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, NlcgyEiStKi6I7stt7mV76aM3yaT7y6wNKXSHhpT8seArq4I6tkd9LMme2EhlvXf 5otxOi903N6MBYepnrSrGA== 0000921895-06-001743.txt : 20060808 0000921895-06-001743.hdr.sgml : 20060808 20060808164234 ACCESSION NUMBER: 0000921895-06-001743 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060808 DATE AS OF CHANGE: 20060808 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: 061013680 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_06302006.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 June 30, 2006
----------------------

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

COMMISSION FILE NUMBER 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 a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer __ Accelerated Filer X Non-Accelerated Filer
---- ---

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

The number of shares of Common Stock issued and outstanding as of July 25,
2006 was 48,784,380 and 47,984,780, which includes redeemable common shares.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

Page

PART I. Financial Information 3

Item 1. Condensed Consolidated Financial Statements 3

Condensed Consolidated Balance Sheets at June 30, 2006
(unaudited) and December 31, 2005 3

Unaudited Condensed Consolidated Statements of Operations
for the three and six months ended June 30, 2006 and 2005 4

Unaudited Condensed Consolidated Statements of Cash Flows
for the six months ended June 30, 2006 and 2005 5

Notes to the Unaudited Condensed Consolidated
Financial Statements 6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 15

Item 3. Qualitative and Quantitative Disclosures about Market Risk 23

Item 4. Controls and Procedures 23

PART II. Other Information 23

Item 1. Legal Proceedings 23

Item 1A. Risk Factors 24

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 31

Item 4. Submission of Matters to a Vote of Security Holders 32

Item 5. Other Information 32

Item 6. Exhibits 32

PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
June 30, 2006 December 31, 2005
------------- -----------------
Assets (Unaudited)
Current assets:
Cash and cash equivalents ............................................... $ 13,911,480 $ 18,796,973
Marketable securities ................................................... 25,617,872 17,833,683
Accounts receivable, net of allowances of $5,103,602 and
$3,846,882, respectively .............................................. 12,736,058 15,187,408
Prepaid expenses and other current assets ............................... 1,005,426 911,715
------------ ------------

Total current assets .............................................. 53,270,836 52,729,779

Property and equipment, net of accumulated depreciation of
$8,655,019 and $7,150,762, respectively .................................. 5,514,362 5,277,609
Goodwill ................................................................... 3,512,796 3,512,796
Other intangible assets, net ............................................... 247,749 216,864
Other assets ............................................................... 2,295,030 2,236,725
------------ ------------

Total assets ...................................................... $ 64,840,773 $ 63,973,773
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ......................................................... $ 1,136,086 $ 1,152,228
Accrued expenses ......................................................... 4,699,914 4,522,212
Deferred revenue ......................................................... 8,042,134 7,401,018
------------ ------------
Total current liabilities ......................................... 13,878,134 13,075,458

Deferred revenue ........................................................... 3,060,802 2,240,208
------------ ------------

Total liabilities ................................................. 16,938,936 15,315,666

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,
48,757,130 and 48,441,614 shares issued, respectively and 47,957,530
and 47,892,014 shares outstanding, respectively ....................... 48,757 48,442
Additional paid-in capital ............................................... 93,113,793 87,342,747
Accumulated deficit ...................................................... (39,601,010) (34,659,329)
Common stock held in treasury, at cost (799,600 and 549,600 shares,
respectively ) ........................................................ (5,304,502) (3,632,930)
Accumulated other comprehensive loss ..................................... (355,201) (440,823)
------------ ------------

Total stockholders' equity ........................................ 47,901,837 48,658,107
------------ ------------
Total liabilities and stockholders' equity ........................ $ 64,840,773 $ 63,973,773
============ ============

See accompanying notes to unaudited condensed consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Three Months Ended June 30, Six Months Ended June 30,
-------------------------------- ---------------------------------

2006 2005 2006 2005
------------ ------------ ------------ ------------

Revenues:
Software license revenue ................... $ 8,726,021 $ 6,650,442 $ 14,402,710 $ 12,932,951
Maintenance revenue ........................ 2,908,514 1,791,267 5,499,517 3,321,441
Software services and other revenue ........ 1,033,692 1,053,878 1,974,320 1,633,231
------------ ------------ ------------ ------------
12,668,227 9,495,587 21,876,547 17,887,623
------------ ------------ ------------ ------------

Operating expenses:
Amortization of purchased and capitalized
software .............................. 101,333 193,417 253,055 416,000
Cost of maintenance, software services and
other revenue ......................... 2,320,065 1,468,866 4,304,662 2,796,083
Software development costs ............... 4,905,137 2,763,745 9,512,240 5,431,136
Selling and marketing .................... 5,686,742 3,979,124 10,590,747 7,484,343
General and administrative ............... 1,390,140 1,031,285 2,711,434 2,017,311
------------ ------------ ------------ ------------
14,403,417 9,436,437 27,372,138 18,144,873
------------ ------------ ------------ ------------
Operating income (loss) ............. (1,735,190) 59,150 (5,495,591) (257,250)
------------ ------------ ------------ ------------

Interest and other income, (net) ........... 384,009 236,909 670,660 423,495
------------ ------------ ------------ ------------

Income (loss) before income taxes ... (1,351,181) 296,059 (4,824,931) 166,245

Provision (benefit) for income taxes ....... (46,386) 7,954 116,750 11,969
------------ ------------ ------------ ------------

Net income ( loss) .................. $ (1,304,795) $ 288,105 $ (4,941,681) $ 154,276
------------ ------------ ------------ ------------

Basic net income (loss) per share .......... $ (0.03) $ 0.01 $ (0.10) $ 0.00
============ ============ ============ ============
Diluted net income (loss) per share ........ $ (0.03) $ 0.01 $ (0.10) $ 0.00
============ ============ ============ ============
Weighted average basic shares
outstanding .............................. 48,047,291 47,594,072 48,026,914 47,561,653
============ ============ ============ ============
Weighted average diluted shares
outstanding .............................. 48,047,291 50,623,983 48,026,914 50,806,365
============ ============ ============ ============

See accompanying notes to unaudited condensed consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Six Months Ended
June 30,
2006 2005
------------ ------------
Cash flows from operating activities:
Net loss ........................................................ $ (4,941,681) $ 154,276
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation and amortization ............................... 1,828,762 1,708,690
Share-based payment compensation ............................ 4,660,622 --
Non-cash professional services .............................. -- (75,728)
Realized loss on marketable securities ...................... 28,855 22,701
Realized loss on foreign currency exchange .................. 41,670 --
Tax benefit from stock option exercise ...................... (10,467) --
Provision for returns and doubtful accounts ................. 1,917,634 965,196
Changes in operating assets and liabilities:
Accounts receivable ......................................... 538,581 (1,840,715)
Prepaid expenses and other current assets ................... (89,291) (303,600)
Other assets ................................................ (134,275) 24,987
Accounts payable ............................................ (24,756) 162,520
Accrued expenses ............................................ 141,179 (267,424)
Deferred revenue ............................................ 1,483,756 1,510,824
------------ ------------

Net cash provided by operating activities ................. 5,440,589 2,061,727
------------ ------------

Cash flows from investing activities:
Sale of marketable securities ................................... 35,377,326 31,448,900
Purchase of marketable securities ............................... (43,209,250) (31,405,029)
Purchase of property and equipment .............................. (1,703,124) (1,356,820)
Purchase of software licenses ................................... (168,000) --
Purchase of intangible assets ................................... (121,533) (78,258)
------------ ------------

Net cash used in investing activities ......................... (9,824,581) (1,391,207)
------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options ......................... 1,100,272 783,203
Payments to acquire treasury stock .............................. (1,671,572) (1,067,119)
Tax benefit from stock option exercise .......................... 10,467 --
------------ ------------

Net cash used in financing activities ......................... (560,833) (283,916)
------------ ------------

Effect of exchange rate changes on cash and cash equivalents ....... 59,332 (31,969)
------------ ------------

Net increase (decrease) in cash and cash equivalents ............... (4,885,493) 354,635

Cash and cash equivalents, beginning of period ..................... 18,796,973 15,484,573
------------ ------------

Cash and cash equivalents, end of period ........................... $ 13,911,480 $ 15,839,208
============ ============

Cash paid for income taxes $ 25,000 $ 6,294
============ ============

The Company did not pay any interest expense for the six months ended June 30, 2006 and 2005.
See accompanying notes to unaudited condensed consolidated financial statements.

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 preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's significant estimates include those related to
revenue recognition, accounts receivable allowances, deferred income taxes and
accounting for share-based payment compensation. Actual results could differ
from those estimates.

(d) UNAUDITED INTERIM FINANCIAL INFORMATION

The unaudited interim consolidated financial statements of the Company as
of June 30, 2006 and for the three and six months ended June 30, 2006 and 2005,
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 June 30, 2006, and the results of its operations for the three
and six months ended June 30, 2006 and 2005.

(e) 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
$9.4 million and $12.4 million at June 30, 2006 and December 31, 2005,
respectively. Marketable securities at June 30, 2006 and December 31, 2005
amounted to $25.6 million and $17.8 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.

(f) 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 code 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. 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,
based upon historical experience and known or expected trends.

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.

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 June 30, 2006 and 2005, 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 June 30, 2006, the Company had two customers
that together accounted for 32% of revenues and one customer that accounted for
17% of the accounts receivable balance at June 30, 2006.

(g) 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 $767,739 and $579,451 for the three months
ended June 30, 2006 and 2005, respectively, and $1,504,257 and $1,164,580 for
the six months ended June 30, 2006 and 2005, 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.

(h) 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 $45,468 and $65,851 for
the three months ended June 30, 2006 and 2005, respectively, and $90,648 and
$128,110 for the six months ended June 30, 2006 and 2005, respectively. The
gross carrying amount and accumulated amortization of other intangible assets as
of June 30, 2006 and December 31, 2005 are as follows:

June 30, December 31,
2006 2005
--------- ---------
Customer relationships and purchased technology:

Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (216,850) (216,850)
--------- ---------

Net carrying amount $ -- $ --
========= =========

Patents:

Gross carrying amount $ 771,397 $ 649,864
Accumulated amortization (523,648) (433,000)
--------- ---------

Net carrying amount $ 247,749 $ 216,864
========= =========

(i) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY

Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. 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 $287,250 and $372,306, net of accumulated
amortization of $4,899,750 and $4,646,694 is included in other assets in the
balance sheets as of June 30, 2006 and December 31, 2005, respectively.
Amortization expense was $101,333 and $193,417 for the three months ended June
30, 2006 and 2005, respectively and $253,055 and $416,000 for the six months
ended June 30, 2006 and 2005, 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.

(j) 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. The Company provides a full valuation
allowance against its deferred tax assets.

(k) 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.

(l) SHARE-BASED PAYMENTS

Effective January 1, 2006, the Company adopted the provisions of Financial
Accounting Standards Board ("FASB") Statement of Financial Accounting Standards
("SFAS") No. 123(R), SHARE-BASED PAYMENT, which establishes the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services. Under the provisions of SFAS No. 123(R), share-based payment
compensation is measured at the grant date, based on the fair value of the
award, and is recognized as an expense over the requisite employee service
period (generally the vesting period). The Company adopted SFAS No. 123(R) using
the modified prospective method and, as a result, periods prior to January 1,
2006 have not been restated.

(m) FINANCIAL INSTRUMENTS

As of June 30, 2006 and December 31, 2005, 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.

(n) FOREIGN CURRENCY

Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations
within interest and other income, net. Such amounts have historically not been
material.

(o) 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 the net loss for the three and six months ended June 30,
2006, all common stock equivalents were excluded from diluted net loss per share
for the periods. As of June 30, 2006, potentially dilutive common stock
equivalents included 10,935,664 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:

Three Months Ended June 30, 2006 Three Months Ended June 30, 2005
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
Basic EPS $(1,304,795) 48,047,291 $ (0.03) $ 288,105 47,594,072 $ 0.01
========= =========

Effect of dilutive securities:
Stock Options -- 3,029,911

----------- ---------- -------- ----------- ---------- --------
Diluted EPS $(1,304,795) 48,047,291 $ (0.03) $ 288,105 50,623,983 $ 0.01
============ ========== ========= =========== ========== ========

Six Months Ended June 30, 2006 Six Months Ended June 30, 2005
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- ------ ----------- ------------- ------
Basic EPS $(4,941,681) 48,026,914 $ (0.10) $ 154,276 47,561,653 $ 0.00
========= =========
Effect of dilutive securities:
Stock Options - 3,244,712
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $(4,941,681) 48,026,914 $ (0.10) $ 154,276 50,806,365 $ 0.00
============ ========== ========= =========== ========== ========

(p) COMPREHENSIVE INCOME (LOSS)

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

Three Months Ended June 30, Six Months Ended June 30,
2006 2005 2006 2005
---- ---- ---- ----
Net Income (loss) $(1,304,795) $ 288,105 $(4,941,681) $ 154,276
----------- ----------- ----------- -----------

Other comprehensive income (loss):
Foreign currency translation
adjustments 93,063 (16,446) 104,502 (31,969)

Unrealized gains (loss) on investments (29,759) 6,968 (18,880) 13,123
----------- ----------- ----------- -----------

Other comprehensive income (loss) 63,304 (9,478) 85,622 (18,846)
----------- ----------- ----------- -----------

Comprehensive income (loss) $(1,241,491) $ 278,627 $(4,856,059) $ 135,430
=========== =========== =========== ===========

(q) NEW ACCOUNTING PRONOUNCEMENTS

Company's 2007 fiscal year, with the cumulative effect of the change in
accounting principle recorded as an adjustment to opening retained earnings. The
Company is currently evaluating the impact of adopting FIN 48 on the
consolidated financial statements.

(r) RECLASSIFICATIONS

Certain reclassifications have been made to prior years' consolidated
financial statement presentations to conform to the current year's presentation.

(2) SHARE-BASED PAYMENT ARRANGEMENTS

As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000
Stock Option Plan (the "Plan"). The Plan is administered by the Board of
Directors and, as amended, currently provides for the grant of options to
purchase up to 14,162,296 shares of Company common stock to employees,
consultants and non-employee directors. Options may be incentive ("ISO") or
non-qualified. Exercise prices of ISOs granted must be at least equal to the
fair value of the common stock on the date of grant, and have terms not greater
than ten years, except those to an employee who owns stock with greater than 10%
of the voting power of all classes of stock of the Company, in which case they
must have an option price at least 110% of the fair value of the stock, and
expire no later than five years from the date of grant. Exercise prices of
non-qualified options granted must not be less than eighty percent of the fair
value of the common stock on the date of grant, and have terms not greater than
ten years.

The Company granted options to purchase an aggregate of 50,000 shares of
common stock to certain non-employee consultants in exchange for professional
services during 2002. The aggregate fair value of these options as determined
using the fair value method is expensed over the periods the services are
provided. The related expense amounted to $15,818 and $(75,728) for the three
and six months ended June 30, 2005, respectively. These services were completed
as of December 31, 2005.

On May 14, 2004, the Company adopted the 2004 Outside Directors Stock
Option Plan (the "2004 Plan"). The 2004 Plan is administered by the Board of
Directors and provides for the granting of options to non-employee directors of
the Company to purchase up to 300,000 shares of Company common stock. Exercise
prices of the options must be equal to the fair market value of the common stock
on the date of grant. Options granted have terms of ten years. All options
granted under the 2004 Plan must be granted within three years of the adoption
of the 2004 Plan.

On May 17, 2006, the Company adopted the 2006 Incentive Stock Plan (the
"2006 Plan"). The 2006 Plan is administered by the Board of Directors and
provides for the grant of incentive and nonqualified stock options, and
restricted stock, to employees, officers, consultants and advisors of the
Company. A maximum of 1,500,000 of the authorized but unissued or treasury
shares of the common stock of the Company may be issued upon the grant of
restricted or upon the exercise of options granted under the 2006 Plan. Exercise
prices of the options must be equal to the fair market value of the common stock
on the date of grant. Options granted have terms of ten years. All options and
shares of restricted stock granted under the 2006 Plan must be granted within
ten years of the adoption of the 2006 Plan.

The following table summarizes stock option activity during the six months
ended June 30, 2006:

Weighted
Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic
Options Price Life (Years) Value
------------ ------------ ------------- ------------
Outstanding at December 31, 2005 10,200,908 $ 5.22
Granted 284,000 $ 8.93
Exercised (247,888) $ 3.21
Canceled (61,434) $ 8.97
------------ ------------

Outstanding at March 31, 2006 10,175,586 $ 5.35 6.89 $41,918,935
============ ============ ============ ============

Granted 897,400 $ 6.63
Exercised (67,628) $ 4.50
Canceled (69,694) $ 7.43
------------ ------------

Outstanding at June 30, 2006 10,935,664 $ 5.45 6.88 $21,541,580
============ ============ ============ ============

Options exercisable at June 30, 2006 7,336,289 $ 4.52 5.89 $20,517,033
------------ ------------ ------------ ------------

Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended June
30, 2006 and 2005 was $304,157 and $421,253, respectively. The total cash
received from stock option exercises for the six months ended June 30, 2006 and
2005 was $1,100,272 and $783,203. The total intrinsic value of stock options
exercised during the three months ended June 30, 2006 and 2005 was $148,810 and
$235,516 respectively. The total intrinsic value of stock options exercised
during the six months ended June 30, 2006 and 2005 was $1,623,237 and $1,362,752
respectively.

The Company recognized share-based payment compensation for awards issued
under the Company's stock option plans in the following line items in the
consolidated statement of operations:

Three Months Ended Six Months Ended
June 30, June 30,
2006 2006
---- ----

Cost of maintenance software services and other revenue $ 356,159 $ 699,549
Software development costs 1,078,138 2,133,099
Selling and marketing 684,686 1,345,538
General and administrative 277,119 482,436
---------- ----------
$2,396,102 $4,660,622
========== ==========

The Company recognized $10,467 of tax benefits related to share-based
payment compensation during the three and six months ended June 30, 2006.

For periods prior to January 1, 2006, the Company recorded compensation
expense for employee stock options based upon their intrinsic value on the date
of grant pursuant to Accounting Principles Board ("APB") Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Since the exercise price for such

options was equal to the fair market value of the Company's stock at the date of
grant, the stock options had no intrinsic value upon grant and, therefore, no
expense was recorded in the consolidated statements of operations.

Had the compensation cost of the Company's share-based payments been
determined in accordance with SFAS No. 123, the Company's pro forma net income
and net income per share for the three and six months ended June 30, 2005 would
have been:

Three Months Ended Six Months Ended
June 30, June 30,
2005 2005
---- ----

Net Income as reported $ 288,105 $ 154,276

Add share-based payment compensation expense
included in reported net income, net of tax $ - $ -

Deduct total share-based payment compensation
expense determined under fair-value-based method,
net of tax $(2,563,735) $(4,813,325)
----------- -----------

Net loss - pro forma $(2,275,630) $(4,659,049)
=========== ===========

Basic and diluted net income per common share-as
reported $ .01 $ .00

Basic and diluted net loss per common share-pro forma $ (.05) $ (.10)

Under the modified prospective method, SFAS No. 123(R) applies to new
awards and to awards outstanding on the effective date that are subsequently
modified or cancelled. Compensation expense for outstanding awards for which the
requisite service had not been rendered as of December 31, 2005 is recognized
over the remaining service period using the compensation cost calculated for pro
forma disclosure purposes under SFAS No. 123. Prior to the adoption of SFAS No.
123(R), the Company valued graded vesting awards based on the entire award for
purposes of pro forma disclosure. The Company has elected to continue valuing
awards with graded vesting, based on the value of the entire award. The Company
amortizes the fair value of all awards on a straight-line basis over the total
vesting period. Cumulative compensation expense recognized at any date will at
least equal the grant date fair value of the vested portion of the award at that
time.

The Company estimates the fair value of share-based payments using the
Black-Scholes option pricing model. The Company believes that this valuation
technique and the approach utilized to develop the underlying assumptions are
appropriate in estimating the fair value of the Company's share-based payments
granted during the three and six months ended June 30, 2006. Estimates of fair
value are not intended to predict actual future events or the value ultimately
realized by the employees who receive equity awards.

The per share weighted average fair value of share-based payments granted
during the three months ended June 30, 2006 and 2005 was $3.97 and $5.66,
respectively. The per share weighted average fair value of share-based payments
granted during the six months ended June 30, 2006 and 2005 was $4.30 and $7.06,
respectively . In addition to the exercise and grant date prices of the awards,
certain weighted average assumptions that were used to estimate the fair value
of share-based payment grants in the respective periods are listed in the table
below:

Three months ended June 30, Six months ended June 30,

2006 2005 2006 2005
---- ---- ---- ----
Expected dividend yield 0% 0% 0% 0%
Expected volatility 59% 161% 59-60% 161-166%

Risk-free interest rate 4.9-5.1% 3.5% 4.4-5.1% 3.5%
Expected term (years) 6 5 6 5
Discount for post-vesting restrictions N/A N/A N/A N/A

Options granted during fiscal 2006 have exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
a vesting period of three years and an estimated forfeiture rate of 23%. All
options granted through December 31, 2005 had exercise prices equal to the fair
market value of the stock on the date of grant, a contractual term of ten years,
generally a vesting period of three years and an estimated forfeiture rate of
23%.

The Company estimates expected volatility based primarily on historical
daily price changes of the Company's stock and other factors. The risk-free
interest rate is based on the United States ("U.S.") treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued after December 31, 2005 was determined
using the "simplified method" prescribed in SEC Staff Accounting Bulletin
("SAB") No. 107.

At June 30, 2006, total remaining unrecognized compensation cost related to
unvested share-based payment arrangements was $12,152,329. That cost is expected
to be recognized over a weighted average period of 1.6 years.

In September 2003, the Company entered into a worldwide OEM agreement with
a major technology company (the "OEM"), and granted to the OEM warrants to
purchase 750,000 shares of the Company's common stock with an exercise price of
$6.18 per share. A portion of the warrants may vest annually subject to the
OEM's achievement of pre-defined and mutually agreed upon sales objectives over
a three-year period beginning June 1, 2004. If the OEM generates cumulative
revenues to the Company in the mid-eight figure dollar range from reselling the
Company's products then all the warrants granted will vest. Any warrants that do
not vest by the end of the three-year period will expire. If and when it is
probable that all or a portion of the warrants will vest, the then fair value of
the warrants earned will be recorded as a reduction of revenue. Subsequently,
each quarter the Company will apply variable accounting to adjust such amount to
reflect the fair value of the warrants until they vest. As of June 30, 2006, the
Company had not generated any revenues from this OEM and accordingly no warrants
had vested.

(3) 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 six
months ended June 30, 2006 and 2005 and the location of long-lived assets as of
June 30, 2006 and December 31, 2005 are summarized as follows:

Three Months Ended June 30, Six Months Ended June 30,
2006 2005 2006 2005
---- ---- ---- ----

United States $ 8,603,774 $ 6,331,096 $14,898,771 $12,091,889
Asia 2,117,520 1,959,658 3,499,868 3,342,978
Other international 1,946,933 1,204,833 3,477,908 2,452,756
----------- ----------- ----------- -----------

Total revenues $12,668,227 $ 9,495,587 $21,876,547 $17,887,623
=========== =========== =========== ===========

June 30, December 31,
2006 2005
----------- -----------

Long-lived assets:

United States $ 9,679,247 $ 9,716,031
Asia 1,651,861 1,320,865
Other international 238,829 207,098
----------- -----------

Total long-lived assets $11,569,937 $11,243,994
=========== ===========

(4) 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 quarter and six months ended
June 30, 2006, the Company purchased 250,000 shares of its common stock in open
market purchases for a total cost of $1,671,572. As of June 30, 2006, the
Company had repurchased a total of 799,600 shares for $5,304,502.

(5) COMMITMENTS AND CONTINGENCIES

The Company has an operating lease covering its corporate 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
range from 2006 through 2012. The following is a schedule of future minimum
lease payments for all operating leases as of June 30, 2006:

2006................................................. $ 952,209
2007................................................. 1,701,745
2008................................................. 1,296,586
2009................................................. 1,299,920
2010................................................. 1,324,919
Thereafter........................................... 2,044,348
------------
$ 8,619,727
============

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, such matters are not
expected to have a material adverse effect on our financial condition or
operating results.

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

We were pleased with the rebound in our revenues for the second quarter of
2006.

Revenues for the second quarter of 2006 increased 33% to $12.7 million
compared with revenues in the second quarter of 2005. Revenues from both our OEM
partners and our resellers increased from the same period last year. Revenues
for the six months ended June 30, 2006 increased 22% to $21.9 million compared
with $17.9 million for the same period in the prior year.

Revenues increased 38% compared with the first quarter of 2006. We saw
increases in revenues in all three of our geographic areas: North America;
Europe, Middle East and Africa; and Asia Pacific. Revenues increased from both
OEMs and resellers and for each of our software products. As we expected,
revenues from our VirtualTape Library (VTL) software, grew at a higher rate in
the second quarter of 2006 than our other products. However, the difference in
the rate of growth of VTL software as compared to our other software declined
from the previous quarters.

We again had two customers who each accounted for 10% or more of our
revenues in the second quarter of 2006. In the first quarter of 2006, one of
these customers fell below 10% of our revenues after being a 10% customer for
the year 2005. The increase in revenues from this customer during the second
quarter confirmed our analysis that the first quarter decrease was temporary and
was unrelated to any technical or competitive issues with our software products.

During the second quarter we added personnel to our sales and marketing
teams in many areas. These personnel additions included salespeople dedicated to
our channel sales, to PrimeVault and to our SMB/SOHO initiatives. We are also
continuing our review of our channel sales operations to determine whether
structural changes or additional resources will help to contain or to accelerate
the positive momentum. Among other things, we are continuing to look at whether
we have dedicated, and have available, the proper resources to channel sales and
whether the proper initiatives are in place. We still anticipate that we will
need to add resources to our sales and marketing team to realize the full
potential of our existing opportunities, to establish our visibility in the
marketplace, and to generate additional business prospects.

In addition to increased revenues, the other indicators we use to assess
our performance and growth continued to be positive.

Cash flows from operations in the second quarter of 2006 were again
positive. This is the seventh consecutive quarter we have realized positive cash
flows even as we have invested in our business. The amount of cash from
operations was lower than in the first quarter, but this was to be expected
given the lower account receivable balance at the end of the first quarter of
2006 as compared with the fourth quarter of 2005. This lower account receivable
balance was due to the decline in our revenue in the first quarter of 2006
compared with the fourth quarter of 2005. We believe that our ability to fund
our own growth internally bodes well for our long-term success.

Deferred revenue at quarter end increased 10%, compared with the balance at
March 31, 2006, and by 61% 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. Operating
expenses increased by $1.4 million, or 11%, over the previous quarter. Operating
expenses include $2.4 million in share-based payment compensation expense for
the second quarter of 2006, and $2.3 million in share-based payment compensation
expense for the first quarter of 2006, as required by accounting standards that
went into effect on January 1, 2006. The sum of other operating expenses
increased by $1.3 million, or 12%, from the first quarter of 2006. Operating
expenses for the quarter ended June 30, 2006 increased by $5 million from the
second quarter of 2005. Of such increase, $2.4 million was attributable to
share-based payment compensation expense.

Our gross margins increased to 81% for the second quarter from 77% for the
first quarter of 2006. Share-based payment compensation expense was 3% of
revenue for the quarter and 4% of revenue for the first quarter of 2006.

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.

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 JUNE 30, 2006 COMPARED WITH
THE THREE MONTHS ENDED JUNE 30, 2005.

Revenues for the three months ended June 30, 2006 increased 33% to $12.7
million compared with $9.5 million for the three months ended June 30, 2005. Our
operating expenses increased 53% from $9.4 million for the three months ended
June 30, 2005 to $14.4 million for the three months ended June 30, 2006.
Included in our operating expenses for the three months ended June 30, 2006 was
$2.4 million, of share-based payment compensation expense related to the
implementation of SFAS No. 123(R) beginning January 1, 2006. For the three
months ended June 30, 2005, there was no expense related to employee share-based
payment compensation expense. Net loss for the three months ended June 30, 2006
was $1.3 million compared with net income of $0.3 million for the three months
ended June 30, 2005. The increase in revenues was due to an increase in software
license revenue and maintenance revenue partially offset by a decrease in
software services and other revenue. Revenue contribution from our OEM partners
increased in absolute dollars and as a percentage of our total revenue for the
quarter ended June 30, 2006. Revenue from resellers and distributors also
increased in absolute dollars. Expenses increased in all aspects of our business
to support our growth. For the three months ended June 30, 2006, 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 261 employees as of June 30, 2005 to 330 employees as of June 30,
2006.

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 31% from $6.7 million for the three
months ended June 30, 2005 to $8.7 million for the three months ended June 30,
2006. 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 our 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 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 second quarters of 2006 and 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 39% to
$3.9 million for the three months ended June 30, 2006 from $2.8 million for the
three months ended June 30, 2005.

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 $1.8 million for the three months ended June 30, 2005 to
$2.9 million for the three months ended June 30, 2006. Our hardware sales
increased from $0.5 million for the three months ended June 30, 2005 to $0.7
million for the three months ended June 30, 2006. This increase was the result
of an increase in demand from our customers for bundled solutions. The increase
in hardware sales was offset by a decrease in our professional services revenue.
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 June 30, 2006, we had $0.3 million of purchased software licenses,
net of accumulated amortization of $4.9 million, that are being amortized over
three years. For the three months ended June 30, 2006, we recorded $0.1 million
of amortization related to these purchased software licenses. As of June 30,
2005, we had $0.6 million of purchased software licenses, net of accumulated
amortization of $4.3 million, and recorded approximately $0.2 million of
amortization for the three months ended June 30, 2005 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.

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, training and
share-based payment compensation expense associated with the implementation of
SFAS No. 123(R). 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 June 30, 2006
increased by 58% to $2.3 million compared with $1.5 million for the three months
ended June 30, 2005. The increase in cost of maintenance, software services and
other revenue was principally due to $0.4 million of share-based payment
compensation expense. There was no share-based payment compensation expense
included in cost of maintenance, software services and other revenue for the
three months ended June 30, 2005. Additionally, cost of maintenance, software
services and other revenue increased 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 increase in cost of
maintenance, software services and other revenues was also due to an increase in
hardware cost, which was directly related to our increase in hardware sales.
Hardware costs increased from $0.3 million for the three months ended June 30,

2005 to $0.5 million for the three months ended June 30, 2006. 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 June 30, 2006 was $10.2 million or
81% of revenue compared to $7.8 million or 82% of revenue for the three months
ended June 30, 2005. The decrease in gross margin was mainly related to the
share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the three months ended June 30, 2006.
Share-based payment compensation expense was equal to 3% of revenue for the
three months ended June 30, 2006.

SOFTWARE DEVELOPMENT COSTS

Software development costs consist primarily of personnel costs for product
development personnel, share-based payment compensation expense associated with
the implementation of SFAS No. 123(R), and other related costs associated with
the development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased 77% to $4.9 million
for the three months ended June 30, 2006 from $2.8 million for the three months
ended June 30, 2005. The increase in software development costs was primarily
due to $1.1 million of share-based payment compensation expense. There was no
share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the three months ended June 30, 2005.
The increase is also 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
software development process.

SELLING AND MARKETING

Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, share-based payment compensation expense associated
with the implementation of SFAS No. 123(R), 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 43% to $5.7 million for the three months ended June 30, 2006 from $4.0
million for the three months ended June 30, 2005. The increase in selling and
marketing expenses was partially due to $0.7 million of share-based payment
compensation expense. There was no share-based payment compensation expense
included in selling and marketing expenses for the three months ended June 30,
2005. As a result of the increase in our revenues and interest in our software,
our commission expense and travel expenses also increased. In addition, we
continued to hire new sales and sales support personnel and to expand our
worldwide presence to accommodate our anticipated revenue growth. We believe
that to continue to grow sales, our sales and marketing expenses will continue
to increase.

GENERAL AND ADMINISTRATIVE

General and administrative expenses consist primarily of personnel costs of
general and administrative functions, share-based payment compensation expense
associated with the implementation of SFAS No. 123(R), public company related
costs, directors and officers insurance, legal and professional fees, and other
general corporate overhead costs. General and administrative expenses increased
35% to $1.4 million for the three months ended June 30, 2006 from $1.0 million
for the three months ended June 30, 2005. The overall increase in general and
administrative expenses was primarily due to $0.3 million of share-based payment
compensation expense. There was no share-based payment compensation expense
included in general and administrative expenses for the three months ended June
30, 2005. Additionally, 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.

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 to $0.4 million for the three months ended June 30, 2006 compared to
$0.2 million for the three months ended June 30, 2005. This increase is
primarily due to a higher average cash balance and higher interest rates.

INCOME TAXES

For the three months ended June 30, 2006, 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 provision for income taxes for the three months ended June
30, 2006 consist primarily of foreign taxes and U.S. federal alternative minimum
taxes and state minimum taxes that are expected to be incurred (despite our
pre-tax book loss) primarily as a result of the limitations of our ability to
utilize net operating losses and the non-deductibility of certain share-based
payment compensation for income tax purposes that has been recognized for
financial statement purposes.

RESULTS OF OPERATIONS - FOR THE SIX MONTHS ENDED JUNE 30, 2006 COMPARED WITH THE
SIX MONTHS ENDED JUNE 30, 2005.

Revenues for the six months ended June 30, 2006 increased 22% to $21.9
million compared with $17.9 million for the six months ended June 30, 2005. Our
operating expenses increased 51% from $18.1 million for the six months ended
June 30, 2005 to $27.4 million for the six months ended June 30, 2006. Included
in our operating expenses for the six months ended June 30, 2006 was $4.7
million, of share-based payment compensation expense related to the
implementation of SFAS No. 123(R) beginning January 1, 2006. For the six months
ended June 30, 2005, there was no expense related to employee share-based
payment compensation expense. Net loss for the six months ended June 30, 2006
was $4.9 million compared with net income of $0.2 million for the six months
ended June 30, 2005. We experienced an increase in revenue from all lines of
business. Revenue contribution from our OEM partners increased in absolute
dollars and as a percentage of our total revenue for the six months ended June
30, 2006. Revenue from resellers and distributors also increased in absolute
dollars. Expenses increased in all aspects of our business to support our
growth. For the six months ended June 30, 2006, 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 261 employees
as of June 30, 2005 to 330 employees as of June 30, 2006.

REVENUES

SOFTWARE LICENSE REVENUE

Software license revenue increased 11% from $12.9 million for the six
months ended June 30, 2005 to $14.4 million for the six months ended June 30,
2006. 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 our OEM partners increased as a percentage
of total revenue.

MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Maintenance, software services and other revenue increased 51% to $7.5
million for the six months ended June 30, 2006 from $5.0 million for the six
months ended June 30, 2005. 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 $3.3 million for the six months ended
June 30, 2005 to $5.5 million for the six months ended June 30, 2006. Growth in
our professional services sales, which increased by $0.2 million for the six
months ended June 30, 2006 compared with the six months ended June 30, 2005,
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 $0.9 million for the six months
ended June 30, 2005 to $1.1 million for the six months ended June 30, 2006. 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 $0.4
million for the six months ended June 30, 2005, to $0.3 million for the six
months ended June 30, 2006. The decrease in amortization expense was due to some
of the purchased software licenses being fully amortized as of June 30, 2006. We
will continue to evaluate third party software licenses and may make additional
purchases, which would result in an increase in amortization expense.

COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE

Cost of maintenance, software services and other revenues for the six
months ended June 30, 2006 increased by 54% to $4.3 million compared with $2.8
million for the six months ended June 30, 2005. The increase in cost of
maintenance, software services and other revenue was partially due to $0.7
million of share-based payment compensation expense. There was no share-based
payment compensation expense included in cost of maintenance, software services
and other revenue for the six months ended June 30, 2005. Additionally, cost of
maintenance, software services and other revenue increased 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
increase in cost of maintenance, software services and other revenues was also
due to an increase in hardware cost, which was directly related to our increase
in hardware sales. Hardware costs increased from $0.6 million for the six months
ended June 30, 2005 to $0.8 million for the six months ended June 30, 2006. Our
cost of maintenance, software services and other revenue will continue to grow
in absolute dollars as our revenue increases.

Gross profit for the six months ended June 30, 2006 was $17.3 million or
79% of revenue compared to $14.7 million or 82% of revenue for the six months
ended June 30, 2005. The decrease in gross margin was mainly related to the
share-based payment compensation expense included in cost of maintenance,
software services and other revenue for the six months ended June 30, 2006.
Share-based payment compensation expense was equal to 3% of revenue for the six
months ended June 30, 2006.

SOFTWARE DEVELOPMENT COSTS

Software development costs increased 75% to $9.5 million for the six months
ended June 30, 2006 from $5.4 million for the six months ended June 30, 2005.
The increase in software development costs was partially due to $2.1 million of
share-based payment compensation expense. There was no share-based payment
compensation expense included in cost of maintenance, software services and
other revenue for the six months ended June 30, 2005. The increase is also 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 software development
process.

SELLING AND MARKETING

Selling and marketing expenses increased 42% to $10.6 million for the six
months ended June 30, 2006 from $7.5 million for the six months ended June 30,
2005. The increase in selling and marketing expenses was partially due to $1.3
million of share-based payment compensation expense. There was no share-based
payment compensation expense included in selling and marketing expenses for the
six months ended June 30, 2005. As a result of the increase in our revenues and
interest in our software, our commission expense and travel expenses also
increased. In addition, we continued to hire new sales and sales support
personnel and to expand our worldwide presence to accommodate our anticipated
revenue growth.

GENERAL AND ADMINISTRATIVE

General and administrative expenses increased 34% to $2.7 million for the
six months ended June 30, 2006 from $2.0 million for the six months ended June
30, 2005. The overall increase in general and administrative expenses was
primarily due to $0.5 million of share-based payment compensation expense. There
was no share-based payment compensation expense included in general and
administrative expenses for the six months ended June 30, 2005. As a result of
the overall growth of our business, we experienced an increase in general and
administrative expenses related to headcount, insurance, and other general
corporate overhead costs.

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 to $0.7 million for the six months ended June 30, 2006 compared to
$0.4 million for the six months ended June 30, 2005. This increase is primarily
due to a higher average cash balance and higher interest rates.

INCOME TAXES

For the six months ended June 30, 2006, 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 provision for income taxes for the six months ended June 30,
2006 consist primarily of foreign taxes and U.S. federal alternative minimum
taxes and state minimum taxes that are expected to be incurred (despite our
pre-tax book loss) primarily as a result of the limitations of our ability to
utilize net operating losses and the non-deductibility of certain share-based
payment compensation for income tax purposes that has been recognized for
financial statement purposes.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies are those related to revenue recognition,
accounts receivable allowances, deferred income taxes and accounting for
share-based payment compensation.

REVENUE RECOGNITION. 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.

ACCOUNTS RECEIVABLE. 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.

DEFERRED INCOME TAXES. Consistent with the provisions of Statement of
Financial Accounting Standards No. 109, we regularly estimate our ability to
recover deferred income taxes, and report such assets at the amount that is
determined to be more-likely-than-not recoverable. This evaluation considers
several factors, including an estimate of the likelihood of generating
sufficient taxable income in future periods over which temporary differences
reverse, the expected reversal of deferred tax liabilities, past and projected
taxable income, and available tax planning strategies. As of June 30, 2006,
based primarily upon our cumulative losses, a valuation allowance has been
recorded against our deferred tax assets. In the event that evidence becomes
available in the future to indicate that our deferred taxes will likely be
recoverable (e.g., taxable income generated in and projected for future
periods), our estimate of the recoverability of deferred taxes may change,
resulting in a reversal of all or a portion of such valuation allowance.

ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to
Unaudited Condensed Consolidated Financial Statements - Note (1l) SHARE-BASED
PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified
prospective method. Through December 31, 2005, we accounted for our stock option
plans under the intrinsic value method of Accounting Principles Board ("APB")
Opinion No. 25, and as a result no compensation costs had been recognized in our
historical consolidated statements of operations.

We have used and expect to continue to use the Black-Scholes option-pricing
model to compute the estimated fair value of stock-based awards. The
Black-Scholes option pricing model includes assumptions regarding dividend
yields, expected volatility, expected option term and risk-free interest rates.
The assumptions used in computing the fair value of stock-based awards reflect
our best estimates, but involve uncertainties relating to market and other
conditions, many of which are outside of our control. We estimate expected
volatility based primarily on historical daily price changes of our stock and
other factors. Additionally, we estimate forfeiture rates based primarily upon
historical experiences, adjusted when appropriate for known events or expected
trends. If other assumptions or estimates had been used, the share-based payment
compensation expense that was recorded for the three and six months ended June
30, 2006 could have been materially different. Furthermore, if different
assumptions or estimates are used in future periods, share-based payment
compensation expense could be materially impacted in the future. Total
compensation cost related to unvested share-based payment awards not yet
recognized as of June 30, 2006 is $12,152,329. That cost is expected to be
recognized over a weighted average period of 1.6 years.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES-an
interpretation of FASB Statement No. 109 (FIN 48), which prescribes accounting
for and disclosure of uncertainty in tax provisions. This interpretation defines
the criteria that must be met for the benefits of a tax position to be
recognized in the financial statements and the measurement of tax benefits
recognized. The provisions of FIN 48 are effective as of the beginning of the
Company's 2007 fiscal year, with the cumulative effect of the change in
accounting principle recorded as an adjustment to opening retained earnings. The
Company is currently evaluation the impact of adopting FIN 48 on the
consolidated financial statements.

LIQUIDITY AND CAPITAL RESOURCES

Our total cash and cash equivalents and marketable securities balance as of
June 30, 2006 increased by $2.9 million compared to December 31, 2005. Our cash
and cash equivalents totaled $13.9 million and marketable securities totaled
$25.6 million at June 30, 2006. As of June 30, 2005, we had approximately $15.8
million in cash and cash equivalents and $18.4 million in marketable securities.

We continued to invest in our infrastructure to support our long-term
growth during the six months ended June 30, 2006. We made investments in
property and equipment and we increased the number of employees during the
second quarter of 2006. 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 October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 799,600
shares have been repurchased at an aggregate purchase price of $5.3 million.
During the second quarter and for the six months ended June 30, 2006, we
repurchased 250,000 shares at an aggregate purchase price of $1.7 million.

Net cash provided by operating activities totaled $5.4 million for the six
months ended June 30, 2006, compared to $2.1 million for the six months ended
June 30, 2005. Net cash provided by operating activities of $5.4 million was
primarily derived from a decrease in net accounts receivable of $2.5 million, an
increase in deferred revenue of $1.5 million and non-cash charges of $1.8
million for depreciation and amortization and $4.7 million related to
share-based payment compensation expense. These amounts were partially offset by
our net loss of $4.9 million for the six months ended June 30, 2006. The cash
provided by operating activities for the six months ended June 30, 2005 was
mainly comprised of our net income of $0.2 million, an increase in deferred
revenue of $1.5 million and non-cash charges of $1.6 million. These amounts were
partially offset by net increases in accounts receivable, prepaid expenses and
other current assets and accrued expenses.

Net cash used in investing activities was $9.8 million for the six months
ended June 30, 2006, due primarily to net purchases of marketable securities of
$7.8 million, purchases of property and equipment of $1.7 million and purchases
of software licenses and intangible assets of $0.3 million. Net cash used in
investing activities was $1.4 million for the six months ended June 30, 2005,
due primarily to purchase of property and equipment of $1.4 million.

Net cash used in financing activities was $0.6 million for the six months
ended June 30, 2006. We received proceeds from the exercise of stock options of
$1.1 million and we made payments of $1.7 million for the six months ended June
30, 2006 to acquire treasury stock. Net cash used in financing activities was
$0.3 million for the six months ended June 30, 2005. This amount was primarily
related to payments to acquire treasury stock of $1.1 million partially offset
by proceeds from the exercise of stock options of $0.8 million.

We currently do not have any debt and our only material cash commitments
are related to our office leases. We have an operating lease covering our
corporate 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 2006 through 2012. Refer to Note 5 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.

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 June 30, 2006, 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 June 30, 2006, 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 June 30, 2006, 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.

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 1A. RISK FACTORS

We are affected by risks specific to us as well as factors that affect
all businesses operating in a global market. The significant factors known to us
that could materially adversely affect our business, financial condition, or
operating results are set forth below, whether or not there has been a material
change in any Risk Factor.

DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET AND OUR RELIANCE ON OUR PARTNERS, 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, the degrees of effort and success of our partners'
sales and marketing efforts, and other factors that are beyond our control,
reduce 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.

THE MARKET 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 DISK-BASED BACKUP SOLUTIONS IS STILL MATURING, AND OUR BUSINESS
WILL SUFFER IF IT DOES NOT CONTINUE TO DEVELOP AS WE EXPECT.

The continued adoption of disk-based backup solutions, such as our
VirtualTape Library software, is critical to our future success. The market for
disk-based backup solutions is still maturing, making it difficult to predict
its potential size or future growth rate. If this market develops 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 important
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. 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 AND SMALL OFFICE/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.

THE MARKET FOR OUR PRIMEVAULT(SM) SERVICES IS COMPETITIVE AND IT IS UNCERTAIN
WHETHER WE WILL ATTRACT ENOUGH CUSTOMERS TO PROVIDE AN ADEQUATE RETURN ON
INVESTMENT.

We have begun to make investments in infrastructure and in operating,
sales and marketing personnel for our PrimeVault disaster recovery, data backup,
managed storage, and VTL replication services. The market for these services is
competitive with a number of vendors offering similar services. Despite what we
believe are competitive advantages offered by our PrimeVault services based on
our proprietary IPStor and VTL families of software, there can be no assurance

that we will be able to attract enough customers, or earn enough revenues, to
cover our investment in PrimeVault services or to provide an adequate return on
that investment.

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.

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 storage 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 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 infrastructures. 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 could result in 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.

Our other products may also contain errors or defects. If we are unable
to fix the errors or other problems that may be discovered, 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 or VTL
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 typically
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 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.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A PORTION OF OUR RECEIVABLES ARE
CONCENTRATED WITH TWO CUSTOMERS.

We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. For the quarter ended June 30, 2006, we had
two customers who together accounted for 32% of our revenues. While we believe
that we will continue to receive revenue from these clients, our agreements do
not have any minimum sales requirements and we cannot guarantee continued
revenue. If our contracts with either of these customers are terminated, or if
the volume of sales from these customer significantly declines, it would have a
material adverse effect on our operating results.

In addition, as of June 30, 2006, one customer accounted for a total of
17% of our outstanding receivables. While we currently have no reason to
question the collectibility of this receivable, a business failure or
reorganization by this customer could harm our ability to collect this
receivable and could 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
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.

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

As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.

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, companies with whom we have OEM relationships have been
acquired by other companies. These acquisitions caused disruptions in the sales
and marketing of our products and in 2005, acquisitions of two of our OEM
partners had an impact on our revenues. If additional OEM customers are
acquired, the new parents 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.

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.

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.

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;

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
June 30, 2006, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $5.66 and $9.78. 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 network storage 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 ABILITY TO FORECAST EARNINGS IS LIMITED BY THE IMPACT OF ACCOUNTING REQUIREMENTS.

The Financial Accounting Standards Board requires companies to recognize
the fair value of stock options and other share-based payment compensation to
employees as compensation expense in the statement of operations. However, this
expense, which, in accordance with accounting standards, we calculate based on
the "Black-Scholes" model, is subject to factors beyond our control. These
factors include the market price of our stock on a particular day and stock
price "volatility." In addition, we do not know how many options our employees
will exercise in any future period. These unkowns make it difficult for us to
forecast accurately what the stock option and equity-based compensation expense
will be in the future. Because we are unable to make accurate expense forecasts,
our ability to make accurate forecasts of future earnings is compromised.

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

Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Further, we have entered into change of
control agreements with certain executives, which may also have the effect of
delaying, deterring or preventing a change in control.

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 June 30, 2006, we had outstanding options and warrants to purchase
an aggregate of 11,685,664 shares of our common stock at a weighted average
exercise price of $5.49 per share. We also have 1,543,958 shares of our common
stock reserved for issuance under our stock plans with respect to options (or
restricted stock) 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 our headquarters facilities
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.

Any interruption in power supply or telecommunications would be
particularly disruptive to our PrimeVault backup and disaster recovery
operations. If PrimeVault customers are unable to access their data, confidence
in our ability to provide disaster recovery and backup services will be damaged
which will impair our ability to retain existing customers, to gain new
customers and to expand our operations.

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.

UNITED STATES GOVERNMENT EXPORT RESTRICTIONS COULD IMPEDE OUR ABILITY TO SELL
OUR SOFTWARE TO CERTAIN END USERS.

Certain of our products include the ability for the end user to encrypt
data. The United States, through the Bureau of Industry Security, places
restrictions on the export of certain encryption technology. These restrictions
may include: the requirement to have a license to export the technology; the
requirement to have software licenses approved before export is allowed; and
outright bans on the licensing of certain encryption technology to particular
end users or to all end users in a particular country. Certain of our products
are subject to various levels of export restrictions. These export restrictions
could negatively impact our business.

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 three
patents issued, 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.

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 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 2. UNREGISTERED SALES OF EQUITY PROCEEDS AND USE OF PROCEEDS

Shares of common stock repurchased during the quarter ended June 30, 2006:

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

May, 2006 171,300 $ 6.72 171,300 1,279,100

June, 2006 78,700 $ 6.61 78,700 1,200,400

Total 250,000 $ 6.69 250,000 1,200,400

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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its annual meeting of stockholders on May 17, 2006. 45,752,610
shares of Common Stock, 95% of the outstanding shares, were represented in
person or by proxy.

Steven L. Bock was elected to serve as a director of the Company for a term
expiring in 2009 with 45,661,743 shares voted in favor, 90,867 shares withheld
and 0 broker non-votes.

Patrick B. Carney was elected to serve as a director of the Company for a term
expiring in 2009 with 45,459,840 shares voted in favor, 292,770 shares withheld
and 0 broker non-votes.

The FalconStor Software, Inc., 2006 Incentive Stock Plan was approved with
27,204,416 shares voted in favor, 2,354,198 shares voted against, 51,465 shares
abstained, and 16,142,531 broker non-votes.

The selection of KPMG LLP as the independent registered public accounting firm
for the Company was ratified with 45,683,900 shares voted in favor, 50,148
shares voted against, 18,562 shares abstained and 0 broker non-votes.

ITEM 5. OTHER INFORMATION

On August 7, 2006, the Compensation Committee of the Company's Board of
Directors established an incentive compensation program for certain officers
including the Chief Financial Officer, the Vice President of Business
Development and the Vice President of Business Solutions. These officers are
eligible to earn a quarterly bonus, which amounts shall be determined by the
Company's Chief Executive Officer based on individual performance. The maximum
annual payout under this program is 35% of base salary per officer.

ITEM 6. EXHIBITS

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)

99.1 FalconStor Software, Inc., 2006 Incentive Stock Plan

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)

August 8, 2006

EX-31.1 2 ex311to10q04637_06302006.htm 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
              caused 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 the
          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:    August 8, 2006                            /s/  ReiJane Huai
                                                        ------------------------
                                                        ReiJane Huai
                                                        Chief Executive Officer

EX-31.2 3 ex312to10q04637_06302006.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
              caused 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 the
          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:    August 8, 2006                                 /s/  James Weber
                                                        ------------------------
                                                        James Weber
                                                        Chief Financial Officer

EX-32.1 4 ex321to10q04637_06302006.htm 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 June 30, 2006
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
                                                        August 8, 2006

EX-32.2 5 ex322to10q04637_06302006.htm 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 June 30, 2006
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
                                                        August 8, 2006

EX-99.1 6 ex991to10q04637_06302006.htm sec document



                                                                    Exhibit 99.1

                            FALCONSTOR SOFTWARE, INC.

                            2006 INCENTIVE STOCK PLAN

         1.    PURPOSE OF THE PLAN.

     This 2006 Incentive Stock Plan (the "Plan") is intended as an incentive, to
retain in the employ of and as directors,  officers,  consultants,  advisors and
employees to FalconStor Software,  Inc., a Delaware corporation (the "Company"),
and any  Subsidiary of the Company,  within the meaning of Section 424(f) of the
United States Internal Revenue Code of 1986, as amended (the "Code"), persons of
training,   experience  and  ability,   to  attract  new  directors,   officers,
consultants,  advisors and employees whose services are considered valuable,  to
encourage the sense of  proprietorship  and to stimulate the active  interest of
such persons in the  development  and  financial  success of the Company and its
Subsidiaries.

     It is further  intended that certain options  granted  pursuant to the Plan
shall  constitute  incentive  stock options within the meaning of Section 422 of
the Code (the "Incentive  Options") while certain other options granted pursuant
to the Plan shall be nonqualified  stock options (the  "Nonqualified  Options").
Incentive  Options  and  Nonqualified   Options  are  hereinafter   referred  to
collectively as "Options."

     The  Company  intends  that the Plan meet the  requirements  of Rule  16b-3
("Rule 16b-3") promulgated under the Securities Exchange Act of 1934, as amended
(the  "Exchange   Act")  and  that   transactions   of  the  type  specified  in
subparagraphs  (c) to (f)  inclusive of Rule 16b-3 by officers and  directors of
the Company  pursuant to the Plan will be exempt from the  operation  of Section
16(b)  of the  Exchange  Act.  Further,  the Plan is  intended  to  satisfy  the
performance-based  compensation exception to the limitation on the Company's tax
deductions  imposed by Section  162(m) of the Code with respect to those Options
for which qualification for such exception is intended. In all cases, the terms,
provisions,  conditions  and  limitations  of the Plan  shall be  construed  and
interpreted consistent with the Company's intent as stated in this Section 1.

         2.    ADMINISTRATION OF THE PLAN.

     The Board of  Directors  of the Company  (the  "Board")  shall  appoint and
maintain as administrator of the Plan a Committee (the  "Committee")  consisting
of two or more  directors  who are  "Non-Employee  Directors"  (as such  term is
defined  in Rule  16b-3)  and  "Outside  Directors"  (as such term is defined in
Section 162(m) of the Code), which shall serve at the pleasure of the Board. The
Committee,  subject  to  Sections  3, 5 and 6 hereof,  shall have full power and
authority to designate  recipients of Options and restricted stock  ("Restricted
Stock") and to determine the terms and conditions of the  respective  Option and
Restricted Stock  agreements  (which need not be identical) and to interpret the



provisions and supervise the  administration  of the Plan.  The Committee  shall
have the authority, without limitation, to designate which Options granted under
the Plan shall be Incentive Options and which shall be Nonqualified  Options. To
the  extent  any  Option  does not  qualify  as an  Incentive  Option,  it shall
constitute a separate Nonqualified Option.

     Subject to the  provisions of the Plan, the Committee  shall  interpret the
Plan and all Options and  Restricted  Stock granted  under the Plan,  shall make
such  rules as it deems  necessary  for the proper  administration  of the Plan,
shall  make  all  other   determinations   necessary   or   advisable   for  the
administration  of the Plan and shall correct any defects or supply any omission
or reconcile any inconsistency in the Plan or in any Options or Restricted Stock
granted under the Plan in the manner and to the extent that the Committee  deems
desirable to carry into effect the Plan or any Options or Restricted  Stock. The
act  or  determination  of a  majority  of the  Committee  shall  be the  act or
determination of the Committee and any decision reduced to writing and signed by
all of the members of the Committee  shall be fully  effective as if it had been
made by a majority  at a meeting  duly held.  Subject to the  provisions  of the
Plan, any action taken or determination  made by the Committee  pursuant to this
and the other Sections of the Plan shall be conclusive on all parties.

     In the event that for any reason the  Committee  is unable to act or if the
Committee at the time of any grant,  award or other  acquisition  under the Plan
does not consist of two or more Non-Employee  Directors, or if there shall be no
such Committee, then the Plan shall be administered by the Board, and references
herein to the Committee (except in the proviso to this sentence) shall be deemed
to be references to the Board,  and any such grant,  award or other  acquisition
may be approved or ratified in any other manner contemplated by subparagraph (d)
of Rule 16b-3;  provided,  however, that grants to the Company's Chief Executive
Officer or to any of the Company's other four most highly  compensated  officers
that are intended to qualify as  performance-based  compensation  under  Section
162(m) of the Code may only be granted by the Committee.

         3.    DESIGNATION OF OPTIONEES AND GRANTEES.

     Restricted   Stock  (the  "Grantees"  and  together  with  Optionees,   the
"Participants")  shall include directors,  officers and employees of the Company
or any  subsidiary  and  consultants  subject to their  meeting the  eligibility
requirements  of Rule 701  promulgated  under  the  Securities  Act of 1933,  as
amended (the  "Securities  Act"),  provided that  Incentive  Options may only be
granted  to  employees  of  the  Company  and  any   Subsidiary.   In  selecting
Participants,  and in  determining  the  number of shares to be  covered by each
Option or shares of Restricted Stock granted to Participants,  the Committee may
consider any factors it deems relevant, including without limitation, the office
or position held by the  Participant or the  Participant's  relationship  to the
Company,  the Participant's degree of responsibility for and contribution to the
growth and success of the Company or any Subsidiary, the Participant's length of
service,  promotions and potential. A Participant who has been granted an Option
or Restricted Stock hereunder may be granted an additional Option or Options, or
Restricted Stock if the Committee shall so determine.

                                       2



         4.    STOCK RESERVED FOR THE PLAN.

     Subject to adjustment as provided in Section 8 hereof, a total of 1,500,000
shares of the Company's  Common Stock, par value $0.001 per share (the "Stock"),
shall be subject to the Plan.  The maximum number of shares of Stock that may be
subject to Options granted under the Plan to any individual in any calendar year
shall not exceed fifteen  percent (15%) of the shares and the method of counting
such shares shall conform to any  requirements  applicable to  performance-based
compensation   under   Section   162(m)  of  the  Code,  if   qualification   as
performance-based compensation under Section 162(m) of the Code is intended. The
shares of Stock subject to the Plan shall consist of unissued  shares,  treasury
shares or previously  issued shares held by any  Subsidiary of the Company,  and
such amount of shares of Stock shall be and is hereby reserved for such purpose.
Any of such shares of Stock that may remain unissued and that are not subject to
outstanding  Options at the  termination  of the Plan shall cease to be reserved
for the  purposes  of the Plan,  but until  termination  of the Plan the Company
shall at all times  reserve a  sufficient  number of shares of Stock to meet the
requirements of the Plan.  Should any Option or share of Restricted Stock expire
or be canceled  prior to its exercise or vesting in full or should the number of
shares of Stock to be  delivered  upon the  exercise  or  vesting  in full of an
Option or share of  Restricted  Stock be reduced for any  reason,  the shares of
Stock  theretofore  subject to such Option or share of  Restricted  Stock may be
subject to future Options or shares of Restricted  Stock under the Plan,  except
where such reissuance is  inconsistent  with the provisions of Section 162(m) of
the Code where  qualification as  performance-based  compensation  under Section
162(m) of the Code is intended.

         5.    TERMS AND CONDITIONS OF OPTIONS.

     Options granted under the Plan shall be subject to the following conditions
and shall contain such additional terms and conditions,  not  inconsistent  with
the terms of the Plan, as the Committee shall deem desirable:

               (a)  OPTION  PRICE.  The  purchase  price of each  share of Stock
purchasable  under an Incentive  Option shall be  determined by the Committee at
the time of grant,  but shall not be less than 100% of the Fair Market Value (as
defined  below)  of such  share of Stock on the  date  the  Option  is  granted;
provided,  however,  that with  respect  to an  Optionee  who,  at the time such
Incentive  Option is granted,  owns (within the meaning of Section 424(d) of the
Code) more than 10% of the total  combined  voting power of all classes of stock
of the Company or of any Subsidiary, the purchase price per share of Stock shall
be at least  110% of the Fair  Market  Value  per  share of Stock on the date of
grant.  The  purchase  price  of  each  share  of  Stock   purchasable  under  a
Nonqualified Option shall not be less than 100% of the Fair Market Value of such
share of Stock on the date the Option is granted.  The  exercise  price for each
Option  shall be subject to  adjustment  as provided  in Section 8 below.  "Fair
Market  Value"  means the  closing  price on the date of grant on the  principal
securities  exchange on which shares of Stock are listed (if the shares of Stock
are so  listed),  or on the  NASDAQ  Stock  Market  (if the  shares of Stock are
regularly quoted on the NASDAQ Stock Market),  or, if not so listed or regularly
quoted,  the mean  between the closing bid and asked  prices of publicly  traded
shares of Stock in the over the counter market, or, if such bid and asked prices


                                       3


shall not be  available,  as reported  by any  nationally  recognized  quotation
service  selected by the Company,  or as determined by the Committee in a manner
consistent with the provisions of the Code. Anything in this Section 5(a) to the
contrary  notwithstanding,  in no event shall the  purchase  price of a share of
Stock be less than the minimum price  permitted  under the rules and policies of
any national securities exchange on which the shares of Stock are listed.

               (b) OPTION  TERM.  The term of each Option  shall be fixed by the
Committee, but no Option shall be exercisable more than ten years after the date
such  Option is granted  and in the case of an  Incentive  Option  granted to an
Optionee  who, at the time such  Incentive  Option is granted,  owns (within the
meaning  of  Section  424(d)  of the Code)  more than 10% of the total  combined
voting  power of all  classes of stock of the Company or of any  Subsidiary,  no
such Incentive  Option shall be exercisable  more than five years after the date
such Incentive Option is granted.

               (c) EXERCISABILITY. Subject to Section 5(j) hereof, Options shall
be exercisable at such time or times and subject to such terms and conditions as
shall be determined by the  Committee at the time of grant;  provided,  however,
that in the absence of any Option vesting periods designated by the Committee at
the time of grant,  Options shall vest and become exercisable as to one-third of
the total  amount of shares  subject to the Option on each of the first,  second
and third  anniversaries  of the date of grant;  and  provided  further  that no
Options shall be exercisable until such time as any vesting limitation  required
by Section 16 of the Exchange Act, and related rules, shall be satisfied if such
limitation  shall be required for continued  validity of the exemption  provided
under Rule 16b-3(d)(3).

     Notwithstanding  any provision in this Plan, in the event there is a Change
of Control (as defined below), 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, subject to Board approval at the time, 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 of the Change of Control.

     For  purposes  of the  Plan,  a Change in  Control  shall be deemed to have
occurred if:


                                       4


                    (i) 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
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);

                    (ii) 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

                    (iii) The consummation of:

                         (a) 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:

                              (i) 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


                                       5


                    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;

                              (ii)  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

                              (iii) 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 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;

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

               (c) 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.

                                       6


               (d) METHOD OF  EXERCISE.  Options to the extent then  exercisable
may be  exercised in whole or in part at any time during the option  period,  by
giving written notice to the Company specifying the number of shares of Stock to
be purchased,  accompanied by payment in full of the purchase price, in cash, or
by check or such other  instrument  as may be acceptable  to the  Committee.  As
determined by the Committee, in its sole discretion,  at or after grant, payment
in full or in part may be made at the  election of the  Optionee (i) in the form
of Stock  owned by the  Optionee  (based on the Fair  Market  Value of the Stock
which is not the subject of any pledge or security interest, (ii) in the form of
shares of Stock withheld by the Company from the shares of Stock otherwise to be
received with such withheld  shares of Stock having a Fair Market Value equal to
the exercise  price of the Option,  or (iii) by a combination  of the foregoing,
such Fair Market  Value  determined  by  applying  the  principles  set forth in
Section 5(a),  provided that the combined value of all cash and cash equivalents
and the Fair Market Value of any shares  surrendered  to the Company is at least
equal to such exercise price and except with respect to (ii) above,  such method
of payment will not cause a disqualifying disposition of all or a portion of the
Stock  received  upon  exercise  of an  Incentive  Option.  Notwithstanding  the
forgoing,  an  Optionee  may not take any  actions  that are  prohibited  by the
Sarbanes-Oxley  Act of 2002 and the rules  and  regulations  promulgated  by the
Securities and Exchange  Commission or any agency thereunder.  An Optionee shall
have the right to dividends  and other rights of a  stockholder  with respect to
shares  of Stock  purchased  upon  exercise  of an  Option  at such  time as the
Optionee (i) has given written  notice of exercise and has paid in full for such
shares,  and (ii) has  satisfied  such  conditions  that may be  imposed  by the
Company with respect to the withholding of taxes.

               (e) NON-TRANSFERABILITY OF OPTIONS.  Options are not transferable
and may be  exercised  solely by the  Optionee  during his lifetime or after his
death by the person or persons  entitled  thereto  under his will or the laws of
descent and distribution.  The Committee,  in its sole discretion,  may permit a
transfer  of a  Nonqualified  Option  to (i) a  trust  for  the  benefit  of the
Optionee,  (ii) a member of the Optionee's  immediate family (or a trust for his
or her benefit) or (iii) pursuant to a domestic  relations order. Any attempt to
transfer,  assign,  pledge or otherwise  dispose of, or to subject to execution,
attachment or similar  process,  any Option  contrary to the  provisions  hereof
shall  be void  and  ineffective  and  shall  give  no  right  to the  purported
transferee.

               (f)  TERMINATION  BY DEATH.  Unless  otherwise  determined by the
Committee,  if any Optionee's  employment  with or service to the Company or any
Subsidiary  terminates  by  reason  of  death,  the  Option  may  thereafter  be
exercised,  to the extent then exercisable (or on such accelerated  basis as the
Committee shall determine at or after grant), by the legal representative of the
estate or by the legatee of the Optionee  under the will of the Optionee,  for a
period of one (1) year after the date of such death (or, if later,  such time as
the Option may be  exercised  pursuant  to  Section  14(d)  hereof) or until the
expiration  of the  stated  term of such  Option  as  provided  under  the Plan,
whichever period is shorter.

               (g)  TERMINATION  BY  REASON  OF  DISABILITY.   Unless  otherwise
determined by the Committee, if any Optionee's employment with or service to the
Company  or  any  Subsidiary   terminates  by  reason  of  total  and  permanent
disability, any Option held by such Optionee may thereafter be exercised, to the
extent it was  exercisable at the time of  termination  due to disability (or on


                                       7


such accelerated basis as the Committee shall determine at or after grant),  but
may not be exercised  after three (3) months after the date of such  termination
of employment or service (or, if later, such time as the Option may be exercised
pursuant to Section 14(d)  hereof) or the  expiration of the stated term of such
Option,  whichever period is shorter;  PROVIDED,  HOWEVER, that, if the Optionee
dies within such three (3) month  period,  any  unexercised  Option held by such
Optionee  shall  thereafter  be  exercisable  to  the  extent  to  which  it was
exercisable  at the time of death for a period of one (1) year after the date of
such death (or, if later,  such time as the Option may be exercised  pursuant to
Section 14(d) hereof) or for the stated term of such Option, whichever period is
shorter.

                  (h)  TERMINATION  BY REASON OF  RETIREMENT.  Unless  otherwise
determined by the Committee, if any Optionee's employment with or service to the
Company or any Subsidiary terminates by reason of Normal or Early Retirement (as
such terms are defined  below),  any Option held by such Optionee may thereafter
be exercised to the extent it was exercisable at the time of such Retirement (or
on such  accelerated  basis as the Committee shall determine at or after grant),
but  may  not be  exercised  after  three  (3)  months  after  the  date of such
termination of employment or service (or, if later,  such time as the Option may
be exercised  pursuant to Section 14(d) hereof) or the  expiration of the stated
term of such Option, whichever date is earlier; provided,  however, that, if the
Optionee dies within such three (3) month period, any unexercised Option held by
such Optionee  shall  thereafter be  exercisable,  to the extent to which it was
exercisable at the time of death, for a period of one (1) year after the date of
such death (or, if later,  such time as the Option may be exercised  pursuant to
Section 14(d) hereof) or for the stated term of such Option, whichever period is
shorter.

     For  purposes  of  this  paragraph  (h),  "Normal  Retirement"  shall  mean
retirement from active employment with the Company or any Subsidiary on or after
the normal  retirement  date specified in the  applicable  Company or Subsidiary
pension plan or if no such pension plan,  age 65, and "Early  Retirement"  shall
mean  retirement  from  active  employment  with the  Company or any  Subsidiary
pursuant  to the  early  retirement  provisions  of the  applicable  Company  or
Subsidiary pension plan or if no such pension plan, age 55.

               (i)  OTHER  TERMINATION.   Unless  otherwise  determined  by  the
Committee  upon  grant,  if any  Optionee's  employment  with or  service to the
Company or any Subsidiary terminates for any reason other than death, disability
or Normal or Early Retirement, the Option shall thereupon terminate, except that
the portion of any Option that was  exercisable on the date of such  termination
of  employment  or service may be  exercised  for the lesser of thirty (30) days
after  the date of  termination  or the  balance  of such  Option's  term if the
Optionee's employment or service with the Company or any Subsidiary or Affiliate
is terminated by the Company or such Subsidiary without cause (the determination
as to  whether  termination  was for  cause  to be made by the  Committee).  The
transfer  of an  Optionee  from the employ of or  service to the  Company to the
employ of or service to a Subsidiary,  or vice versa,  or from one Subsidiary to
another,  shall not be deemed to  constitute  a  termination  of  employment  or
service for purposes of the Plan.

               (j) LIMIT ON VALUE OF INCENTIVE OPTION. The aggregate Fair Market
Value,  determined as of the date the Incentive Option is granted,  of Stock for


                                       8


which  Incentive  Options  are  exercisable  for the first time by any  Optionee
during any calendar  year under the Plan (and/or any other stock option plans of
the Company or any Subsidiary) shall not exceed $100,000.

               (k) GRANTS TO FOREIGN  EMPLOYEES.  The terms of grants to foreign
employees  may vary from the terms of this  Section  5  provided  that the terms
shall only be more restrictive than any term in this Section 5.

               (l) DIVIDEND  EQUIVALENTS.  Simultaneously  with the grant of any
Option and under such terms and  conditions as the Committee  deems  appropriate
and  subject to Section 12 herein,  the  Committee  may grant  special  dividend
equivalent rights ("Dividend  Equivalents")  which amount shall be determined by
multiplying  the number of shares of Stock subject to an Option by the per-share
cash  dividend,  or the  per-share  fair  market  value  (as  determined  by the
Committee) of any dividend in consideration other than cash, paid by the Company
on its Stock on a dividend  payment date (other than the regular  quarterly cash
dividends of the  Company).  Unless  otherwise  determined  by the  Committee at
grant,  the Dividend  Equivalents (i) shall have the same vesting  schedule,  if
any, as the Options to which the Dividend  Equivalents  relate and (ii) shall be
payable upon exercise of the Options to which the Dividend  Equivalents  relate.
At the discretion of the Committee,  Dividend  Equivalents  shall be credited to
accounts on the Company's records for purposes of the Plan. Dividend Equivalents
may be accrued as a cash obligation,  or may be converted to shares of Stock for
the  Participant.  The Committee shall determine  whether any deferred  Dividend
Equivalents will accrue interest. The Committee may provide that an Optionee may
use Dividend Equivalents to pay the Purchase Price.  Dividend Equivalents may be
payable in cash or shares of Stock or in a combination of the two, as determined
by the Committee.

          6.   TERMS AND CONDITIONS OF RESTRICTED STOCK.

     Restricted  Stock  may  be  granted  under  this  Plan  aside  from,  or in
association  with,  any  other  award  and  shall be  subject  to the  following
conditions and shall contain such  additional  terms and  conditions  (including
provisions  relating to the  acceleration of vesting of Restricted  Stock upon a
Change  of  Control),  not  inconsistent  with  the  terms of the  Plan,  as the
Committee shall deem desirable:

               (a) GRANTEE RIGHTS. A Grantee shall have no rights to an award of
Restricted  Stock unless and until  Grantee  accepts the award within the period
prescribed by the Committee and, if the Committee  shall deem  desirable,  makes
payment to the Company in cash,  or by check or such other  instrument as may be
acceptable to the Committee.  After  acceptance and issuance of a certificate or
certificates,  as provided  for below,  the  Grantee  shall have the rights of a
stockholder with respect to Restricted Stock subject to the  non-transferability
and forfeiture restrictions described in Section 6(d) below.

                                       9


               (b)  ISSUANCE OF  CERTIFICATES.  The  Company  shall issue in the
Grantee's  name a  certificate  or  certificates  for the shares of Common Stock
associated with the award promptly after the Grantee accepts such award.

               (c) DELIVERY OF  CERTIFICATES.  Unless  otherwise  provided,  any
certificate or certificates  issued  evidencing shares of Restricted Stock shall
not be delivered to the Grantee  until such shares are free of any  restrictions
specified by the Committee at the time of grant.

               (d)  FORFEITABILITY,  NON-TRANSFERABILITY  OF  RESTRICTED  STOCK.
Shares of Restricted  Stock are  forfeitable  until the terms of the  Restricted
Stock grant have been satisfied. Shares of Restricted Stock are not transferable
until the date on which the  Committee  has  specified  such  restrictions  have
lapsed.   Unless  otherwise  provided  by  the  Committee  at  or  after  grant,
distributions  in the form of dividends or  otherwise  of  additional  shares or
property in respect of shares of  Restricted  Stock shall be subject to the same
restrictions as such shares of Restricted Stock.

               (e) CHANGE OF CONTROL. Upon the occurrence of a Change in Control
as defined  in  Section  5(c),  the  Committee  may  accelerate  the  vesting of
outstanding  Restricted  Stock,  in  whole  or in  part,  as  determined  by the
Committee, in its sole discretion.

               (f) TERMINATION OF EMPLOYMENT. Unless otherwise determined by the
Committee at or after grant,  in the event the Grantee  ceases to be an employee
or otherwise  associated  with the Company for any other  reason,  all shares of
Restricted  Stock  theretofore  awarded  to  him  which  are  still  subject  to
restrictions shall be forfeited and the Company shall have the right to complete
a blank  stock  power.  The  Committee  may  provide  (on or after  grant)  that
restrictions  or forfeiture  conditions  relating to shares of Restricted  Stock
will be waived in whole or in part in the event of  termination  resulting  from
specified causes, and the Committee may in other cases waive in whole or in part
restrictions or forfeiture conditions relating to Restricted Stock.

         7.    TERM OF PLAN.

     No Option or shares of  Restricted  Stock shall be granted  pursuant to the
Plan on or after the date that is ten years from the effective date of the Plan,
but Options or shares of Restricted Stock theretofore  granted may extend beyond
that date.

         8.    CAPITAL CHANGE OF THE COMPANY.

     In   the   event   of   any    merger,    reorganization,    consolidation,
recapitalization,  stock dividend,  stock split or other equity restructuring or
change in corporate  structure  affecting the Stock, the Committee shall make an
appropriate  and equitable  adjustment in the number and kind of shares reserved
for issuance under the Plan and in the number and option price of shares subject
to outstanding  Options granted under the Plan, to the end that after such event
each  Optionee's  proportionate  interest  shall be  maintained  (to the  extent
possible) as  immediately  before the  occurrence  of such event.  The Committee


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shall, to the extent  feasible,  make such other  adjustments as may be required
under the tax laws so that any Incentive Options previously granted shall not be
deemed  modified  within the meaning of Section 424(h) of the Code.  Appropriate
adjustments  shall  also be made in the  case of  outstanding  Restricted  Stock
granted under the Plan.

     The adjustments  described above will be made only to the extent consistent
with continued qualification of the Option under Section 422 of the Code (in the
case of an Incentive Option) and Section 409A of the Code.

         9.    PURCHASE FOR INVESTMENT/CONDITIONS.

     Unless  the  Options  and shares  covered by the Plan have been  registered
under the Securities Act, or the Company has determined  that such  registration
is unnecessary,  each person exercising or receiving Options or Restricted Stock
under  the Plan may be  required  by the  Company  to give a  representation  in
writing that he is acquiring the  securities  for his own account for investment
and not with a view to, or for sale in connection  with, the distribution of any
part thereof. The Committee may impose any additional or further restrictions on
awards of Options or Restricted Stock as shall be determined by the Committee at
the time of award.

         10.   TAXES.

               (a)  The  Company  may  make  such  provisions  as  it  may  deem
appropriate,  consistent  with applicable law, in connection with any Options or
Restricted  Stock granted under the Plan with respect to the  withholding of any
taxes (including income or employment taxes) or any other tax matters.

               (b) If  any  Grantee,  in  connection  with  the  acquisition  of
Restricted Stock,  makes the election  permitted under Section 83(b) of the Code
(that is, an  election to include in gross  income in the year of  transfer  the
amounts  specified in Section  83(b)),  such Grantee shall notify the Company of
the election with the Internal  Revenue Service  pursuant to regulations  issued
under the authority of Code Section 83(b).

               (c) If any Grantee shall make any  disposition of shares of Stock
issued pursuant to the exercise of an Incentive  Option under the  circumstances
described  in Section  421(b) of the Code  (relating  to  certain  disqualifying
dispositions),  such Grantee shall notify the Company of such disposition within
ten (10) days hereof.

         11.   EFFECTIVE DATE OF PLAN.

     The Plan shall be effective on April 3, 2006; provided,  however,  that if,
and only if, certain options are intended to qualify as Incentive Stock Options,
the Plan  must  subsequently  be  approved  by  majority  vote of the  Company's
stockholders no later than April 3, 2007, and further, that in the event certain
Option   grants   hereunder   are  intended  to  qualify  as   performance-based
compensation  within the meaning of Section 162(m) of the Code, the requirements
as to  shareholder  approval  set  forth  in  Section  162(m)  of the  Code  are
satisfied.

                                       11


         12.   AMENDMENT AND TERMINATION.

     The Board may  amend,  suspend,  or  terminate  the  Plan,  except  that no
amendment  shall be made that would impair the rights of any  Participant  under
any Option or Restricted  Stock  theretofore  granted without the  Participant's
consent,  and except that no amendment shall be made which, without the approval
of the stockholders of the Company would:

               (a)  materially  increase the number of shares that may be issued
under the Plan, except as is provided in Section 8;

               (b) materially increase the benefits accruing to the Participants
under the Plan;

               (c) materially  modify the  requirements  as to  eligibility  for
participation in the Plan;

               (d) decrease the  exercise  price of an Incentive  Option to less
than  100% of the  Fair  Market  Value  per  share of Stock on the date of grant
thereof or the exercise price of a Nonqualified  Option to less than 100% of the
Fair Market Value per share of Stock on the date of grant thereof;

               (e) extend the term of any Option  beyond  that  provided  for in
Section 5(b); or

               (f) except as  otherwise  provided in Sections  5(c),  5(l) and 8
hereof,  reduce the exercise  price of outstanding  Options or effect  repricing
through cancellations and re-grants of new Options.

     Subject to the  forgoing,  the  Committee may amend the terms of any Option
theretofore  granted,  prospectively or  retrospectively,  but no such amendment
shall impair the rights of any Optionee without the Optionee's consent.

     It is the  intention  of the Board that the Plan comply  strictly  with the
provisions  of  Section  409A of the Code and  Treasury  Regulations  and  other
Internal  Revenue  Service  guidance  promulgated  thereunder (the "Section 409A
Rules") and the  Committee  shall  exercise its  discretion  in granting  awards
hereunder (and the terms of such awards), accordingly. The Plan and any grant of
an award hereunder may be amended from time to time (without,  in the case of an
award,  the consent of the  Participant)  as may be necessary or  appropriate to
comply with the Section 409A Rules.

         13.   GOVERNMENT REGULATIONS.

     The  Plan,  and the grant and  exercise  of  Options  or  Restricted  Stock
hereunder,  and the  obligation of the Company to sell and deliver  shares under
such Options and Restricted Stock shall be subject to all applicable laws, rules
and regulations,  and to such approvals by any governmental  agencies,  national
securities exchanges and interdealer quotation systems as may be required.

                                       12


         14.   GENERAL PROVISIONS.

               (a) CERTIFICATES.  All certificates for shares of Stock delivered
under  the Plan  shall  be  subject  to such  stop  transfer  orders  and  other
restrictions  as the Committee may deem advisable  under the rules,  regulations
and other  requirements  of the  Securities  and Exchange  Commission,  or other
securities  commission  having  jurisdiction,  any  applicable  Federal or state
securities  law, any stock exchange or interdealer  quotation  system upon which
the  Stock is then  listed  or traded  and the  Committee  may cause a legend or
legends to be placed on any such  certificates to make appropriate  reference to
such restrictions.

               (b) EMPLOYMENT MATTERS.  Neither the adoption of the Plan nor any
grant or award  under  the Plan  shall  confer  upon any  Participant  who is an
employee of the Company or any Subsidiary any right to continued  employment or,
in the case of a Participant who is a director, continued service as a director,
with the Company or a Subsidiary,  as the case may be, nor shall it interfere in
any way with  the  right of the  Company  or any  Subsidiary  to  terminate  the
employment of any of its  employees,  the service of any of its directors or the
retention of any of its consultants or advisors at any time.

               (c) LIMITATION OF LIABILITY.  No member of the Committee,  or any
officer or employee of the Company acting on behalf of the  Committee,  shall be
personally liable for any action,  determination or interpretation taken or made
in good faith with  respect to the Plan,  and all members of the  Committee  and
each and any officer or employee of the Company acting on their behalf shall, to
the extent  permitted by law, be fully  indemnified and protected by the Company
in respect of any such action, determination or interpretation.

               (d) REGISTRATION OF STOCK. Notwithstanding any other provision in
the Plan,  no Option  may be  exercised  unless and until the Stock to be issued
upon the exercise  thereof has been registered under the Securities Act of 1933,
as amended,  and  applicable  state  securities  laws, or are, in the opinion of
counsel to the Company,  exempt from such registration in the United States. The
Company shall not be under any obligation to register under  applicable  federal
or state  securities  laws any Stock to be issued upon the exercise of an Option
granted  hereunder in order to permit the exercise of an Option and the issuance
and sale of the Stock  subject to such  Option,  although the Company may in its
sole discretion register such Stock at such time as the Company shall determine.
If the Company chooses to comply with such an exemption from  registration,  the
Stock issued  under the Plan may, at the  direction  of the  Committee,  bear an
appropriate  restrictive  legend restricting the transfer or pledge of the Stock
represented  thereby,  and the Committee may also give appropriate stop transfer
instructions with respect to such Stock to the Company's transfer agent.

         15.   NON-UNIFORM DETERMINATIONS.

     The  Committee's   determinations  under  the  Plan,   including,   without
limitation,  (i) the  determination of the Participants to receive awards,  (ii)
the form,  amount and timing of such awards,  (iii) the terms and  provisions of
such awards and (ii) the agreements evidencing the same, need not be uniform and


                                       13


may be  made  by it  selectively  among  Participants  who  receive,  or who are
eligible to receive, awards under the Plan, whether or not such Participants are
similarly situated.

         16.   GOVERNING LAW.

     The  validity,  construction,  and  effect  of the Plan and any  rules  and
regulations  relating to the Plan shall be  determined  in  accordance  with the
internal laws of the State of Delaware,  without  giving effect to principles of
conflicts of laws, and applicable federal law.

                                                       FalconStor Software, Inc.
                                                                   April 3, 2006
                                                       As amended August 7, 2006




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