its
customer. Since the software is not essential for the functionality of the
equipment included in the Company's bundled solutions, and both the hardware and
software have stand alone value to the customer, a portion of the contractual
fees is recognized as revenue when the software or hardware is delivered based
on the relative fair value of the delivered element(s).

For the three months ended September 30, 2005, the Company had two
customers that together accounted for 33% of revenues and one customer that
accounted for 14% of the accounts receivable balance at September 30, 2005.

(F) 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). Depreciation expense was $615,861 and $511,192 for the three months
ended September 30, 2005 and 2004, respectively, and $1,780,441 and $1,479,227
for the nine months ended September 30, 2005 and 2004, 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.

(G) GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Consistent with Statement of Financial Accounting
Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has
not amortized goodwill related to its acquisitions, but instead tested the
balance for impairment. The Company's annual impairment assessment is performed
as of December 31st of each year, and at other times if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $46,162 and $57,308 for
the three months ended September 30, 2005 and 2004, respectively, and $174,273
and $163,220 for the nine months ended September 30, 2005 and 2004,
respectively. The gross carrying amount and accumulated amortization of other
intangible assets as of September 30, 2005 and December 31, 2004 are as follows:

September 30, December 31,
2005 2004
Customer relationships and purchased technology: --------- ---------

Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (216,850) (180,708)
--------- ---------
Net carrying amount $ -- $ 36,142
========= =========

Patents:

Gross carrying amount $ 622,780 $ 523,623
Accumulated amortization (390,276) (252,145)
--------- ---------
Net carrying amount $ 232,504 $ 271,478
========= =========

(H) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY

Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the

-7-

Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs. Software development costs were fully
amortized as of the first quarter of 2004. Amortization of software development
costs is recorded at the greater of straight line over three years or the ratio
of current revenue of the related products to total current and anticipated
future revenue of these products.

Purchased software technology of $548,333 and $1,045,806, net of
accumulated amortization of $4,470,667 and $3,865,194, is included in other
assets in the balance sheets as of September 30, 2005 and December 31, 2004,
respectively. Amortization expense was $189,472 and $347,027 for the three
months ended September 30, 2005 and 2004, respectively, and $605,472 and
$1,163,444 for the nine months ended September 30, 2005 and 2004, respectively.
Amortization of purchased software technology is recorded at the greater of the
straight line basis over the products estimated remaining life or the ratio of
current period revenue of the related products to total current and anticipated
future revenue of these products.

(I) INCOME TAXES

Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.

(J) 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.

(K) ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board ("APB") Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations including Financial
Accounting Standards Board ("FASB") Interpretation No. 44, ACCOUNTING FOR
CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB
OPINION NO. 25 to account for its fixed-plan stock options. Under this method,
compensation expense is recorded only if on the date of grant the current market
price of the underlying stock exceeded the exercise price. SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION, established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based
employee compensation plans. As allowed by SFAS No. 123, the Company has elected
to continue to apply the intrinsic-value-based method of accounting described
above, and has adopted only the disclosure requirements of SFAS No. 123.

Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:

Three Months Ended Nine Months Ended
September 30, September 30,
2005 2004 2005 2004
---- ---- ---- ----

Net Income (loss) as reported $ 482,879 $ (2,293,083) $ 637,155 $ (6,227,681)

Add stock-based employee compensation expense
included in reported net income, net of tax -- -- -- 7,969

-8-

Deduct total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of tax (2,508,463) (2,451,647) (7,321,788) (7,538,144)
------------ ------------ ------------ ------------
Net loss - pro forma $ (2,025,584) $ (4,744,730) $ (6,684,633) $(13,757,856)
============ ============ ============ ============

Basic and diluted net income (loss) per common
share-as reported $ .01 $ (.05) $ .01 $ (.13)

Basic and diluted net loss per common share-pro
forma $ (.04) $ (.10) $ (.14) $ (.29)

Due to the pro-forma net loss in all periods, diluted net loss per common
share is equal to basic net loss per common share on a pro-forma basis.

The per share weighted average fair value of stock options granted was
$5.95 for the three months ended September 30, 2005. There were no stock options
granted for the three months ended September 30, 2004. The per share weighted
average fair value of stock options granted was $6.94 and $5.38 for the nine
months ended September 30, 2005 and 2004, respectively, on the date of grant
using the Black-Scholes option pricing method with the following weighted
average assumptions:

2005--expected dividend yield of 0%, risk free interest rate of 3.5%,
expected stock volatility ranging from 151% to 166% and an expected option life
of five years for options granted to employees of the Company;

2004-- expected dividend yield of 0%, risk free interest rate of 3.0%,
expected stock volatility ranging from 116% to 160% and an expected option life
of five years for options granted to employees of the Company.

(L) FINANCIAL INSTRUMENTS

As of September 30, 2005 and December 31, 2004, the fair value of the
Company's financial instruments including cash and cash equivalents, accounts
receivable, accounts payable and accrued expenses, approximates book value due
to the short maturity of these instruments.

(M) FOREIGN CURRENCY

Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the unaudited consolidated
statements of operations.

(N) EARNINGS PER SHARE (EPS)

Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the three and nine months ended September 30,
2004, all common stock equivalents were excluded from diluted net loss per share
for these periods. As of September 30, 2005, potentially dilutive common stock
equivalents included 10,195,261 stock options outstanding and 750,000 warrants
outstanding (such warrants become exercisable only if certain performance
targets are met by the grantee).

The following represents a reconciliation of the numerators and
denominators of the basic and diluted earnings per share ("EPS") computation:

-9-

Three Months Ended September 30, 2005 Three Months Ended September 30, 2004
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------

Basic EPS $ 482,879 47,720,496 $ 0.01 $(2,293,083) 47,054,294 $ (0.05)
======== ========
Effect of dilutive securities: Stock
Options 2,810,516
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $ 482,879 50,531,012 $ 0.01 $(2,293,083) 47,054,294 $ (0.05)
=========== ========== ======== =========== ========== ========

Nine Months Ended September 30, 2005 Nine Months Ended September 30, 2004
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------

Basic EPS $ 637,155 47,615,182 $ 0.01 $(6,227,681) 46,852,779 $ (0.13)
======== ========
Effect of dilutive securities:Stock
Options 3,099,980
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $ 637,155 50,715,162 $ 0.01 $(6,227,681) 46,852,779 $ (0.13)
=========== ========== ======== =========== ========== ========

(O) COMPREHENSIVE INCOME (LOSS)

The Company's comprehensive income (loss) is as follows:

Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
---- ---- ---- ----
Net income (loss) $ 482,879 $(2,293,083) $ 637,155 $(6,227,681)
----------- ----------- ----------- -----------
Other comprehensive income (loss): Foreign currency
translation adjustments (136,697) (69,739) (168,666) (69,361)

Unrealized gains (loss) on investments (25,929) 29,354 (12,806) (114,380)
----------- ----------- ----------- -----------
Other comprehensive loss (162,626) (40,385) (181,472) (183,741)
----------- ----------- ----------- -----------
Comprehensive income (loss) $ 320,253 $(2,333,468) $ 455,683 $(6,411,422)
=========== =========== =========== ===========

(P) USE OF ESTIMATES

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

(Q) NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123 (R), SHARE BASED PAYMENT
("SFAS 123(R)"). This statement replaces SFAS No.123, ACCOUNTING FOR STOCK BASED
COMPENSATION and supersedes APB No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES. SFAS 123 (R) requires all stock based compensation to be recognized
as an expense in the financial statements and that such cost be measured
according to the grant date fair value of stock options or other equity
instruments. SFAS 123 (R) will become effective for the Company on January 1,
2006. The Company is currently evaluating the impact that the adoption of this
statement will have on the Company's consolidated financial statements, although
the Company expects that there will be a negative impact on its results of
operations.

-10-

(2) 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 and nine
months ended September 30, 2005 and September 30, 2004 and the location of
long-lived assets as of September 30, 2005 and December 31, 2004 are summarized
as follows:

Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
---- ---- ---- ----
United States $ 6,963,134 $ 4,797,735 $19,055,023 $11,300,465
Asia 1,357,702 1,854,925 4,700,680 4,387,127
Oher international 1,735,829 817,339 4,188,585 3,524,342
----------- ----------- ----------- -----------

Total revenues $10,056,665 $ 7,469,999 $27,944,288 $19,211,934
=========== =========== =========== ===========

September 30, December 31,
2005 2004
------------ -------------
Long-lived assets (includes all non-current assets):

United States $ 9,665,033 $ 9,929,214
Asia 1,139,479 950,387
Other international 242,775 322,544
------------ -----------

Total long-lived assets $ 11,047,287 $11,202,145
============ ===========

(3) STOCK REPURCHASE PROGRAM

On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the three and nine months ended
September 30, 2005, the Company purchased 75,000 and 222,500 shares of its
common stock in open market purchases for a total cost of $476,512 and
$1,543,631, respectively. As of September 30, 2005, the Company had repurchased
a total of 499,600 shares for $3,258,406.

(4) COMMITMENTS AND CONTINGENCIES

The Company's only material contractual obligations relate to its operating
leases. The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to offices in foreign countries. The expiration dates for these leases
ranges from 2005 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of September 30, 2005:

2005............................. $ 458,051
2006............................. 1,782,818
2007............................. 1,506,326
2008............................. 1,222,281
2009............................. 1,255,913
Thereafter....................... 3,000,385
-----------
$ 9,225,774
===========

-11-

During the third quarter of 2004, the Company resolved claims relating to
alleged patent infringement brought by Dot Hill Systems Corporation ("Dot Hill")
and by Crossroad Systems (Texas), Inc. ("Crossroads") against the Company in the
United States District Court for the Western District of Texas. Pursuant to the
terms of the Settlement Agreement between the Company and Crossroads, the
Company, without admission of infringement, made a one-time payment of $1.3
million and granted to Crossroads licenses to certain Company technology in
exchange for a worldwide, perpetual license to the technology underlying the
Crossroads patents at issue in the litigation. All claims against the Company by
both Dot Hill and Crossroads have now been dismissed.

We are 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, we believe that such
matters will not have a material adverse effect on our financial condition or
operating results.

-12-

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

Our revenues for the third quarter of 2005 increased 35% compared with the
same period a year ago and 6% from the previous quarter. This continued growth
on both a quarterly sequential basis and year over year indicates that we are
increasing our market presence and that our resellers, OEM customers and end
users value our products.

We recorded a profit for the second consecutive quarter. Net income for the
quarter was $0.5 million, or $0.01 per share, compared with a net loss of $2.3
million, or $0.05 per share, for the same period a year ago. Operating expenses
in the third quarter of 2004 included a charge of $1.3 million related to the
settlement of a patent litigation. We are pleased that we have, for the first
time in our history, recorded consecutive profitable quarters. We have now
recorded profits in three of our last four quarters and we were profitable for
the nine months ended September 30, 2005.

Revenues from our OEM partners increased as compared with the second
quarter. We expected this ramp up in our OEM revenues and expect that our OEM
revenues will continue to grow. This future growth is anticipated to come from,
in part, an additional Tier-1 OEM with whom we signed an agreement after the
close of the third quarter. The agreement enables the OEM to enter the
disk-based backup market with an integrated VirtualTape solution powered by our
VirtualTape Library software. Due to the release date of the OEM product, and
the revenue reporting terms of the agreement, we do not expect to see any
revenue impact from this new OEM relationship until 2006.

Revenues from our resellers were lower in the third quarter than in the
second quarter and fell below our expectations.

As we expected, revenues from our VirtualTape Library software,
particularly OEM-branded, grew at a higher rate in the third quarter of 2005
than our other products. We anticipate that this trend will continue in the
fourth quarter.

Deferred revenue at quarter end increased 10%, compared with the balance at
June 30, 2005, and by 80% compared with the same period a year ago. We consider
the continued growth of our deferred revenue as an important indicator of the
success of our products. We believe that support and maintenance renewals, which
comprise the majority of our deferred revenue, are expressions of satisfaction
with our products and our support organization from our end users.

We remain pleased with our ability to scale our business. The increase in
revenues continued to outpace the increase in operating expenses. Operating
expenses increased 4% over the previous quarter and 13% from the same period
last year, excluding a charge of $1.3 million in 2004 related to the settlement
of a patent litigation. Our gross margins increased from 80% for the third
quarter of 2004 to 82% for the third quarter this year. The main contributors to
increased expenses were increased compensation costs and infrastructure
investment. We plan to continue adding research and development, sales and
support personnel, both in the United States and worldwide, as necessary.

We also plan to continue investing in infrastructure, including both
equipment and property. During the third quarter of 2005, we opened an office in
Taipei, Taiwan, and a new Australia/New Zealand regional headquarters in Sydney,
Australia. During the third quarter we also invested in equipment and personnel
for our PrimeVault disaster recovery hosting service.

-13-

We continue to operate the business with the goal of long term growth. We
believe that our ability to continue to refine our existing products and
features and to introduce new products and features will be the primary driver
of additional growth among existing resellers, OEMs and end users, and will
drive our strategy to attempt to engage additional OEM partners and to expand
the FalconStor product lines offered by these OEMs.

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 2004.

Revenues for the three months ended September 30, 2005 increased 35% to
$10.1 million compared with $7.5 million for the three months ended September
30, 2004. Our operating expenses, excluding the $1.3 million patent infringement
litigation settled in the third quarter of 2004, increased 13% from $8.6 million
for the three months ended September 30, 2004 to $9.8 million for the three
months ended September 30, 2005. Net income for the three months ended September
30, 2005 was $0.5 million compared with a net loss of $2.3 million for the three
months ended September 30, 2004. The increase in revenues was mainly due to an
increase in (i) demand for our network storage solution software and (ii) sales
from our OEM partners. Revenue contribution from our OEM partners increased in
absolute dollars and as a percentage of our total revenue for the quarter ended
September 30, 2005. Revenue from resellers and distributors also increased in
absolute dollars. Expenses increased in cost of maintenance, software services
and other revenue, software development, and selling and marketing to support
our growth. For the three months ended September 30, 2005, we increased the
number of employees and continued to invest in our infrastructure by purchasing
additional computers and equipment. We increased the number of employees from
207 employees as of September 30, 2004 to 267 employees as of September 30,
2005.

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue is comprised of software licenses sold through our
OEMs, value-added resellers and distributors to end users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer. We sometimes receive nonrefundable royalty advances
and engineering fees from some of our OEM partners. These arrangements are
evidenced by a signed customer contract, and the revenue is recognized when the
software product master is delivered and accepted, and the engineering services,
if any, have been performed.

Software license revenue increased 29% from $5.4 million for the three
months ended September 30, 2004 to $7.0 million for the three months ended
September 30, 2005. Increased market acceptance and demand for our product and
increased sales from our OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from OEM partners increased as a
percentage of total revenue. We expect our software license revenue to continue
to grow and the percentage of future software license revenue derived from our
OEM partners to continue to increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenues are comprised of software
maintenance and technical support, professional services primarily related to
the implementation of our software, engineering services, and sales of computer
hardware. Revenue derived from maintenance and technical support contracts is
deferred and recognized ratably over the contractual maintenance term.
Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In the third quarter of 2005, we had a limited number of transactions
in which we purchased hardware and bundled this hardware with our software and
sold the bundled solution to our customer. A portion of the contractual fees is
recognized as revenue when the hardware or software is delivered to the customer
based on the relative fair value of the delivered element(s). Maintenance,
software services and other revenue increased 49% to $3.0 million for the three
months ended September 30, 2005 from $2.0 million for the three months ended
September 30, 2004.

-14-

The major factor behind the increase in maintenance, software services and
other revenue was an increase in the number of maintenance and technical support
contracts we sold. As we are in business longer, and as we license more
software, we expect these revenues will continue to increase. The majority of
our new customers purchase maintenance and support and most customers renew
their maintenance and support after their initial contracts expire. Maintenance
revenue increased from $1.3 million for the three months ended September 30,
2004 to $2.0 million for the three months ended September 30, 2005. Growth in
our professional services sales, which increased by $0.2 million for the three
months ended September 30, 2005 compared with the three months ended September
30, 2004, also contributed to the increase in software services and other
revenues. This increase in professional services revenue was related to the
increase in our software license customers who elected to purchase professional
services. Additionally, our hardware sales increased from approximately $0.5
million for the three months ended September 30, 2004 to approximately $0.7
million for the three months ended September 30, 2005. This increase was the
result of an increase in demand from our customers for bundled solutions. We
expect maintenance, software services and other revenues to continue to
increase.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed various software for resale since
2001. As of September 30, 2005, we had $5.0 million of purchased software
licenses that are being amortized over three years. For the three months ended
September 30, 2005, we recorded $0.2 million of amortization related to these
purchased software licenses. As of September 30, 2004, we had $4.9 million of
purchased software licenses and recorded approximately $0.3 million of
amortization for the three months ended September 30, 2004 related to these
purchased software licenses. We will continue to evaluate third party software
licenses and may make additional purchases, which would result in an increase in
amortization expense.

The Company did not capitalize any software development costs until our
initial product reached technological feasibility in March 2001. At that point,
we capitalized $0.1 million of software development costs, which were being
amortized at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products. Capitalized software costs were fully amortized as of
the end of the first quarter of 2004.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues consists
primarily of personnel and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased that was resold. Cost of maintenance, software services
and other revenues for the three months ended September 30, 2005 increased by
50% to $1.7 million compared with $1.1 million for the three months ended
September 30, 2004. The increase in cost of maintenance, software services and
other revenue was principally due to an increase in personnel. As a result of
our increased sales of maintenance and support contracts and professional
services, we hired additional employees to provide technical support and to
implement our software. Additionally, due to the increase in hardware sales, our
associated hardware costs increased from $0.3 million for the three months ended
September 30, 2004 to $0.5 million for the three months ended September 30,
2005. Our cost of maintenance, software services and other revenue will continue
to grow in absolute dollars as our revenue increases.

Gross profit for the three months ended September 30, 2005 was $8.2 million
or 82% of revenue compared to $6.0 million or 80% of revenue for the three
months ended September 30, 2004. The increase in gross profit and gross margin
was directly related to the increase in revenues. Additionally, the increased
percentage of revenue from our OEM partners contributed to the increase in gross
margins since revenues from our OEM partners typically have higher gross
margins.

-15-

SOFTWARE DEVELOPMENT COSTS

Software development costs consist primarily of personnel costs for product
development personnel and other related costs associated with the development of
new products, enhancements to existing products, quality assurance and testing.
Software development costs increased 32% to $3.0 million for the three months
ended September 30, 2005 from $2.3 million for the three months ended September
30, 2004. The increase in software development costs was primarily due to an
increase in employees required to enhance and test our core network storage
software product, as well as to develop new innovative features and options. In
addition, we required additional employees to test and integrate our software
with our OEM partners' products. We intend to continue recruiting and hiring
product development personnel to support our development process.

SELLING AND MARKETING

Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, travel, public relations expense, marketing
literature and promotions, commissions, trade show expenses, and the costs
associated with our foreign sales offices. Selling and marketing expenses
increased 8% to $3.8 million for the three months ended September 30, 2005 from
$3.5 million for the three months ended September 30, 2004. As a result of the
increase in revenue and interest in our software, our commission expense and
travel expenses increased. We believe that to continue to grow sales, our sales
and marketing expenses will continue to increase.

GENERAL AND ADMINISTRATIVE

General and administrative expenses consist primarily of personnel costs of
general and administrative functions, public company related costs, directors
and officers insurance, legal and professional fees, and other general corporate
overhead costs. General and administrative expenses decreased 19% to $1.1
million for the three months ended September 30, 2005 from $1.4 million for the
three months ended September 30, 2004. The overall decrease in general and
administrative expenses was primarily due to a decrease in legal expenses. For
the three months ended September 30, 2004, we had $0.4 million in legal expenses
attributable to litigation relating to alleged patent infringement. Absent the
$0.4 million in legal expense attributable to alleged patent infringement in the
third quarter of 2004, our general and administrative expenses increased 15%
from the same period a year ago. As our revenue and number of employees
increase, our legal and professional fees and other general corporate overhead
costs are likely to increase as well.

LITIGATION SETTLEMENT CHARGE

During the third quarter of 2004, we resolved claims relating to alleged
patent infringement brought by Dot Hill and by Crossroads against us in the
United States District Court for the Western District of Texas. Pursuant to the
terms of the Settlement Agreement between Crossroads and us, we, without
admission of infringement, made a one-time payment of $1.3 million and granted
to Crossroads licenses to certain of our technology in exchange for a worldwide,
perpetual license to the technology underlying the Crossroads patents at issue
in the litigation. All claims against us by both Dot Hill and Crossroads have
been dismissed.

INTEREST AND OTHER INCOME

We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
remained consistent at $0.2 million.

INCOME TAXES

For the three months ended September 30, 2005, our provision for income
taxes consisted of U.S. and foreign taxes in amounts necessary to align our
year-to-date tax provision with the effective rate that we expect to achieve for
the full year. Our effective rate for the three months ended September 30, 2005
differs from the U.S. Federal statutory rate primarily due to the availability
of net operating losses to offset a substantial portion of our U.S. taxable
income. For the three months ended September 30, 2004, we did not record a tax
benefit associated with the pre-tax loss incurred for the period due primarily
to the uncertainty of recoverability of the related deferred tax assets.
Accordingly, we provided a full valuation allowance against our net deferred tax
assets.

-16-

RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO
THE NINE MONTHS ENDED SEPTEMBER 30, 2004.

REVENUES

Revenues for the nine months ended September 30, 2005 increased 45% to
$27.9 million compared with $19.2 million for the nine months ended September
30, 2004. Our operating expenses, excluding the $1.3 million patent infringement
litigation settled in the third quarter of 2004, increased 13% from $24.7
million for the nine months ended September 30, 2004 to $27.9 million for the
nine months ended September 30, 2005. Net income for the nine months ended
September 30, 2005 was $0.6 million compared with a net loss of $6.2 million for
the nine months ended September 30, 2004. The increase in revenues was mainly
due to an increase in (i) demand for our network storage solution software and
(ii) sales from our OEM partners. Revenue contribution from our OEM partners
increased in absolute dollars and as a percentage of our total revenue for the
nine months ended September 30, 2005. Revenue from resellers and distributors
also increased in absolute dollars. Expenses increased in cost of maintenance,
software services and other revenue, software development, and selling and
marketing to support our growth. For the nine months ended September 30, 2005,
we increased the number of employees and continued to invest in our
infrastructure by purchasing additional computers and equipment. We increased
the number of employees from 207 employees as of September 30, 2004 to 267
employees as of September 30, 2005.

SOFTWARE LICENSE REVENUE

Software license revenue increased 44% from $13.9 million for the nine
months ended September 30, 2004 to $19.9 million for the nine months ended
September 30, 2005. Increased market acceptance and demand for our product and
the ramp up in sales from OEM partners were the primary drivers of the increase
in software license revenue. Software license revenue increased from both our
OEM partners and from our resellers. Revenue from our OEM partners increased as
a percentage of total revenue. We expect software license revenue to continue to
grow and the percentage of software license revenue derived from OEM partners to
increase.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenue increased 50% to $8.0
million for the nine months ended September 30, 2005 compared with $5.3 million
for the nine months ended September 30, 2004. The primary reason for the
increase in maintenance, software services and other revenue was an increase in
the number of our maintenance and technical support contracts. As we are in
business longer, and as we license more software, we expect these revenues will
continue to increase. The majority of our new customers purchase maintenance and
support and most customers renew their maintenance and support after their
initial contracts expire. Maintenance revenue increased from $3.2 million for
the nine months ended September 30, 2004 to $5.3 million for the nine months
ended September 30, 2005. Growth in our hardware sales, which increased from
$1.1 million for the nine months ended September 30, 2004 to $1.6 million for
the nine months ended September 30, 2005, also contributed to the increase in
software services and other revenues. This increase was the result of an
increase in demand from our customers for bundled solutions.

COST OF REVENUES

AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE

Amortization of purchased and capitalized software decreased from $1.2
million for the nine months ended September 30, 2004 to $0.6 million for the
nine months ended September 30, 2005. The decrease in amortization expense was
due to some of the purchased software licenses being fully amortized as of
September 30, 2005. We will continue to evaluate third party software licenses
and may make additional purchases, which would result in an increase in
amortization expense. Amortization of capitalized software costs was $7,881 for
the nine months ended September 30, 2004. Capitalized software costs were fully
amortized as of the end of the first quarter of 2004.

-17-

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues for the nine
months ended September 30, 2005 increased by 45% to $4.5 million compared with
$3.1 million for the nine months ended September 30, 2004. The increase in cost
of maintenance, software services and other revenues was principally due to an
increase in personnel. As a result of our increased sales of maintenance and
support contracts, we hired additional employees to provide technical support.
Our cost of maintenance, software services and other revenue will continue to
grow in absolute dollars as our revenue increases.

Gross profit for the nine months ended September 30, 2005 was $22.9 million
or 82% of revenues compared with $15.0 million or 78% of revenues for the nine
months ended September 30, 2004. The increase in gross profit and gross margin
was directly related to the increase in revenues. Additionally, the increased
percentage of revenue from our OEM partners contributed to the increase in gross
margin since revenues from our OEM partners typically have higher gross margins.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 28% to $8.4 million for the nine
months ended September 30, 2005 compared with $6.6 million for the nine months
ended September 30, 2004. The increase in software development costs was mainly
due to an increase in employees required to enhance and test our core network
storage software product, as well as to develop new innovative features and
options. In addition, we required additional employees to test and integrate our
software with our OEM partners' products. We intend to continue recruiting and
hiring product development personnel to support our development process.

SELLING AND MARKETING

Selling and marketing expenses increased 10% to $11.3 million for the nine
months ended September 30, 2005 from $10.2 million for the nine months ended
September 30, 2004. This increase in selling and marketing expenses was
partially due to increased commission expense, which is directly related to our
increase in revenues. Additionally, salary related expenses increased as we
increased our headcount to support our revenue growth.

GENERAL AND ADMINISTRATIVE

General and administrative expenses decreased 12% to $3.1 million for the
nine months ended September 30, 2005 from $3.6 million for the nine months ended
September 30, 2004. The decrease in general and administrative expenses was
primarily due to a decrease in legal expenses. For the nine months ended
September 30, 2004 we had $1.0 million in legal expenses attributable to
litigation related to alleged patent infringement. This decrease in legal
expenses was offset by an increase in professional services of $0.2 million
associated with our compliance with the provisions of the Sarbanes-Oxley Act of
2002. Absent the $1.0 million in legal expense attributable to alleged patent
infringement in the first nine months of 2004, our general and administrative
expenses increased 22% from the same period a year ago. As our revenue and
number of employees increase, our legal and professional fees and other general
corporate overhead costs are likely to increase as well.

LITIGATION SETTLEMENT CHARGE

INTEREST AND OTHER INCOME

We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
increased 21% to $0.7 million for the nine months ended September 30, 2005 from

-18-

$0.6 million for the nine months ended September 30, 2004. This increase in
interest income was due to higher interest rates and higher average cash, cash
equivalent and marketable securities balances.

INCOME TAXES

For the nine months ended September 30, 2005, our provision for income
taxes consisted of U.S. and foreign income taxes provided at the effective rate
expected for the full year. Our effective rate for the nine months ended
September 30, 2005 differs from the U.S. Federal statutory rate primarily due to
the availability of net operating losses to offset a substantial portion of our
U.S. taxable income. We did not record a tax benefit associated with the pre-tax
loss incurred for the nine months ended September 30, 2004, due primarily to the
uncertainty of recoverability of the related deferred tax assets. Accordingly,
we provided a full valuation allowance against our net deferred tax assets.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies are those related to revenue recognition
and accounts receivable allowances. We recognize revenue in accordance with the
provisions of Statement of Position 97-2, SOFTWARE REVENUE RECOGNITION, as
amended. Software license revenue is recognized only when pervasive evidence of
an arrangement exists and the fee is fixed and determinable, among other
criteria. An arrangement is evidenced by a signed customer contract for
nonrefundable royalty advances received from OEMs or a customer purchase order
or a royalty report summarizing software licenses sold for each software license
resold by an OEM, distributor or solution provider to an end user. The software
license fees are fixed and determinable as our standard payment terms range from
30 to 90 days, depending on regional billing practices, and we have not provided
any of our customers extended payment terms. When a customer licenses software
together with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.

We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Accounting Financial Standards ("SFAS") No. 123 (R), SHARE BASED
PAYMENT ("SFAS 123(R)"). This statement replaces SFAS No.123, ACCOUNTING FOR
STOCK BASED COMPENSATION and supersedes APB No. 25, ACCOUNTING FOR STOCK ISSUED
TO EMPLOYEES. SFAS 123 (R) requires all stock based compensation to be
recognized as an expense in the financial statements and that such cost be
measured according to the grant date fair value of the stock options or other
equity instruments. SFAS 123 (R) will become effective for the Company on
January 1, 2006. We are currently evaluating the impact that the adoption of
this statement will have on our consolidated financial statements, although we
expect that there will be a negative impact on our results of operations.

LIQUIDITY AND CAPITAL RESOURCES

Our total cash and cash equivalents and marketable securities balance as of
September 30, 2005 increased by $1.2 million compared to December 31, 2004. Our
cash and cash equivalents totaled $16.4 million and marketable securities
totaled $18.8 million at September 30, 2005. As of September 30, 2004, we had
approximately $13.9 million in cash and cash equivalents and $19.0 million in
marketable securities.

For the nine months ended September 30, 2005 we generated positive cash
flows. We continued to invest in our infrastructure to support our long-term
growth during the nine months ended September 30, 2005. We made investments in

-19-

property and equipment and we increased the number of employees during the third
quarter and first nine months of 2005. As we continue to grow, we will continue
to make investments in property and equipment and will need to continue to
increase our headcount.

In connection with our acquisition of IP Metrics in July 2002, we were
required to make cash payments to the former shareholders of IP Metrics, which
were contingent on the level of revenues from IP Metrics products for a period
of twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. We believe that we have no
further payment obligations.

In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 499,600
shares have been repurchased at an aggregate purchase price of $3.3 million.
During the third quarter of 2005, 75,000 shares were purchased at an aggregate
purchase price of $0.5 million. For the nine months ended September 30, 2005, we
repurchased 222,500 shares at an aggregate purchase price of $1.5 million.

Net cash provided by operating activities totaled $4.4 million for the nine
months ended September 30, 2005, compared with net cash used in operating
activities of $2.1 million for the nine months ended September 30, 2004. This
increase was primarily due to our net income of $0.6 million for the nine months
ended September 30, 2005, compared with a net loss of $6.2 million for the nine
months ended September 30, 2004. Net cash provided by operating activities of
$4.4 million was primarily derived from increases in deferred revenue of $2.2
million, an increase in accounts payable of $0.5 million and non-cash charges of
$2.5 million. These amounts were partially offset by net increases in accounts
receivable, prepaid expenses and other currents assets and a decrease in accrued
expenses. The cash used in operating activities for the nine months ended
September 30, 2004 was mainly comprised of our net loss of $6.2 million, and a
net increase in accounts receivable, offset by increases in accounts payable,
accrued expenses and deferred revenue of $2.6 million in the aggregate and
non-cash charges of $2.8 million.

Net cash used in investing activities was $2.8 million for the nine months
ended September 30, 2005, due primarily to net purchases of marketable
securities of $0.3 million, purchases of property and equipment of $2.3 million
and purchases of software licenses and intangible assets of $0.2 million. Net
cash provided by investing activities was $7.0 million for the nine months ended
September 30, 2004, due primarily to net sales of marketable securities of $9.1
million. This amount was partially offset by purchases of property and equipment
of $1.8 million, net cash paid for acquisition of IP Metrics of $0.1 million,
and purchases of software licenses and intangible assets of $0.2 million.

Net cash used in financing activities was $0.5 million for the nine months
ended September 30, 2005. We received proceeds from the exercise of stock
options of $1.0 million and we made payments of $1.5 million for the nine months
ended September 30, 2005 to acquire treasury stock. Net cash provided by
financing activities was $0.7 million for the nine months ended September 30,
2004. This amount was primarily related to proceeds from the exercise of stock
options of $0.9 million partially offset by payments to acquire treasury stock
of $0.3 million.

We currently do not have any debt and our only material commitments are
related to our office leases. We have an operating lease covering our primary
office facility that expires in February, 2012. We also have several operating
leases related to offices in foreign countries. The expiration dates for these
leases range from 2004 through 2012. Refer to Note 4 of the notes to our
unaudited condensed consolidated financial statements.

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

RISK FACTORS

WE HAVE HAD A HISTORY OF NET LOSSES AND MAY NOT BE ABLE TO MAINTAIN PROFITABILITY.

For the third quarter of 2005, we had a net profit of $0.5 million. This is
only the third profitable quarter in our history. Other than the second and
third quarters of 2005 and the fourth quarter of 2004, we have had a history of
losses, including the full year ended December 31, 2004, in which we had a net
loss of $5.9 million. Our business model depends upon signing agreements with
additional OEM customers, further developing our reseller sales channel, and

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expanding our sales force. Any difficulty in obtaining these OEM and reseller
customers or in attracting qualified sales personnel will hinder our ability to
generate additional revenues and achieve or maintain profitability.

FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.

Achieving our anticipated growth will depend on a number of factors, some
of which include:

o retention of key management, marketing and technical personnel;

o our ability to increase our customer base and to increase the sales of our
products; and

o competitive conditions in the network storage infrastructure software
market.

We cannot assure you that the anticipated growth will be achieved. The
failure to achieve anticipated growth could harm our business, financial
condition and operating results.

WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.

During the third quarter of 2003, we signed a lease for new office space
that commenced on November 1, 2003 and continues through February, 2012. This
commitment along with several operating leases related to our foreign offices
could impact our ability to achieve or to maintain profitability.

DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS
AND APPROPRIATELY BUDGETING FOR EXPENSES.

The rapidly evolving nature of the network storage software market in which
we sell our products, and other factors that are beyond our control, reduces our
ability to accurately forecast our quarterly and annual revenue. However, we
must use our forecasted revenue to establish our expense budget. Most of our
expenses are fixed in the short term or incurred in advance of anticipated
revenue. As a result, we may not be able to decrease our expenses in a timely
manner to offset any shortfall in revenue.

OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.

The operating results of our business depend in part on the overall demand
for network storage software. Because our sales are primarily to major corporate
customers, any softness in demand for network storage software may result in
decreased revenues.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR RECEIVABLES ARE
CONCENTRATED IN ONE CUSTOMER.

We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the three months ended September 30,
2005, we had two customers that together accounted for 33% of our revenues.
While we believe that we will continue to receive revenue from these clients,
our agreements typically give customers the ability to terminate the
relationship upon 90 days notice. If our contracts with these partners are
terminated, or if the volume of sales from these clients significantly declines,
it would have a material adverse effect on our operating results.

In addition, as of September 30, 2005, one customer accounted for 14% of
our outstanding receivables. While we currently have no reason to question the
collectibility of these receivables, a business failure or reorganization by
this customer could harm our ability to collect these receivables and damage our
cash flow.

THE REPORTING TERMS OF SOME OF OUR OEM AGREEMENTS MAY CAUSE US DIFFICULTY IN
ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS, BUDGETING FOR EXPENSES OR
RESPONDING TO TRENDS.

Certain of our OEM customers do not report license revenue to us until
sixty days or more after the end of the quarter in which the software was
licensed. There will thus be a delay before we learn whether licensing revenue
from these OEMs has met, exceeded, or fallen short of our expectations. The
reporting schedule from these OEMs also means that our ability to respond to

-21-

trends in the market could be harmed as well. For example, if, in a particular
quarter, we see a significant increase or decrease in revenue from our channel
sales or one of our other OEM partners, there will be a delay in our ability to
determine whether this is an anomaly or a part of a trend. However, we must use
our forecasted revenue to establish our expense budget. Most of our expenses are
fixed in the short term or incurred in advance of anticipated revenue. As a
result, we may not be able to decrease our expenses in a timely manner to offset
any shortfall in revenue or to increase our sales, marketing or support
headcounts to take advantage of positive developments.

THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL
MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.

The continued adoption of Storage Area Networks (SAN) and Network Attached
Storage (NAS) solutions is critical to our future success. The markets for SAN
and NAS solutions are still maturing, making it difficult to predict their
potential sizes or future growth rates. If these markets develop more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.

THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of IP-based Storage Area Networks (SAN) is critical to
our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current storage networking
infrastructure, and they may elect to remain with current network architectures
or to adopt new architecture in limited stages or over extended periods of time.
We are uncertain whether a viable market for our products will develop or be
sustainable. If this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.

THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.

The rapid adoption of disk-based backup solutions is critical to our future
success. The market for disk-based backup solutions is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current tape backup
infrastructure, and they may elect to remain with their current infrastructure
or to adopt new solutions in limited stages or over extended periods of time. We
are uncertain whether a viable market for our products will develop or be
sustainable. If this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.

WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS, SMALL OFFICE AND HOME
OFFICE MARKETS.

We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.

IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.

The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.

-22-

OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.

Our current products are only one part of a SAN or NAS system. All
components of these systems must comply with the same industry standards in
order to operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.

OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.

Our IPStor platform is complex and is designed to be deployed in large and
complex networks. Many of our customers have unique infrastructures, which may
require additional professional services in order for our software to work
within their infrastructure. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
defects in our product within our customers' networks could result in lost
profits or damage to our customers. These problems could cause us to incur
significant service and engineering costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.

FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.

We have entered into agreements with resellers and OEM partners to develop
storage appliances that combine certain aspects of IPStor functionality with
third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would suffer.

OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.

Prior to offering our products for sale, our OEM customers require that
each of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification of a product by an OEM does not assure
any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including engineering, sales, marketing and management
efforts, toward qualifying our products with OEMs in anticipation of sales to
them. If we are unsuccessful or delayed in qualifying any products with an OEM,
such failure or delay would preclude or delay sales of that product to the OEM,
which may impede our ability to grow our business.

WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.

Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage infrastructure software market and in other markets. The OEM
customers and resellers may choose to focus their sales efforts on other
products in the network storage software market or other markets. The OEM
customers might also choose not to continue to develop or to market products
which include our products. This would likely result in lower revenues to us and
would impede our ability to grow our business.

ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.

As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage

-23-

to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.

WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.

Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
This could result in lost sales opportunities for us with other customers or
could cause other potential OEM partners to consider or select software from our
competitors for their storage solutions. In addition, the desire for product
differentiation could cause potential OEM partners to select software from our
competitors. We cannot guarantee that our current strategic partners, or those
companies with whom we may partner in the future, will continue to be our
partners for any period of time. If our software were to be replaced in an OEM
solution by competing software, or if our software is not selected by OEMs for
future solutions, it would likely result in lower revenues to us and would
impede our ability to grow our business.

CONSOLIDATION IN THE NETWORK STORAGE INDUSTRY COULD HURT OUR STRATEGIC
RELATIONSHIPS

In the past several months, two companies with whom we have OEM
relationships have been acquired by other companies. If an OEM customer is
acquired, the new parent might choose to stop offering solutions containing our
software. Even if the solutions continued to be offered, there might be a loss
of focus and sales momentum as the companies are integrated.

THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.

The network storage software market is intensely competitive even during
periods when demand is stable. Some of our current and potential competitors
have longer operating histories, significantly greater resources, broader name
recognition and a larger installed base of customers than we have. Those
competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.

Our competitors also may:

o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us; or

o bundle their products with other products to increase demand for their
products.

In addition, some OEMs with whom we do business, or hope to do business,
may enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.

OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.

Our previous results are not necessarily indicative of our future
performance and our future quarterly results may fluctuate significantly.

Our future performance will depend on many factors, including:

o the timing of securing software license contracts and the delivery of
software and related revenue recognition;

o the seasonality of information technology, including network storage
products, spending;

-24-

o the average unit selling price of our products;

o existing or new competitors introducing better products at competitive
prices before we do;

o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;

o new products or enhancements from us or our competitors;

o import or export restrictions on our proprietary technology; and

o personnel changes.

Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.

OUR STOCK PRICE MAY BE VOLATILE

The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the past twelve months ended
September 30, 2005, the closing market price of our common stock as quoted on
the NASDAQ National Market System fluctuated between $5.23 and $9.67. The market
price of our common stock may be significantly affected by the following
factors:

o actual or anticipated fluctuations in our operating results;

o failure to meet financial estimates;

o changes in market valuations of other technology companies,
particularly those in the storage networking software market;

o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;

o loss of one or more key OEM customers; and

o departures of key personnel.

The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.

OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.

The Financial Accounting Standards Board ("FASB") has required companies to
recognize the fair value of stock options and other stock-based compensation to
employees as compensation expense in the statement of operations. In accordance
with SEC rules, we must implement the FASB rules effective in the first quarter
of 2006. While it is too early to tell the exact impact of this requirement,
there will be a negative impact on our results of operations.

WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting

-25-

power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Finally, we have entered into change of
control agreements with certain executives.

WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.

As of September 30, 2005, we had outstanding options and warrants to
purchase an aggregate of 10,945,261 shares of our common stock at a weighted
average exercise price of $5.24 per share. We also have 1,234,477 shares of our
common stock reserved for issuance under our stock option plans with respect to
options that have not been granted.

The exercise of all of the outstanding options and warrants and/or the
grant and exercise of additional options would dilute the then-existing
stockholders' percentage ownership of common stock, and any sales in the public
market of the common stock issuable upon such exercise could adversely affect
prevailing market prices for the common stock. Moreover, the terms upon which we
would be able to obtain additional equity capital could be adversely affected
because the holders of such securities can be expected to exercise or convert
them at a time when we would, in all likelihood, be able to obtain any needed
capital on terms more favorable than those provided by such securities.

OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS

In August, 2003, our business was interrupted due to a large scale blackout
in the northeastern United States. While the headquarters facilities we moved in
to in November, 2003 contain redundant power supplies and generators, our
domestic and foreign operations, and the operations of our industry partners,
remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.

Terrorist actions domestically or abroad could lead to business disruptions
or to cancellations of customer orders or a general decrease in corporate
spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.

THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.

We sell our products worldwide. Accordingly, our operating results could be
materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.

Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.

Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.

Our success is dependent upon our proprietary technology. Currently, the
IPStor software suite is the core of our proprietary technology. We have one
patent issued, one patent for which we have received a notice of allowance, and
multiple pending patent applications, numerous trademarks registered and
multiple pending trademark applications related to our products. We cannot
predict whether we will receive patents for our pending or future patent
applications, and any patents that we own or that are issued to us may be
invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.

-26-

We also rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.

OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.

In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights.

We were already subject to one action, which alleged that our technology
infringed on patents held by a third party. While we settled this litigation,
the fees and expenses of the litigation as well as the litigation settlement
were expensive and the litigation diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. Any potential intellectual property litigation
against us could force us to take specific actions, including:

o cease selling our products that use the challenged intellectual
property;

o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which
license may not be available on reasonable terms, or at all; or

o redesign those products that use infringing intellectual property or
cease to use an infringing product or trademark.

DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.

Many of our products are designed to include software or other intellectual
property licensed from third parties, including "Open Source" software. At least
one intellectual property rights holder has alleged that it holds the rights to
software traditionally viewed as Open Source. It may be necessary in the future
to seek or renew licenses relating to various aspects of these products. There
can be no assurance that the necessary licenses would be available on acceptable
terms, if at all. The inability to obtain certain licenses or other rights or to
obtain such licenses or rights on favorable terms, or the need to engage in
litigation regarding these matters, could have a material adverse effect on our
business, operating results, and financial condition. Moreover, the inclusion in
our products of software or other intellectual property licensed from third
parties on a nonexclusive basis could limit our ability to protect our
proprietary rights in our products.

THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.

Our success depends upon the continued contributions of our key employees,
many of whom would be extremely difficult to replace. We do not have key person
life insurance on any of our personnel. Worldwide competition for skilled
employees in the network storage software industry is extremely intense. If we
are unable to retain existing employees or to hire and integrate new employees,
our business, financial condition and operating results could suffer. In
addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
and could incur substantial costs defending ourselves against those claims.

WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.

We have made, and may continue to make, acquisitions of other companies or
their assets. Integration of the acquired products, technologies and businesses,
could divert management's time and resources. Further, we may not be able to
properly integrate the acquired products, technologies or businesses, with our
existing products and operations, train, retain and motivate personnel from the
acquired businesses, or combine potentially different corporate cultures. If we
are unable to fully integrate the acquired products, technologies or businesses,
or train, retain and motivate personnel from the acquired businesses, we may not

-27-

receive the intended benefits of the acquisitions, which could harm our
business, operating results and financial condition.

IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.

The preparation of consolidated financial statements and related disclosure
in accordance with generally accepted account principles requires management to
establish policies that contain estimates and assumptions that affect the
amounts reported in the consolidated financial statements and the accompanying
notes. Note 1 to the Consolidated Financial Statements in this Report on Form
10-Q describes the significant accounting policies essential to preparing our
financial statements. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosures. We base our
estimates on historical experience and assumptions that we believe to be
reasonable under the circumstances. Actual future results may differ materially
from these estimates. We evaluate, on an ongoing basis, our estimates and
assumptions.

LONG TERM CHARACTER OF INVESTMENTS.

Our present and future equity investments may never appreciate in value,
and are subject to normal risks associated with equity investments in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.

UNKNOWN FACTORS

Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.

ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities. If interest rates were to change by
10% from the levels at September 30, 2005, the effect on our financial results
would be insignificant.

FOREIGN CURRENCY RISK. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. If foreign currency
exchange rates were to change by 10% from the levels at September 30, 2005, the
effect on our other comprehensive income would be insignificant. We do not use
derivative financial instruments to limit our foreign currency risk exposure.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report, and,
based on their evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. No changes in the Company's internal controls over financial
reporting occurred during the quarter ended September 30, 2005, that have
materially affected, or are reasonably likely to materially affect, the
Company's internal controls over financial reporting.

Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.

-28-

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are 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, we believe that such matters will
not have a material adverse effect on our financial condition or operating
results.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Shares of common stock repurchased during the quarter ended September 30, 2005:

Total Number of Maximum Number
Shares Purchased of Shares That May
Total Number of Average Price as Part of Publicly Yet be Purchased
Shares Purchased Paid Per Share Announced Plan Under the Plan

August, 2005 35,800 $6.35 35,800 1,539,600

September, 2005 39,200 $6.36 39,200 1,500,400

Total 75,000 $6.35 75,000 1,500,400

The Company's Board of Directors approved a program, effective October 24, 2001,
to repurchase up to two million shares of the Company's common stock. The
program has no expiration date.

ITEM 5. OTHER INFORMATION

On November 7, 2005, the Company's Board of Directors approved a Second Amended
and Restated Employment Agreement (the "Employment Agreement") with ReiJane
Huai, the Company's Chief Executive Officer. The Employment Agreement contains
two changes from the previous Amended and Restated Employment Agreement with Mr.
Huai dated September 1, 2004. First, in order to comply with changes in the law
relating to deferred compensation arising out of the American Jobs Creation Act
of 2004, the period in which bonuses are to be paid to Mr. Huai has been
shortened to 75 days following the end of each bonus period. Second, the basis
for the calculation of Mr. Huai's bonus has been changed to exclude (a) the
effects of Statement of Financial Accounting Standards 123(R), and (b) such
other extraordinary, non-recurring and/or other unusual events as determined by
the Compensation Committee of the Company's Board of Directors.

On November 7, 2005, the Company's Board of Directors approved the FalconStor
Software, Inc., 2005 Key Executive Severance Protection Plan (the "Plan"). The
Plan has an effective date of December 1, 2005 and provides for the payment of
severance benefits to certain key Company executives in the event that there is
a change of control of the Company, as defined in the Plan, and the executive is
involuntarily terminated, other than for cause, within two years after the
change of control. ReiJane Huai, Wayne Lam, James Weber, and Bernie Wu, each of
whom are executive officers of the Company, are Group III participants in the
Plan.

ITEM 6. EXHIBITS

Exhibits

10.1 Second Amended and Restated Employment Agreement

-29-

10.2 FalconStor Software, Inc., 2005 Key Executive Severance
Protection Plan

31.1 Certification of the Chief Executive Officer

31.2 Certification of the Chief Financial Officer

32.1 Certification of Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)

32.2 Certification of Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)

-30-

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

FALCONSTOR SOFTWARE, INC.

/s/ James Weber
-----------------
James Weber
Chief Financial Officer, Vice President and Treasurer
(Chief Accounting Officer)

November 8, 2005

EX-10 2 ex101to10q04637_09302005.htm EX 10.1 sec document




                                                                    Exhibit 10.1



   FALCONSTOR SOFTWARE, INC. SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT
                             Employee: ReiJane Huai

     SECOND  AMENDED  AND  RESTATED  EMPLOYMENT  AGREEMENT  made this 7th day of
November,  2005  (hereinafter  referred to as this "Employment  Agreement"),  by
FalconStor Software,  Inc., a Delaware corporation  (hereinafter  referred to as
the  "Corporation"),  and ReiJane Huai with an address at 3 Carlisle Drive,  Old
Brookville, NY 11545 (hereinafter referred to as the "Employee").
     WHEREAS, the Employee desires to continue to be employed by the Corporation
as President and Chief Executive  Officer ("CEO"),  and the Corporation  desires
that the  Employee  continue to be so  employed,  upon the terms and  conditions
hereinafter set forth.
     NOW,  THEREFORE,  in consideration of the premises and the mutual covenants
and agreements hereinafter set forth, the parties intending to be legally bound,
agree as follows:
     1. TERM OF  EMPLOYMENT.  The Board hereby employs the Employee as President
and CEO,  and the  Employee  hereby  agrees  to serve  the  Corporation  in such
capacity for the period  commencing on September 1, 2004 (the "Effective  Date")
and ending on December  31,  2007  (hereinafter  referred to as the  "Employment
Period"), unless sooner terminated as hereinafter provided.
     2. SCOPE OF DUTIES.  The Employee  shall serve as a President  and CEO. The
Employee shall report and be solely responsible to the Board of Directors of the
Corporation (the "Board").  The Employee's  performance shall be reviewed by the
Board annually.
     3. TIME TO BE DEVOTED TO  EMPLOYMENT.  The Employee  shall,  except  during
vacation periods or absences due to temporary illness,  devote substantially all
of his professional and business time,  attention and energies to his duties and
responsibilities  hereunder,  and  except  for  business  trips  which  shall be
necessary or desirable in the Corporation's business, shall render such services
at the  principal  office of the  Corporation.  Nothing  herein  contained or in
Section 10 hereof shall prevent or be construed as preventing  the Employee from
holding  or  purchasing  five  (5%)  percent  or less of any  class  of stock or
securities of a corporation which is listed on a national securities exchange or
regularly traded in the over-the-counter  market, or making other investments or
participating  in business  ventures not in competition with the business of the
Corporation, as long as such investments and business ventures shall not require
any time during  normal  business  hours and do not conflict  with his duties or
obligations to the Corporation as provided in this Employment Agreement.



     4. DIRECT  COMPENSATION.  (a) In consideration for services rendered and to
be rendered by the Employee hereunder during the Employment Period, the Employee
shall  receive a salary of Two  Hundred  and  Seventy-Five  Thousand  ($275,000)
Dollars per year, or such greater amount as the Board shall  determine from year
to year based on the Employee's performance (the "Base Salary"),  which shall be
paid  semi-monthly  in arrears or at such other intervals as other employees are
paid.
     (b) The  Employee  shall be  entitled  to  receive a cash bonus (i) for the
period from  September  1, 2004  through  December  31,  2005 (the "First  Bonus
Period") in an amount equal to 2.50% of the  Corporation's  net operating income
for  such  period  as  determined  by  reference  to  the  Corporation's  income
statements,  but without giving effect to (a) Statement of Financial  Accounting
Standard  123R,  or (b) such other  extraordinary,  non-recurring  and/or  other
unusual items as determined by the Compensation Committee of the Company's Board
of  Directors  and  agreed by a majority  of the  independent  directors  of the
Company's Board of Directors (hereinafter referred to as the "Operating Income")
during  the First  Bonus  Period,  (ii) for the fiscal  year of the  Corporation
ending  December 31, 2006 (the "Second Bonus  Period") in an amount equal to the
product  of (A)  the  Applicable  Percentage  (as  defined  below)  and  (B) the
Operating  Income for the Second  Bonus  Period and (iii) for the fiscal year of
the Corporation ending December 31, 2007 (the "Third Bonus Period") in an amount
equal to the  product of (A) the  Applicable  Percentage  and (B) the  Operating
Income for the Third Bonus Period.  Each bonus payable to the Employee  shall be
paid  within 75 days  after the last day of the  applicable  Bonus  Period.  For
purposes hereof, "Applicable Percentage" shall mean (I) 1.50%, if the percentage
obtained by dividing (x) the Operating Income for the Second Bonus Period or the
Third Bonus Period,  as the case may be, by (y) the  shareholders  equity of the
Corporation  during the Second  Bonus Period or the Third Bonus  Period,  as the
case may be, as determined by reference to the annual  audited  balance sheet of
the  Corporation  for  the  year  ending  as of the  end of  such  Bonus  Period
(hereinafter referred to as "Shareholders  Equity") is less than or equal to 5%,
(II) 2.00%, if the percentage  obtained by dividing (x) the Operating Income for
the Second  Bonus Period or the Third Bonus  Period,  as the case may be, by (y)
the  Shareholders  Equity is more  than 5% but less than or equal to 10%,  (III)
2.25%, if the percentage  obtained by dividing (x) the Operating  Income for the
Second  Bonus Period or the Third Bonus  Period,  as the case may be, by (y) the
Shareholders  Equity is more than 10% but less than or equal to 15%, (IV) 2.50%,
if the percentage  obtained by dividing (x) the Operating  Income for the Second
Bonus  Period  or the  Third  Bonus  Period,  as the  case  may  be,  by (y) the
Shareholders  Equity  is more  than  15% but  less  than or equal to 20% and (V)
3.00%, if the percentage  obtained by dividing (x) the Operating  Income for the
Second  Bonus Period or the Third Bonus  Period,  as the case may be, by (y) the
Shareholders Equity is more than 20%.


                                       2


     5. FRINGE  BENEFITS.  (a) The Employee  shall be entitled to participate in
any and all fringe benefits and/or plans,  generally afforded to other employees
of the  Corporation  (to the extent the Employee  otherwise  qualifies under the
specific  terms  and  conditions  of  each  such  benefit),  including,  without
limitation,  group  disability,  life insurance,  medical  insurance and pension
plans  (401K)  which are,  or which may  become  available  generally  to senior
personnel of the  Corporation.  The Employee shall be entitled to four (4) weeks
of vacation time during each year of the Employment Period.
     (b) If the Corporation has a group disability plan in force at the time the
Employee's employment  terminates,  the Corporation shall offer the Employee the
opportunity  to continue  disability  coverage at the Employee's own expense for
such  period as the  Employee  desires;  provided,  that the  Employee  shall be
required to make all insurance premium contributions.
     (c) Upon termination of the Employee's  employment,  the Corporation  shall
offer the Employee the opportunity to continue the Employee's  health  insurance
coverage in effect  immediately  prior to such  termination or health  insurance
coverage generally  available at such time to executives of the Corporation,  at
the Employee's own expense,  for such period as the Employee desires;  provided,
that the Employee shall be required to make all insurance premium contributions.
     6. TERMINATION OF EMPLOYMENT.  During the Employment Period, the Employee's
employment  may be terminated by the Board on the  occurrence of any one or more
of the following events:
     (a) The death of the Employee;
     (b) For "Cause",  which shall mean (i) the willful  failure by the Employee
to  substantially  perform  his duties  hereunder  (including  the breach of any
provision  of  Section 9 and/or 10  hereof),  for  reasons  other  than death or
disability;  (ii) the willful engaging by the Employee in misconduct  materially
injurious to the Corporation;  or (iii) the commission by the Employee of an act
constituting (A) common law fraud against the Corporation or (B) a felony; or
     (c) If the  Employee  is unable  substantially  to perform  the  Employee's
duties and  responsibilities  hereunder to the full extent required by the Board
by reason of illness,  injury or incapacity for three consecutive months, or for
more than four  months in the  aggregate  during any  period of twelve  calendar
months  (such  condition  constituting  "disability"  for the  purposes  of this
Employment Agreement); provided, however, that the Corporation shall continue to
pay the Employee's  then current Base Salary until the Company acts to terminate
the Employee.  The Employee agrees, in the event of a dispute under this Section
6(c), to submit to a physical  examination by a licensed  physician  selected by
the Board and consented to by the Employee.
     7. DEATH  BENEFIT.  In addition to all other  insurance  and similar  death
benefits  generally  made  available  to employees  of the  Corporation,  if the
Employee's  death  occurs  during  the  term  of  the  Employment   Period,  the


                                       3


Corporation shall provide a death benefit to the estate of the Employee equal to
the Employee's then current annual Base Salary at the date of death.  Such death
benefit shall be payable as may be determined by the  Corporation,  but not less
often than six (6) equal monthly  installments,  payable on the last day of each
month,  commencing  in the  month  subsequent  to the  month in which  the death
occurs.
     8. SEVERANCE PAYMENT.  (a) If the Corporation and the Employee do not enter
into a renewal  agreement  to be effective  January 1, 2008,  for a period of at
least two years and  containing  similar terms and conditions to those set forth
herein, then the Corporation will pay the Employee, as additional  compensation,
an amount equal to the Employee's then current annual Base Salary, as determined
under Section 4(a), payable semi-monthly in arrears for the twelve months ending
December  31,  2008;  such  compensation  is  hereinafter  referred  to  as  the
"Severance Payment".
     (b)  Notwithstanding  the  provisions of Section 8 (a) above,  the Employee
will not receive the Severance Payment if,
          (i) the  Corporation  declines to enter into a renewal  agreement with
the  Employee  because  the  Employee   breached  the   confidentiality   and/or
non-compete  provisions of this Employment Agreement or any other material terms
or conditions of his employment;
          (ii) the Employee has been terminated for Cause hereunder;
          (iii) the Employee declines to enter into a renewal agreement with the
Corporation, and the Corporation has offered a renewal agreement for a period of
not less than two years,  containing  similar terms and  conditions as discussed
herein; or
          (iv) the Employee  has  received a change of control  payment from the
Corporation  that provides change of control benefits that are at least equal to
the amount  that would be  received by the  Employee  pursuant  to Section  8(a)
above.
     (c) If the Employee's employment is terminated for Cause, the Corporation's
sole  obligation  hereunder  shall be to pay the  Employee  (i) any  accrued and
unpaid Base Salary as of the date of  termination,  (ii) an amount equal to such
reasonable  and  necessary   business  expenses  incurred  by  the  Employee  in
connection  with the  Employee's  employment on behalf of the  Corporation on or
prior to the date of termination,  but not previously paid to the Employee,  and
(iii)  if  the  basis  for  such  termination  arises  under  clause  (i) of the
definition  of  "Cause,"  his base  Salary (at the rate in effect on the date of
termination) through the twelve-month  anniversary of the date of termination in
accordance with the normal payroll  practices of the Corporation with respect to
Base Salary.
     9.  DISCLOSURE  OF  INFORMATION.  All  memoranda,  notes,  records or other
documents  made or compiled by the Employee or made  available to him during the
term of his employment  concerning the business of the Corporation  shall be the
Corporation's  property  and  shall  be  delivered  to  the  Corporation  on the
termination of the Employee's employment. The Employee shall not use for himself


                                       4


or others, or divulge to others, any proprietary or confidential  information of
the  Corporation,  obtained  by  him  as a  result  of  his  employment,  unless
authorized  by the  Corporation.  For  purposes  of this  Section  9,  the  term
"proprietary or confidential  information"  shall mean all information  which is
known only to the Employee or to the Employee and employees,  former  employees,
consultants or others in a confidential  relationship  with the  Corporation and
relates  to  specific  matters  such  as  trade  secrets,  customers,  potential
customers  and vendor  lists,  pricing  and credit  techniques,  program  codes,
software  design  know-how,   research  and  development   activities,   private
processes, and books and records, as they may exist from time to time, which the
Employee may have acquired or obtained by virtue of work heretofore or hereafter
performed  for or on behalf of the  Corporation  or which he may  acquire or may
have acquired knowledge of during the performance of said work, and which is not
known to others,  or readily  available  to others from  sources  other than the
Employee or officers or other  employees  of the  Corporation,  or is not in the
public domain.  In the event of a breach or a threatened  breach by the Employee
of the  provisions  of this Section 9, the  Corporation  shall be entitled to an
injunction  restraining the Employee from  disclosing,  in whole or in part, the
aforementioned  proprietary or confidential  information of the Corporation,  or
from  rendering any services to any person,  firm,  corporation,  association or
other entity to whom such proprietary or confidential  information,  in whole or
in part,  has been  disclosed or is threatened to be disclosed.  Nothing  herein
contained shall be construed as prohibiting  the  Corporation  from pursuing any
other  remedies  available  to the  Corporation  for such  breach or  threatened
breach, including the recovery of damages from the Employee.
     10.  RESTRICTIVE  COVENANTS.  (a)  The  Employee  hereby  acknowledges  and
recognizes  the highly  competitive  nature of the  Corporation's  business  and
accordingly  agrees that, in consideration of the premises  contained herein, he
will not from and after the date hereof and during the  Employment  Period until
the Designated Date (as hereinafter defined):  (i) directly or indirectly engage
in any Competitive  Activity (as hereinafter  defined),  whether such engagement
shall  be  as  an  officer,  director,  employee,   consultant,  agent,  lender,
stockholder,  or  other  participant  or  (ii)  assist  others  in  engaging  in
Competitive Activity. As used herein, the term "Competitive Activity" shall mean
and  include the  development  and/or  marketing  of  computer  hardware  and/or
software for Storage Networking applications and other similar systems.
     (b) As used in this  Section  10,  the  "Designated  Date"  shall  mean the
following:
          (i) if the Employee  terminates  his employment  with the  Corporation
prior to the  expiration of the  Employment  Period (other than as a result of a
breach by the  Corporation  of a material  term or condition of this  Employment
Agreement),  then the "Designated  Date" shall mean the second (2nd) anniversary
of the effective date of such termination;
          (ii) if the  Corporation  terminates  the  employment  of the Employee
under this Employment  Agreement for Cause,  then the "Designated Date" shall be
the second (2nd) anniversary of the effective date of such termination;


                                       5


          (iii) if the Corporation, during the Employment Period, terminates the
employment of the Employee without Cause,  then the "Designated Date" shall mean
the effective date of such termination; or
          (iv) if the  Corporation  offers  the  Employee  a  renewal  agreement
pursuant to Section 8(a) hereof and the Employee does not accept such agreement,
then the "Designated Date" shall mean December 1, 2009.
     (c) It is the desire and intent of the parties that the  provisions of this
Section 10 shall be enforced to the fullest  extent  permissible  under the laws
and public policies applied in each jurisdiction in which enforcement is sought.
Accordingly, if any particular provision of this Section 10 shall be adjudicated
to be invalid  or  unenforceable,  such  provision  of this  Section 10 shall be
deemed  amended to delete from the  portion  thus  adjudicated  to be invalid or
unenforceable, such deletion to apply only with respect to the operation of such
provisions  of this  Section  10 in the  particular  jurisdiction  in which such
adjudication is made and, further, only to the extent required in order for this
Section 10 to be enforceable.
     (d) With respect to Inventions (including but not limited to software) made
or conceived by the Employee,  whether or not during the hours of his employment
or with the use of the Corporation's facilities,  materials or personnel, either
solely  or  jointly  with  others  during  the  Employee's   employment  by  the
Corporation:
          (i) The Employee  shall inform the  Corporation  promptly and fully of
such  Inventions  by written  report,  setting  forth in detail  the  procedures
employed and the results  achieved.  A report shall be submitted by the Employee
upon  completion  of  any  studies  or  research  projects   undertaken  on  the
Corporation's  behalf whether or not in the  Employee's  opinion a given project
has resulted in an Invention.
          (ii) The  Employee  shall  apply,  at the  Corporation's  request  and
expense,   for  the  United  States  and/or  foreign  letters  patent  or  other
registrations  either in the Employee's  name or otherwise,  as the  Corporation
shall desire.
          (iii)  The  Employee  hereby  assigns  and  agrees  to  assign  to the
Corporation  all of his right and interest to any and all such Inventions and to
make  applications  for United States  and/or  foreign  letters  patent or other
registrations granted upon such Invention.
          (iv) The  Employee  shall  acknowledge  and  deliver  promptly  to the
Corporation, without charge to the Corporation, but at its expense, such written
instruments  and do such other acts in  support of his  inventorship,  as may be
necessary in the opinion of the Corporation to obtain and maintain United States
and/or foreign letters patent or other registration and to vest the entire right
in such  Inventions,  patents and patent  applications in the  Corporation.  The
Employee  agrees that if the  Corporation  is unable  because of the  Employee's
mental or  physical  incapacity  or  unavailability  or for any other  reason to
secure the Employee's  signature to apply for or to pursue any  application  for
any  United  States or  foreign  patents  or  copyright  registrations  covering


                                       6


Inventions assigned to the Corporation as above, the Employee hereby irrevocably
designates and appoints the  Corporation  and its duly  authorized  officers and
agents as the  Employee's  agent  and  attorney  in fact,  to act for and in the
Employee's  behalf and stead to execute and file any such applications and to do
all other lawfully  permitted acts to further the application for,  prosecution,
issuance,  maintenance or transfer of letters patent or copyright  registrations
thereon  with the same legal force and effect as if  originally  executed by the
Employee.   The  Employee  hereby  waives  and  irrevocably  quitclaims  to  the
Corporation any and all claims, of any nature whatsoever, which the Employee now
or  hereafter  may  have  for  infringement  of any and all  proprietary  rights
assigned to the Corporation.
          (v) The Corporation  shall also have the royalty-free  right to use in
its business,  and to make, use, and sell products and/or services  derived from
any  Inventions,  discoveries,  concepts and ideas,  whether or not  patentable,
including, but not limited to applications, methods, formulas and techniques, as
well as improvements or know-how, whether or not within the scope of Inventions,
but which are obtained,  created or made by the Employee  during the  Employment
Period, without payment of any additional compensation to the Employee.
          (vi) For the purposes of this Employment Agreement, "Inventions" means
discoveries,  concepts and ideas,  whether  patentable or not, including but not
limited to processes,  methods,  formulas and techniques as well as improvements
or know-how.
     (e) If  there is a breach  or  threatened  breach  by the  Employee  of the
provisions  of  this  Section  10,  the  Corporation  shall  be  entitled  to an
injunction  restraining him from such breach.  Nothing herein contained shall be
construed as  prohibiting  the  Corporation  from  pursuing  any other  remedies
available  for such  breach or  threatened  breach  or any other  breach of this
Employment Agreement.
     (f) The Employee  hereby  warrants and represents that he is not prohibited
by any  agreement or the order of any court from  entering into and carrying out
the terms of this Employment Agreement. In particular, the Employee warrants and
represents  that the scope of his  activity  is not  restricted  in any way with
respect  to  the  design,  development,   enhancement,  sale,  marketing  and/or
promotion of computer software and hardware.
     11. (a)  NOTICES.  All notices  required or permitted to be given under the
provisions  of this  Employment  Agreement  shall be in  writing  and  delivered
personally or by certified or registered mail, return receipt requested, postage
prepaid to the following  persons at the following  addresses,  or to such other
person at such other address as either party may request by notice in writing to
the other party to this Employment Agreement:
          If to the Employee:
               ReiJane Huai
               3 Carlisle Drive,
               Old Brookville, NY 11545


                                       7


          If to the Corporation:
               FalconStor Software, Inc.
               2 Huntington Quadrangle
               Suite 2S01
               Melville, New York 11747

     (b)  CONSTRUCTION.   This  Employment   Agreement  shall  be  construed  in
accordance  with,  and be  governed  by,  the laws of the  State of New York for
contracts entered into and to be performed in New York.
     (c) SUCCESSOR AND ASSIGNS. This Employment Agreement and the various rights
and obligations  arising  hereunder shall inure to the benefit of and be binding
upon the  Employee  and his heirs,  executors  and  administrators  and upon the
Corporation and its successors (including, without limitation, by way of merger)
and  assigns.  This  Employment  Agreement  is personal in nature and may not be
assigned or transferred by the Employee without the prior written consent of the
Corporation.
     (d) ENTIRE AGREEMENT;  AMENDMENT AND RESTATEMENT.  This instrument contains
the entire  understanding  and  agreement  between the  parties  relating to the
subject matter hereof,  and neither this Employment  Agreement nor any provision
hereof may be waived,  modified,  amended,  changed,  discharged or  terminated,
except by an agreement in writing  signed by the party against whom  enforcement
of any waiver,  modification,  change,  amendment,  discharge or  termination is
sought.  This Employment  Agreement amends,  restates and supersedes the Amended
and  Restated   Employment   Agreement  dated  September  1,  2004  between  the
Corporation and the Employee.
     (e) COUNTERPARTS.  This Employment Agreement may be executed simultaneously
in  counterparts,  each of which shall be deemed an original,  and both of which
counterparts shall together constitute a single agreement.
     (f) ILLEGALITY.  Without  limitation of Section 10(c) hereof, if any one or
more of the provisions of this Employment Agreement shall be invalid, illegal or
unenforceable in any respect,  the validity,  legality and enforceability of the
remaining  provisions  contained  herein  shall  not in any way be  affected  or
impaired thereby.
     (g) CAPTIONS.  The captions of the sections hereof are for convenience only
and shall not control or affect the meaning or  construction of any of the terms
or provisions of this Employment Agreement.


                                       8



     IN WITNESS  WHEREOF,  the parties  hereto have set their hands and executed
this Employment Agreement the day and year first above written.


                                  FalconStor Software, Inc.
                                  By: /s/ Jim Weber
                                      ------------------------------------------
                                      Jim Weber
                                      Vice President and Chief Financial Officer



                                  By: /s/ Reijane Huai
                                      ------------------------------------------
                                      ReiJane Huai

EX-10 3 ex102to10q04637_09302005.htm EX-10.2 sec document




                                                                    EXHIBIT 10.2



                            FALCONSTOR SOFTWARE, INC.

                          2005 KEY EXECUTIVE SEVERANCE
                                 PROTECTION PLAN













                        EFFECTIVE AS OF DECEMBER 1, 2005




                                TABLE OF CONTENTS



SECTION 1   ESTABLISHMENT OF PLAN

SECTION 2   DEFINITIONS

     2.1    Base Salary
     2.2    Board
     2.3    Bonus Amount
     2.4    Cause
     2.5    Change in Control
     2.6    Company
     2.7    Effective Date
     2.8    Employer
     2.9    Executive Officer
     2.10   Good Reason
     2.11   Notice of Termination
     2.12   Other Executives
     2.13   Operating Companies
     2.14   Participant
     2.15   Permanent Disability
     2.16   Plan
     2.17   Severance Benefit

SECTION 3   ELIGIBILITY

     3.1    Participation
     3.2    Duration of Participation

SECTION 4   SEVERANCE BENEFITS

     4.1    Right to Severance Benefit
     4.2    Amount of Severance Benefit
     4.3    Options

SECTION 5   TERMINATION OF EMPLOYMENT

     5.1    Written Notice Required
     5.2    Termination Date

SECTION 6   ADDITIONAL PAYMENTS BY THE COMPANY

     6.1    Gross-Up Payment
     6.2    Determination By Accountant

- --------------------------------------------------------------------------------
                                      -i-



     6.3    Notification Required
     6.4    Repayment

SECTION 7   SUCCESSORS TO COMPANY

     7.1    Successors
     7.2    Sale of Operating Companies

SECTION 8   AMENDMENT AND PLAN TERMINATION

     8.1    Amendment and Termination
     8.2    Form of Amendment

SECTION 9   MISCELLANEOUS

     9.1    Indemnification
     9.2    Employment Status
     9.3    No Duty of Mitigation
     9.4    No Setoff
     9.5    Benefits Under Other Plans
     9.6    Validity and Severability
     9.7    Governing Law; Choice of Forum


APPENDIX I
APPENDIX II





- --------------------------------------------------------------------------------
                                      -ii-





                            FALCONSTOR SOFTWARE, INC.
                  2005 KEY EXECUTIVE SEVERANCE PROTECTION PLAN

                        EFFECTIVE AS OF DECEMBER 1, 2005

     WHEREAS, the Board of Directors of FalconStor Software, Inc., recognizes
that the threat of a change in ownership or control of the Company may occur
which can result in significant distractions of its key executive personnel
because of the uncertainties inherent in such a situation; and

     WHEREAS, the Board has determined that it is essential and in the best
interest of the Company and its stockholders to retain the services of its key
executive personnel in the event of a threat of a Change in Control of the
Company and to ensure their continued dedication and efforts in such event
without undue concern for their personal financial and employment security.

     NOW, THEREFORE, in order to fulfill the above purposes, the following plan
has been developed and is hereby adopted.

                         SECTION 1 ESTABLISHMENT OF PLAN

     As of the Effective Date, the Company hereby establishes a severance
compensation plan known as the FalconStor Software, Inc. 2005 Key Executive
Severance Protection Plan as set forth in this document.

                              SECTION 2 DEFINITIONS

     As used herein the following words and phrases shall have the following
respective meanings unless the context clearly indicates otherwise.

2.1  BASE SALARY

     As to any Participant the amount that the Participant is entitled to
receive as wages or salary from his or her Employer on an annualized basis, as
in effect immediately prior to a Change in Control or, if greater, at any time
following the Change in Control.

2.2  BOARD

     The Board of Directors of the Company.

2.3  BONUS AMOUNT

     The term "Bonus Amount" shall mean for any Participant the highest annual
bonus paid or payable to the Participant in respect of any of the three (3)
fiscal years of the Company preceding the Participant's termination of
employment

2.4  CAUSE



     "Cause" for termination by the Employer of the Participant's employment
shall mean (i) willful and continued failure by the Participant to substantially
perform the Participant's duties on behalf of the Employer (other than any such
failure resulting from the Participant's incapacity due to physical or mental
illness or any such actual or anticipated failure after the issuance of a Notice
of Termination for Good Reason by the Participant) for a period of at least
thirty consecutive days after a written demand for substantial performance has
been delivered to the Participant by the Responsible Person, which demand
specifically identifies the manner in which the Responsible Person believes that
the Participant has not substantially performed the Participant's duties, (ii)
willful misconduct or gross negligence by the Participant which is demonstrably
and materially injurious to the Company or any of its subsidiaries, or (iii) the
Participant is convicted of, or has entered a plea of NOLO CONTENDERE to, (x) a
felony or (y) any crime (whether or not a felony) involving dishonesty, fraud,
embezzlement or breach of trust. For purposes of clauses (i) and (ii) of this
definition, an act, or failure to act, on the Participant's part shall not be
deemed "willful" if done, or omitted to be done, by the Participant in good
faith and with reasonable belief that the Participant's act, or failure to act,
was in the best interest of the Company. In addition, as to any Participant who
is an Executive Officer, the Participant shall not be deemed to have been
terminated for Cause unless and until there shall have been delivered to the
Participant a copy of a resolution duly adopted by the affirmative vote of not
less than three-quarters of the entire membership of the Board at a meeting of
the Board (after reasonable notice to the Participant and an opportunity for the
Participant, together with the Participant's counsel, to be heard before the
Board), finding in good faith that the Participant has committed Cause as set
forth in such clauses and specifying the circumstances constituting Cause. For
purposes of this definition, "Responsible Person" shall mean (i) for a
Participant who is an Executive Officer, the Board, and (ii) for a Participant
who is an Other Executive, the Executive Officer to whom the Participant
ultimately reports.

2.5  CHANGE IN CONTROL

     A "Change in Control" shall mean the occurrence of any of the following
after the Effective Date:

     (a) An acquisition (other than directly from the Company) of any voting
securities of the Company (the "Voting Securities") by any "Person" (as the term
"person" is used for purposes of Section 13(d) or 14(d) of the Securities
Exchange Act of 1934, as amended (the "Exchange Act")), immediately after which
such Person has "Beneficial Ownership" (within the meaning of Rule 13d-3
promulgated under the Exchange Act) of more than fifty percent (50%) of (1) the
then-outstanding shares of common stock of the Company (or any other securities
into which such shares of common stock are changed or for which such shares of
common stock are exchanged) (the "Shares") or (2) the combined voting power of
the Company's then-outstanding Voting Securities; PROVIDED, HOWEVER, that in
determining whether a Change in Control has occurred pursuant to this paragraph
(a), the acquisition of Shares or Voting Securities in a "Non-Control
Acquisition" (as hereinafter defined) shall not constitute a Change in Control.
A "Non-Control Acquisition" shall mean an acquisition by (i) an employee benefit


                                       2


plan (or a trust forming a part thereof) maintained by (A) the Company or (B)
any corporation or other Person the majority of the voting power, voting equity
securities or equity interest of which is owned, directly or indirectly, by the
Company (for purposes of this definition, a "Related Entity"), (ii) the Company
or any Related Entity, or (iii) any Person in connection with a "Non-Control
Transaction" (as hereinafter defined);

     (b) The individuals who, as of the Effective Date, are members of the board
of directors of the Company (the "Incumbent Board"), cease for any reason to
constitute at least a majority of the members of the board of directors of the
Company or, following a Merger (as hereinafter defined), the board of directors
of (x) the corporation resulting from such Merger (the "Surviving Corporation"),
if fifty percent (50%) or more of the combined voting power of the
then-outstanding voting securities of the Surviving Corporation is not
Beneficially Owned, directly or indirectly, by another Person (a "Parent
Corporation") or (y) if there is one or more than one Parent Corporation, the
ultimate Parent Corporation; PROVIDED, HOWEVER, that, if the election, or
nomination for election by the Company's common stockholders, of any new
director was approved by a vote of at least two-thirds of the Incumbent Board,
such new director shall, for purposes of the Plan, be considered a member of the
Incumbent Board; and PROVIDED, FURTHER, HOWEVER, that no individual shall be
considered a member of the Incumbent Board if such individual initially assumed
office as a result of an actual or threatened solicitation of proxies or
consents by or on behalf of a Person other than the board of directors of the
Company (a "Proxy Contest"), including by reason of any agreement intended to
avoid or settle any Proxy Contest; or

     (c) The consummation of:

          (i) A merger, consolidation or reorganization (1) with or into the
Company or (2) in which securities of the Company are issued (a "Merger"),
unless such Merger is a "Non-Control Transaction." A "Non-Control Transaction"
shall mean a Merger in which:

               (A) the stockholders of the Company immediately before such
     Merger own directly or indirectly immediately following such Merger at
     least fifty percent (50%) of the combined voting power of the outstanding
     voting securities of (x) the Surviving Corporation, if there is no Parent
     Corporation or (y) if there is one or more than one Parent Corporation, the
     ultimate Parent Corporation;

               (B) the individuals who were members of the Incumbent Board
     immediately prior to the execution of the agreement providing for such
     Merger constitute at least a majority of the members of the board of
     directors of (x) the Surviving Corporation, if there is no Parent
     Corporation, or (y) if there is one or more than one Parent Corporation,
     the ultimate Parent Corporation; and

               (C) no Person other than (1) the Company, (2) any Related Entity,
     or (3) any employee benefit plan (or any trust forming a part thereof)
     that, immediately prior to the Merger, was maintained by the Company or any


                                       3


     Related Entity, or (4) any Person who, immediately prior to the Merger had
     Beneficial Ownership of twenty percent (20%) or more of the then
     outstanding Shares or Voting Securities, has Beneficial Ownership, directly
     or indirectly, of twenty percent (20%) or more of the combined voting power
     of the outstanding voting securities or common stock of (x) the Surviving
     Corporation, if fifty percent (50%) or more of the combined voting power of
     the then outstanding voting securities of the Surviving Corporation is not
     Beneficially Owned, directly or indirectly by a Parent Corporation, or (y)
     if there is one or more than one Parent Corporation, the ultimate Parent
     Corporation;

               (ii) A complete liquidation or dissolution of the Company; or

               (iii) The sale or other disposition of all or substantially all
of the assets of the Company and its subsidiaries taken as a whole to any Person
(other than (x) a transfer to a Related Entity, (y) a transfer under conditions
that would constitute a Non-Control Transaction, with the disposition of assets
being regarded as a Merger for this purpose or (z) the distribution to the
Company's stockholders of the stock of a Related Entity or any other assets).

Notwithstanding the foregoing, a Change in Control shall not be deemed to occur
solely because any Person (the "Subject Person") acquired Beneficial Ownership
of more than the permitted amount of the then outstanding Shares or Voting
Securities as a result of the acquisition of Shares or Voting Securities by the
Company which, by reducing the number of Shares or Voting Securities then
outstanding, increases the proportional number of shares Beneficially Owned by
the Subject Persons; PROVIDED, that if a Change in Control would occur (but for
the operation of this sentence) as a result of the acquisition of Shares or
Voting Securities by the Company and, after such share acquisition by the
Company, the Subject Person becomes the Beneficial Owner of any additional
Shares or Voting Securities and such Beneficial Ownership increases the
percentage of the then outstanding Shares or Voting Securities Beneficially
Owned by the Subject Person, then a Change in Control shall occur.

2.6  COMPANY

     "Company" shall mean FalconStor Software, Inc.

2.7  EFFECTIVE DATE

     The "Effective Date" of this Plan is December 1, 2005.

2.8  EMPLOYER

     "Employer" shall mean, as to any Participant on any date, the Company or
the affiliate (including wholly-owned subsidiaries) of the Company that employs
the Participant on such date.

                                       4


2.9  EXECUTIVE OFFICER

     All employees of the Company designated as "Officers" by the Board pursuant
to Rule 16a1-f of the Securities and Exchange Commission and the Company's
General Counsel.

2.10 GOOD REASON

     "Good Reason" shall mean, as to any Participant, the occurrence of any of
the following events or conditions following a Change in Control:

     (a) a change in the Participant's status, title, position or
responsibilities (including reporting responsibilities) which, in his or her
reasonable judgment, represents a substantial reduction of his or her status,
title, position or responsibilities as in effect immediately prior thereto; the
assignment to the Participant of any duties or responsibilities which, in the
Participant's reasonable judgment, are inconsistent with such status, title,
position or responsibilities; or any removal of the Participant from or failure
to reappoint or reelect him or her to any of such positions, except in
connection with the termination of his or her employment for Cause, Permanent
Disability, as a result of his or her death, or by the Participant other than
for Good Reason;

     (b) a reduction in the Participant's annual base salary;

     (c) (x) the Employer's requiring the Participant to change the office
location at which the Participant is based which results in the Participant
having a commute to such location from the Participant's residence in excess of
50 miles or in excess of 120% (in miles) of the Participant's commute
immediately prior to the date of such change of location, whichever is greater;
or (y) the Employer's requiring the Participant to engage in travel on the
Employer's business to an extent substantially greater than the Participant's
business travel obligations immediately prior to the Change in Control;

     (d) the failure by the Company or any of its affiliates to (i) continue in
effect any material compensation or benefit plan, program or practice in which
the Participant was participating immediately prior to the Change in Control, or
(ii) provide the Participant with compensation and benefits at least equal (in
terms of benefit levels and/or reward opportunities) to those provided for under
each compensation or employee benefit plan, program and practice of the Company
and its affiliates as in effect immediately prior to the Change in Control (or
as in effect following the Change in Control, if greater);

     (e) any material breach by the Company of any provision of this Plan; or

     (f) any purported termination of the Participant's employment for Cause by
the Company which does not otherwise comply with the terms of this Plan.

2.11 NOTICE OF TERMINATION

                                       5


     "Notice of Termination" shall mean a notice which indicates the specific
provisions in this Plan relied upon as the basis for any termination of
employment and which sets forth in reasonable detail the facts and circumstances
claimed to provide a basis for termination of the Participant's employment under
the provision so indicated. No purported termination of employment shall be
effective without such Notice of Termination.

2.12 OTHER EXECUTIVES

     Such other employees of the Company who are so designated by a majority
vote of all Independent Directors of the Company. For purposes of this section,
"Independent Directors" shall mean Directors who meet the independence
requirements of the Nasdaq Stock Market Marketplace Rules at the time any action
is taken.

2.13 OPERATING COMPANIES

     Subsidiary companies of the Company designated by the Company on Appendix I
of the Plan.

2.14 PARTICIPANT

     An employee of the Company who meets the eligibility requirements of
Section 3.

2.15 PERMANENT DISABILITY

     A Participant shall be deemed to have become permanently disabled for
purposes of this Plan if the Chief Executive Officer of the Company (or, in the
case of a determination with respect to the Chief Executive Officer, the Board)
finds, upon the basis of medical evidence satisfactory to him or her, that the
Participant is totally disabled, whether due to physical or mental condition, so
as to be prevented from engaging in further employment by the Company and that
such disability will be permanent and continuous during the remainder of his or
her life.

2.16 PLAN

     This FalconStor Software, Inc. 2005 Key Executive Severance Protection
Plan.

2.17 SEVERANCE BENEFITS

     The benefits payable in accordance with Section 4 of the Plan.

                              SECTION 3 ELIGIBILITY

3.1  PARTICIPATION

     Executive Officers shall automatically become Participants in this Plan in
Group III when designated Executive Officers by the Board. Other Executives
shall become Participants in the Plan if they are designated by the Board or
Compensation Committee thereof as Participants. Participants shall be identified


                                       6


on Appendix II of the Plan. The Company shall amend Appendix II from time to
time as necessary to include new Participants in the Plan or remove Participants
from the Plan who are no longer eligible to participate in the Plan, in each
case in accordance with the terms and conditions of the Plan.

3.2  DURATION OF PARTICIPATION

     A Participant shall cease to be a Participant in the Plan if he or she
ceases to be an Executive Officer of Other Executive at any time prior to a
Change in Control (but subject to Section 4.1(b)) or if his or her employment is
terminated following a Change in Control under circumstances where he or she is
not entitled to a Severance Benefit under the terms of this Plan. A Participant
whose termination of employment entitles him or her to payment of Severance
Benefits shall remain a Participant in the Plan until the full amount of the
Severance Benefits have been paid to him or her.

                          SECTION 4 SEVERANCE BENEFITS

4.1  RIGHT TO SEVERANCE BENEFITS

     (a) A Participant shall be entitled to receive from the Company a Severance
Benefit in the amount provided in Section 4.2 if (i) a Change in Control has
occurred and (ii) within two years thereafter, the Participant's employment with
the Company terminates for any reason, except that notwithstanding the
provisions of this Section 4.1(a), no benefits under this Plan will be payable
should the Participant's termination of employment be (A) by the Employer for
Cause, (B) by reason of Permanent Disability, (C) voluntarily initiated by the
Participant other than for Good Reason, or (D) by reason of the Participant's
death.

     (b) If (i) a Participant's employment is terminated by the Employer without
Cause prior to the date of a Change in Control or (ii) an action is taken with
respect to the Participant prior to the date of a Change in Control that would
constitute Good Reason if taken after a Change in Control, and the Participant
reasonably demonstrates that such termination or action (A) was at the request
of a third party that has indicated an intention or taken steps reasonably
calculated to effect a Change in Control or (B) otherwise arose in connection
with, or in anticipation of, a Change in Control that has been threatened or
proposed, such termination or action shall be deemed to have occurred after such
Change in Control for purposes of the Plan, so long as such Change in Control
actually occurs.

     (c) Notwithstanding any other provision of the Plan, the sale, divestiture
or other disposition of an Operating Company (or part thereof) before the
execution of an agreement providing for a transaction or transactions which, if
consummated, would constitute a Change in Control or before a Change in Control
shall not be deemed to be a termination of employment of Participants employed
by such Operating Company, and such Participants shall not be entitled to
benefits from the Company under this Plan as a result of such sale, divestiture
or other disposition. The sale, divestiture or other disposition of an Operating


                                       7


Company (or part thereof) after the execution of an agreement providing for a
transaction or transactions which, if consummated, would constitute a Change in
Control or after a Change in Control shall not be deemed to be a termination of
employment of Participants employed by such Operating Company, and such
Participants shall not be entitled to benefits from the Company under this Plan
as a result of such sale, divestiture or other disposition, in each case so long
as the provisions of Section 7.2 have been satisfied.

4.2  AMOUNT OF SEVERANCE BENEFIT

     If a Participant's employment is terminated in circumstances entitling him
or her to a Severance Benefit as provided in Section 4.1, such Participant shall
be entitled to the following benefits:

          (a) the Company shall pay to the Participant, as severance pay and in
lieu of any further salary for periods subsequent to the Termination Date (as
specified in Section 5.2), in a single payment (without any discount for
accelerated payment), an amount in cash equal to a formula, as described below,
and based upon a multiplier, as assigned in the table below to the Participant
according to the Participant's designation on Exhibit II ("Participant
Designation"):

           Multiplier     Participant Designation
           ----------     -----------------------
           3 X            Group III
           2 X            Group II
           1 X            Group I

     (X) times the sum of (A) the Participant's Base Salary and (B) the Bonus
Amount, plus the prorated portion of the Participant's Bonus Amount for the year
in which the Participant's employment is terminated;

          (b) for the period of months, as specified for each Participant
Designation Level in the table below, subsequent to the Participant's
termination of employment, the Company shall at its expense continue on behalf
of the Participant and his or her dependents and beneficiaries, the basic life
insurance, flexible spending account, medical and dental benefits which were
being provided to the Participant immediately prior to the Change in Control
(or, if greater, at any time thereafter). The benefits provided in this
Subsection 4.2(b) shall be no less favorable to the Participant, in terms of
amounts and deductibles and costs to him or her, than the coverage provided the
Participant under the plans providing such benefits at the time Notice of
Termination is given. The Company's obligation hereunder to provide the
foregoing benefits shall terminate to the extent the Participant obtains
replacement coverage under a subsequent employer's benefit plans at an equal or
higher level. The Company also shall pay a lump sum equal to the amount of any
additional income tax payable by the Participant and attributable to the
benefits provided under this subparagraph (b) at the time such tax is imposed
upon the Participant;

                                       8


     Number of Months of
     Continued Coverage        Participant Designation
     ------------------        -----------------------
     36 months                 Group III
     24 months                 Group II
     12 months                 Group I

     The amounts provided for in Section 4.2(a) shall be paid or transferred
within thirty (30) days after the Participant's termination of employment (or,
if Section 4.1(b) applies to the termination, then within 30 days after the
Change in Control).

4.3  OPTIONS

     Notwithstanding any provision in the Company's 2000 Stock Option Plan, as
amended, or any other Company Incentive or Non-Qualified Stock Option Plan, or
in this Plan, in the event there is a Change of Control, the Company shall, at
no cost to the Participant, replace any and all stock options granted by the
Company and held by the Participant at the time of the Change of Control,
whether or not vested, with an equal number of unrestricted and fully vested
stock options to purchase shares of the Company's Common Stock (the "Option
Replacement"). With respect to the Option Replacement, all options will become
fully vested.

     Alternatively, in the event of a Change of Control, in lieu of the Option
Replacement, a Participant may elect to surrender the Participant's rights to
such options, and upon such surrender, the Company shall pay to the Participant
an amount in cash per stock option (whether vested or unvested) then held, which
is the difference between the full exercise price of each option surrendered and
the greater of (i) the average price per share paid in connection with the
acquisition of control of the Company if such control was acquired by the
payment of cash or the then fair market value of the consideration paid for such
shares if such control was acquired for consideration other than cash, (ii) the
price per share paid in connection with any tender offer for shares of the
Company's Common Stock leading to control, or (iii) the mean between the high
and low selling price of such stock on the Nasdaq National Market or other
market on which the Company's Common Stock is then traded on the date on which
the Participant entitled to a Severance Benefit.


                       SECTION 5 TERMINATION OF EMPLOYMENT

5.1  WRITTEN NOTICE REQUIRED

     Any purported termination of employment, either by the Company or by the
Participant, shall be communicated by written Notice of Termination to the
other.

                                       9


5.2  TERMINATION DATE

     In the case of the Participant's death, the Participant's Termination Date
shall be his her date of death. In all other cases, the Participant's
Termination Date shall be the date specified in the Notice of Termination
subject to the following:

          (a) If the Participant's employment is terminated by the Company for
Cause or due to Permanent Disability, the date specified in the Notice of
Termination shall be at least thirty (30) days from the date the Notice of
Termination is given to the Participant, provided that in the case of Permanent
Disability the Participant shall not have returned to the full-time performance
of his or her duties during such period of at least thirty (30) days; and

          (b) If the Participant terminates his or her employment for Good
Reason, the date specified in the Notice of Termination shall not be more than
sixty (60) days from the date the Notice of Termination is given to the Company.

                  SECTION 6 ADDITIONAL PAYMENTS BY THE COMPANY

6.1   GROSS-UP PAYMENT

     (a) Other than Severance Benefits due under Section 4.3, hereof, and
subject only to Section 6.1(b) hereof, in the event it shall be determined that
any payment or distribution of any type by the Company or any of its affiliates
to or for the benefit of the Participant, whether paid or payable or distributed
or distributable pursuant to the terms of this Plan or otherwise (the
"Payments"), would be subject to the excise tax imposed by Section 4999 of the
Internal Revenue Code of 1986, as amended (the "Code"), or any interest or
penalties with respect to such excise tax (such excise tax, together with any
such interest and penalties, are collectively referred to as the "Excise Tax"),
then the Participant shall be entitled to receive an additional payment (a
"Gross-Up Payment") in an amount such that after payment by the Participant of
all taxes (including any interest or penalties imposed with respect to such
taxes), including any income taxes, employment taxes and Excise Tax, imposed
upon the Gross-Up Payment, the Participant retains an amount of the Gross-Up
Payment equal to the Excise Tax imposed upon the Payments. Payment of the
Gross-Up Payment shall be made in accordance with Section 6.3.

     (b) Notwithstanding Section 6.1(a), in the event that a reduction to the
Payments in respect of a Participant of 10% or less would cause no Excise Tax to
be payable, the Participant will not be entitled to a Gross-Up Payment and the
Payments shall be reduced (but not below zero) to the extent necessary so that
the Payments shall not be subject to the Excise Tax. Unless the Participant
shall have given prior written notice specifying a different order to the
Company to effectuate the foregoing, the Company shall reduce or eliminate the
Payments, by first reducing or eliminating the portion of the Payments which are
not payable in cash and then by reducing or eliminating cash payments, in each
case in reverse order beginning with payments or benefits which are to be paid


                                       10


the farthest in time from the date of the Change in Control. Any notice given by
the Participant pursuant to the preceding sentence shall take precedence over
the provisions of any other plan, arrangement or agreement governing the
Participant's rights and entitlements to any benefits or compensation.

6.2  DETERMINATION BY ACCOUNTANT

     All determinations required to be made under this Section 6, including
whether a Gross-Up Payment is required and the amount of such Gross-Up Payment,
shall be made by the independent accounting firm retained by the Company on the
date of Change in Control (the "Accounting Firm"), which shall provide detailed
supporting calculations both to the Company and the Participant within 15
business days of the date of termination, if applicable, or such earlier time as
is requested by the Company. If the Accounting Firm determines that no Excise
Tax is payable by the Participant, it shall furnish the Participant with an
opinion that he or she has substantial authority not to report any Excise Tax on
his or her federal income tax return. Any determination by the Accounting Firm
shall be binding upon the Company and the Participant. As a result of the
uncertainty in the application of Section 4999 of the Code at the time of the
initial determination by the Accounting Firm hereunder, it is possible that
Gross-Up payments which will not have been made by the Company should have been
made ("Underpayment"), consistent with the calculations required to be made
hereunder. In the event that the Company exhausts its remedies pursuant to
Section 6.3 and the Participant thereafter is required to make a payment of any
Excise Tax, the Accounting Firm shall determine the amount of the Underpayment
that has occurred and any such Underpayment shall be promptly paid by the
Company to or for the benefit of the Participant.

6.3  NOTIFICATION REQUIRED

     The Participant shall notify the Company in writing of any claim by the
Internal Revenue Service that, if successful, would require the payment by the
Company of the Gross-Up Payment. Such notification shall be given as soon as
practicable but no later than ten (10) business days after the Participant knows
of such claim and shall apprise the Company of the nature of such claim and the
date on which such claim is requested to be paid. The Participant shall not pay
such claim prior to the expiration of the thirty (30) day period following the
date on which it gives such notice to the Company (or such shorter period ending
on the date that any payment of taxes with respect to such claim is due). If the
Company notifies the Participant in writing prior to the expiration of such
period that it desires to contest such claim, the Participant shall:

          (a) give the Company any information reasonably requested by the
     Company relating to such claim,

          (b) take such action in connection with contesting such claim as the
     Company shall reasonably request in writing from time to time, including,
     without limitation, accepting legal representation with respect to such
     claim by an attorney reasonably selected by the Company,

                                       11


          (c) cooperate with the Company in good faith in order to effectively
     contest such claim, and

          (d) permit the Company to participate in any proceedings relating to
     such claim; PROVIDED, HOWEVER, that the Company shall bear and pay directly
     all costs and expenses (including additional interest and penalties)
     incurred in connection with such contest and shall indemnify and hold the
     Participant harmless, on an after-tax basis, for any Excise Tax or income
     tax, including interest and penalties with respect thereto, imposed as a
     result of such representation and payment of costs and expenses. Without
     limitation on the foregoing provisions of this Section 6.3, the Company
     shall control all proceedings taken in connection with such contest and, at
     its sole option, may pursue or forgo any and all administrative appeals,
     proceedings, hearings and conferences with the taxing authority in respect
     of such claim and may, at its sole option, either direct the Participant to
     pay the tax claimed and sue for a refund, or contest the claim in any
     permissible manner, and the Participant agrees to prosecute such contest to
     a determination before any administrative tribunal, in a court of initial
     jurisdiction and in one or more appellate courts, as the Company shall
     determine; PROVIDED, HOWEVER, that if the Company directs the Participant
     to pay such claim and sue for a refund, the Company shall advance the
     amount of such payment to the Participant (unless otherwise prohibited by
     applicable law), on an interest-free basis and shall indemnify and hold the
     Participant harmless, on an after-tax basis, from any Excise Tax or income
     tax, including interest or penalties with respect thereto, imposed with
     respect to such advance or with respect to any imputed income with respect
     to such advance; and PROVIDED, FURTHER, that any extension of the statute
     of limitations relating to payment of taxes for the taxable year of the
     Participant with respect to which such contested amount is claimed to be
     due is limited solely to such contested amount. Furthermore, the Company's
     control of the contest shall be limited to issues with respect to which a
     Gross-Up Payment would be payable hereunder and the Participant shall be
     entitled to settle or contest, as the case may be, any other issue raised
     by the Internal Revenue Service or any other taxing authority.

6.4  REPAYMENT

     If, after the receipt by the Participant of an amount advanced by the
Company pursuant to Section 6.3, the Participant becomes entitled to receive any
refund with respect to such claim, the Participant shall (subject to the
Company's complying with the requirements of Section 6.3) promptly pay to the
Company the amount of such refund (together with any interest paid or credited
thereon after taxes applicable thereto). If, after the receipt by the
Participant of an amount advanced by the Company pursuant to Section 6.3, a
determination is made that the Participant shall not be entitled to any refund
with respect to such claim and the Company does not notify the Participant in
writing of its intent to contest such denial of refund prior to the expiration
of thirty (30) days after such determination, then such advance shall be


                                       12


forgiven and shall not be required to be repaid and the amount of such advance
shall offset, to the extent thereof the amount of Gross-Up Payment required to
be paid.


                         SECTION 7 SUCCESSORS TO COMPANY

7.1  SUCCESSORS

     This Plan shall bind any successor (whether direct or indirect, by
purchase, merger, consolidation or otherwise) to all or substantially all of the
business and/or assets of the Company, in the same manner and to the same extent
that the Company would be obligated under this Plan if no succession had taken
place. In the case of any transaction in which a successor would not by the
foregoing provision or by operation of law be bound by this Plan, the Company
shall require such successor expressly and unconditionally to assume and agree
to perform the Company's obligations under this Plan, in the same manner and to
the same extent that the Company would be required to perform if no such
succession had taken place.

7.2  SALES OF OPERATING COMPANIES

     If a Participant's employment with his or her Employer terminates in
connection with the sale, divestiture or other disposition of the stock or
assets of any Operating Company (or part thereof) (a "Transaction") after the
execution of an agreement providing for a transaction or transactions which, if
consummated, would constitute a Change in Control or after a Change in Control,
such termination shall not be a termination of employment of the Participant for
purposes of the Plan, and (notwithstanding the rights provided to the
Participant by Section 4.1(a)) the Participant shall not be entitled to a
Severance Benefit as a result of such termination of employment if (i) the
Participant is offered continued employment, or continues in employment, with
the divested Operating Company (or part thereof) or the purchaser of the stock
or assets of the Operating Company (or part thereof), as the case may be, or one
of their respective affiliates (the "Post-Transaction Employer") on terms and
conditions that would not constitute Good Reason and (ii) the Company obtains an
agreement from the acquiror of the stock or assets of the divested Operating
Company (or part thereof), enforceable by the Participant, to provide or cause
the Post-Transaction Employer to provide severance pay and benefits, if the
Participant accepts the offered employment or continues in employment with the
Post-Transaction Employer or its affiliates following the Transaction, (A) at
least equal to the Severance Benefit and (B) payable upon a termination of the
Participant's employment with the Post-Transaction Employer and its affiliates
within the period described in Section 4.1(a)(ii) (or such part of it as is then
remaining) for any reason other than Cause, Permanent Disability, the
Participant's death or a termination by the Participant without Good Reason. For
purposes of this Section 7.2, the terms Cause, Good Reason and Permanent
Disability shall have the meanings ascribed to them in Sections 2.4, 2.10 and
2.15 respectively, but the term Employer as it is used in those Sections shall
be deemed to refer to the entity employing the Participant after the
Transaction, the term Company shall mean such employer or, if there is an


                                       13


ultimate parent corporation of such employer, such ultimate parent corporation,
and the terms Board and Chief Executive Officer as used in those Sections shall
be deemed to refer to the individuals or bodies serving those functions for such
employer or, if applicable, such ultimate parent corporation.

                    SECTION 8 AMENDMENT AND PLAN TERMINATION

8.1  AMENDMENT AND TERMINATION

     Prior to a Change in Control, the Plan may be amended or modified in any
respect, and may be terminated, in any such case, by resolution adopted by
two-thirds of the Board; PROVIDED, HOWEVER, that no such amendment, modification
or termination which would adversely affect the benefits or protections
hereunder of any individual who is a Participant as of the date such amendment,
modification or termination is adopted shall be effective as it relates to such
individual unless no Change in Control occurs within one year after such
adoption, any such attempted amendment, modification or termination adopted
within one year prior to a Change in Control being null and void ab initio as it
relates to all such individuals who were Participants prior to such adoption (it
being understood that the removal of Participants from participation in the Plan
shall, for purposes of this proviso, constitute an adverse action for the
Participants so removed); PROVIDED, further, HOWEVER, that the Plan may not be
amended, modified or terminated, (i) at the request of a third party who has
indicated an intention or taken steps to effect a Change in Control and who
effectuates a Change in Control or (ii) otherwise in connection with, or in
anticipation of, a Change in Control which actually occurs, any such attempted
amendment, modification or termination being null and void ab initio. Any action
taken to amend, modify or terminate the Plan which is taken after the execution
of an agreement providing for a transaction or transactions which, if
consummated, would constitute a Change in Control shall conclusively be presumed
to have been taken in connection with a Change in Control. From and after the
occurrence of a Change in Control, the Plan may not be amended or modified in
any manner that would in any way adversely affect the benefits or protections
provided hereunder to any individual who is a Participant in the Plan on the
date the Change in Control occurs.

8.2  FORM OF AMENDMENT

     The form of any amendment or termination of the Plan shall be a written
instrument signed by a duly authorized officer or officers of the Company,
certifying that the amendment or termination has been approved by the Board.

                             SECTION 9 MISCELLANEOUS

9.1  INDEMNIFICATION

     The Company shall pay as they become due all legal fees, costs of
litigation and other expenses incurred in good faith by any Participant as a
result of the Company's refusal or failure to provide the Severance Benefits to
which the Participant becomes entitled under this Agreement, as a result of the


                                       14


Company's contesting the validity, enforceability or interpretation of this
Agreement or the Participant's right to Severance Benefits hereunder. The
Participant shall be conclusively presumed to have acted in good faith unless a
court makes a final determination not otherwise subject to appeal to the
contrary.

9.2  EMPLOYMENT STATUS

     This Plan does not constitute a contract of employment or impose on any
Employer any obligation to retain the Participant as an employee, to change the
status of the Participant's employment as an Executive Officer or an Other
Executive, or to change any employment policies of any Employer. Without
limiting the generality of the immediately preceding sentence, the Employer of a
Participant may terminate the employment of the Participant at any time
following a Change in Control, with or without Cause, subject to Section 5
hereof.

9.3  NO DUTY OF MITIGATION

     The Company acknowledges that it would be very difficult and generally
impracticable to determine a Participant's ability to, or the extent to which a
Participant may, mitigate any damages or injuries the Participant may incur by
reason of the Change of Control. The Company has taken this into account in
adopting this Plan and, accordingly, the Company acknowledges and agrees that no
Participant shall have any duty to mitigate any such damages and that the
Participant shall be entitled to receive all Severance Benefits regardless of
any income which the Participant may receive from other sources following any
Change of Control.

9.4  NO SETOFF

     The Company's obligation to give Severance Benefits to a Participant
pursuant to this Plan and otherwise to perform its obligations hereunder shall
not be affected by any circumstances, including, but not limited to, any setoff,
counterclaim, recoupment, defense or other right which the Company may have
against a Participant.

9.5  BENEFITS UNDER OTHER PLANS

     The benefits that a Participant may be entitled to receive pursuant to
Section 4.2 of this Plan are not intended to be duplicative of any similar
benefits to which the Participant may be entitled from the Company under any
other severance plan, agreement, policy or program maintained by the Company or
any of its Subsidiaries. Accordingly, the benefits to which a Participant is
entitled under Section 4.2 shall be reduced to take account of any other similar
benefits to which the Participant is entitled from the Company; provided,
however, that if the amount of benefits to which the Participant is entitled
under such other severance plan, agreement, policy or program is greater than
the benefits to which the Participant is entitled under Section 4.2 of this


                                       15


Plan, the Participant will be entitled to receive the full amount of the
benefits to which the Participant is entitled under such other plan, agreement,
policy or program.

9.6  VALIDITY AND SEVERABILITY

     The invalidity or unenforceability of any provision of the Plan shall not
affect the validity or enforceability of any other provision of the Plan, which
shall remain in full force and effect, and any prohibition or unenforceability
in any jurisdiction shall not invalidate or render unenforceable such provision
in any other jurisdiction.

9.7  GOVERNING LAW; CHOICE OF FORUM

     The validity, interpretation, construction and performance of the Plan
shall in all respects be governed by the laws of the State of New York. A
Participant shall be entitled to enforce the provisions of this Plan in any
state or federal court located in the State of New York, in addition to any
other appropriate forum.

     IN WITNESS WHEREOF, the Company has caused the Plan to be effective as of
the Effective Date.

                                    FALCONSTOR SOFTWARE, INC.





                                    By:     /s/ Reijane Huai
                                        ----------------------------------------
                                    Title:  Chairman



ATTEST:



By: /s/ Seth R. Horowitz
    -------------------------------

Title:   Corporate Secretary



                                       16

EX-31 4 ex311to10q04637_09302005.htm EX-31.1 sec document




                                                                    Exhibit 31.1



I, ReiJane Huai, Chief Executive Officer of FalconStor  Software,  Inc., certify
that:


     1.   I have  reviewed  this  quarterly  report on Form  10-Q of  FalconStor
          Software, Inc.;

     2.   Based on my  knowledge,  this  report  does  not  contain  any  untrue
          statement  of a  material  fact  or  omit to  state  a  material  fact
          necessary to make the statements  made, in light of the  circumstances
          under which such  statements were made, not misleading with respect to
          the period covered by this quarterly report;

     3.   Based on my knowledge,  the financial statements,  and other financial
          information  included in this report,  fairly  present in all material
          respects the financial condition, results of operations and cash flows
          of the  registrant  as of,  and for,  the  periods  presented  in this
          report;

     4.   The registrant's  other  certifying  officer and I are responsible for
          establishing  and maintaining  disclosure  controls and procedures (as
          defined in Exchange Act Rules  13a-15(e) and  15d-15(e))  and internal
          control  over  financial  reporting  (as defined in Exchange Act Rules
          13a-15(f) and 15d-15(f)) for the registrant and we have:

          a)   designed such disclosure controls and procedures,  or caused such
               disclosure  controls  and  procedures  to be  designed  under our
               supervision,  to ensure that material information relating to the
               registrant,  including  its  consolidated  subsidiaries,  is made
               known to us by others within those entities,  particularly during
               the period in which this report is being prepared;

          b)   designed such  internal  controls over  financial  reporting,  or
               cause such  internal  controls  over  financial  reporting  to be
               designed under our supervision,  to provide reasonable  assurance
               regarding  the   reliability  of  financial   reporting  and  the
               preparation  of financial  statements  for  external  purposes in
               accordance with generally accepted accounting principles;

          c)   evaluated  the  effectiveness  of  the  registrant's   disclosure
               controls  and   procedures  and  presented  in  this  report  our
               conclusions  about the  effectiveness of the disclosure  controls
               and  procedures,  as of the  end of the  period  covered  by this
               report based on such evaluation; and

          d)   disclosed in this report any change in the registrant's  internal
               control  over  financial   reporting  that  occurred  during  the
               registrant's most recent fiscal quarter (the registrant's  fourth
               fiscal  quarter  in  the  case  of an  annual  report)  that  has
               materially  affected,  or  is  reasonably  likely  to  materially
               affect,   the   registrant's   internal  control  over  financial
               reporting; and

     5.   The registrant's other certifying officer and I have disclosed,  based
          on our most recent  evaluation  of  internal  control  over  financial
          reporting,  to the  registrant's  auditors and the audit  committee of
          registrant's  board of directors (or persons performing the equivalent
          functions):

          a)   all  significant  deficiencies  and  material  weaknesses  in the
               design or operation of internal control over financial  reporting
               which are reasonably  likely to adversely affect the registrant's
               ability  to  record,  process,  summarize  and  report  financial
               information; and

          b)   any fraud,  whether or not material,  that involves management or
               other employees who have a significant  role in the  registrant's
               internal control over financial reporting.



Date: November 8, 2005                               /s/  Reijane Huai
                                                     -----------------
                                                     ReiJane Huai
                                                     Chief Executive Officer

EX-31.2 5 ex312to10q04637_09302005.htm sec document





                                                                    Exhibit 31.2



I, James Weber,  Chief Financial Officer of FalconStor  Software,  Inc., certify
that:

     1.   I have  reviewed  this  quarterly  report on Form  10-Q of  FalconStor
          Software, Inc.;

     2.   Based on my  knowledge,  this  report  does  not  contain  any  untrue
          statement  of a  material  fact  or  omit to  state  a  material  fact
          necessary to make the statements  made, in light of the  circumstances
          under which such  statements were made, not misleading with respect to
          the period covered by this quarterly report;

     3.   Based on my knowledge,  the financial statements,  and other financial
          information  included in this report,  fairly  present in all material
          respects the financial condition, results of operations and cash flows
          of the  registrant  as of,  and for,  the  periods  presented  in this
          report;

     4.   The registrant's  other  certifying  officer and I are responsible for
          establishing  and maintaining  disclosure  controls and procedures (as
          defined in Exchange Act Rules  13a-15(e) and  15d-15(e))  and internal
          control  over  financial  reporting  (as defined in Exchange Act Rules
          13a-15(f) and 15d-15(f)) for the registrant and we have:

          a)   designed such disclosure controls and procedures,  or caused such
               disclosure  controls  and  procedures  to be  designed  under our
               supervision,  to ensure that material information relating to the
               registrant,  including  its  consolidated  subsidiaries,  is made
               known to us by others within those entities,  particularly during
               the period in which this report is being prepared;

          b)   designed such  internal  controls over  financial  reporting,  or
               cause such  internal  controls  over  financial  reporting  to be
               designed under our supervision,  to provide reasonable  assurance
               regarding  the   reliability  of  financial   reporting  and  the
               preparation  of financial  statements  for  external  purposes in
               accordance with generally accepted accounting principles;

          c)   evaluated  the  effectiveness  of  the  registrant's   disclosure
               controls  and   procedures  and  presented  in  this  report  our
               conclusions  about the  effectiveness of the disclosure  controls
               and  procedures,  as of the  end of the  period  covered  by this
               report based on such evaluation; and

          d)   disclosed in this report any change in the registrant's  internal
               control  over  financial   reporting  that  occurred  during  the
               registrant's most recent fiscal quarter (the registrant's  fourth
               fiscal  quarter  in  the  case  of an  annual  report)  that  has
               materially  affected,  or  is  reasonably  likely  to  materially
               affect,   the   registrant's   internal  control  over  financial
               reporting; and

     5.   The registrant's other certifying officer and I have disclosed,  based
          on our most recent  evaluation  of  internal  control  over  financial
          reporting,  to the  registrant's  auditors and the audit  committee of
          registrant's  board of directors (or persons performing the equivalent
          functions):

          a)   all  significant  deficiencies  and  material  weaknesses  in the
               design or operation of internal control over financial  reporting
               which are reasonably  likely to adversely affect the registrant's
               ability  to  record,  process,  summarize  and  report  financial
               information; and

          b)   any fraud,  whether or not material,  that involves management or
               other employees who have a significant  role in the  registrant's
               internal control over financial reporting.


Date: November 8, 2005                         /s/  James Weber
                                               ----------------
                                               James Weber
                                               Chief Financial Officer
                                                                                                                                   -

EX-32 6 ex321to10q04637_09302005.htm EX-32.1 sec document





                                                                    Exhibit 32.1





                    CERTIFICATION OF CHIEF EXECUTIVE OFFICER



     Pursuant to Section 906 of the  Sarbanes-Oxley  Act of 2002 (18 U.S.C.  ss.
1350),  the  undersigned,  ReiJane Huai,  Chief Executive  Officer oF FalconStor
Software, Inc., a Delaware Corporation (the "Company"),  does hereby certify, to
his knowledge, that:

     The Quarterly  Report on Form 10-Q for the quarter ended September 30, 2005
of the Company (the "Report")  fully complies with the  requirements of Sections
13(a) and 15(d) of the  Securities  Exchange  Act of 1934,  and the  information
contained in the Report fairly presents, in all material respects, the financial
condition and results of operations of the Company.





                                           /s/  Reijane Huai
                                           ---------------------------
                                           ReiJane Huai
                                           Chief Executive Officer
                                           November 8, 2005

EX-32 7 ex322to10q04637_09302005.htm EX-32.2 sec document




                                                                    Exhibit 32.2



                    CERTIFICATION OF CHIEF FINANCIAL OFFICER



     Pursuant to Section 906 of the  Sarbanes-Oxley  Act of 2002 (18 U.S.C.  ss.
1350),  the  undersigned,  James Weber,  Chief  Financial  Officer oF FalconStor
Software, Inc., a Delaware Corporation (the "Company"),  does hereby certify, to
his knowledge, that:

     The Quarterly  Report on Form 10-Q for the quarter ended September 30, 2005
of the Company (the "Report")  fully complies with the  requirements of Sections
13(a) and 15(d) of the  Securities  Exchange  Act of 1934,  and the  information
contained in the Report fairly presents, in all material respects, the financial
condition and results of operations of the Company.





                                             /s/  James Weber
                                             -----------------------------
                                             James Weber
                                             Chief Financial Officer
                                             November 8, 2005

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