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-----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, MaNxr/0FiGHtBD+7V8sdoG6ZWkKC7Xv6nxqH6m0QfZ3sMuGonxGBihbYtAcWUkhj UCfqRphoELkYP8G+1DcG5g== 0000921895-07-001015.txt : 20070510 0000921895-07-001015.hdr.sgml : 20070510 20070510124249 ACCESSION NUMBER: 0000921895-07-001015 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20070331 FILED AS OF DATE: 20070510 DATE AS OF CHANGE: 20070510 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: 07836103 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_03312007.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 MARCH 31, 2007
-------------------------------------------

|_| 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 April
25, 2007 was 50,099,066 and 49,233,866 , 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 March 31, 2007
(unaudited) and December 31, 2006 3

Unaudited Condensed Consolidated Statements of Operations
for the three months ended March 31, 2007 and 2006 4

Unaudited Condensed Consolidated Statements of Cash Flows
for the three months ended March 31, 2007 and 2006 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 21

Item 4. Controls and Procedures 22

PART II. Other Information 22

Item 1. Legal Proceedings 22

Item 1A. Risk Factors 22

Item 5. Other Information 24

Item 6. Exhibits 25

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

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

March 31, 2007 December 31, 2006
---------------- -----------------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents ............................ $ 20,613,005 $ 15,605,329
Marketable securities ................................ 31,672,638 25,354,259
Accounts receivable, net of allowances of $7,240,375
and $6,016,298, respectively ....................... 19,568,956 24,134,257
Prepaid expenses and other current assets ............ 1,435,385 1,244,937
------------- -------------

Total current assets ............................. 73,289,984 66,338,782

Property and equipment, net of accumulated depreciation
of $11,022,889 and $10,221,780, respectively ......... 6,197,554 5,960,317
Goodwill ............................................... 3,512,796 3,512,796
Other intangible assets, net ........................... 404,587 407,316
Other assets ........................................... 1,936,471 2,011,433
------------- -------------

Total assets ..................................... $ 85,341,392 $ 78,230,644
============= =============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ..................................... $ 1,404,441 $ 1,432,510
Accrued expenses ..................................... 5,258,556 6,505,536
Deferred revenue ..................................... 13,715,851 11,466,552
------------- -------------

Total current liabilities ........................ 20,378,848 19,404,598

Other long-term liabilities ............................ 137,317 137,317
Deferred revenue ....................................... 4,035,984 3,645,482
------------- -------------

Total liabilities ................................ 24,552,149 23,187,397

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, 50,083,892 and 49,085,539 shares
issued, respectively and 49,218,692 and
48,220,339 shares outstanding, respectively ........ 50,084 49,086
Additional paid-in capital ........................... 105,599,197 99,282,308
Accumulated deficit .................................. (38,588,432) (38,033,857)
Common stock held in treasury, at cost (865,200
shares at both March 31, 2007 and December 31, 2006) (5,780,163) (5,780,163)
Accumulated other comprehensive loss, net ............ (491,443) (474,127)
------------- -------------

Total stockholders' equity ....................... 60,789,243 55,043,247
------------- -------------
Total liabilities and stockholders' equity ....... $ 85,341,392 $ 78,230,644
============= =============

See accompanying notes to unaudited condensed consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Three Months Ended March 31,
-----------------------------
2007 2006
------------- -------------

Revenues:
Software license revenue ....................... $ 10,437,505 $ 5,676,689
Maintenance revenue ............................ 4,333,539 2,591,003
Software services and other revenue ............ 1,569,634 940,628
------------ ------------
16,340,678 9,208,320
------------ ------------
Operating expenses:
Amortization of purchased and capitalized
software ................................... 25,536 151,722
Cost of maintenance, software services and
other revenue .............................. 2,744,288 1,984,597
Software development costs ................... 5,516,185 4,607,103
Selling and marketing ........................ 6,968,751 4,904,005
General and administrative ................... 1,937,780 1,321,294
------------ ------------
17,192,540 12,968,721
------------ ------------
Operating loss ........................... (851,862) (3,760,401)
------------ ------------

Interest and other income, net ................. 499,371 286,651
------------ ------------

Loss before income taxes .................. (352,491) (3,473,750)
------------ ------------

Provision for income taxes ..................... 202,084 163,136
------------ ------------

Net loss ................................. $ (554,575) $ (3,636,886)
============ ============

Basic and diluted net loss per share ........... $ (0.01) $ (0.08)
============ ============

Weighted average basic and diluted shares
outstanding .................................. 48,594,410 48,006,309
============ ============

See accompanying notes to unaudited condensed consolidated financial statements.

FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Three Months Ended March 31,
-----------------------------
2007 2006
------------- -------------

Cash flows from operating activities:
Net loss ...................................... $ (554,575) $ (3,636,886)
Adjustments to reconcile net loss to net
cash provided by (used in) operating
activities:
Depreciation and amortization ............. 878,940 925,207
Share-based payment compensation .......... 2,190,085 2,264,520
Loss on marketable securities ............. -- 28,855
Provision for returns and doubtful
accounts .............................. 1,192,345 812,887
Changes in operating assets and liabilities:
Accounts receivable ....................... 3,375,343 4,476,931
Prepaid expenses and other current assets . (191,391) (16,290)
Other assets .............................. 45,278 80,767
Accounts payable .......................... (30,299) (205,787)
Accrued expenses .......................... (1,251,837) (441,292)
Deferred revenue .......................... 2,638,305 449,484
------------ ------------

Net cash provided by operating activities . 8,292,194 4,738,396
------------ ------------

Cash flows from investing activities:
Sale of marketable securities ................. 20,545,870 14,733,241
Purchase of marketable securities ............. (26,840,353) (15,745,007)
Purchase of property and equipment ............ (1,039,456) (774,704)
Purchase of software licenses.................. -- (168,000)
Purchase of intangible assets ................. (51,626) (87,990)
------------ ------------

Net cash used in investing activities ..... (7,385,565) (2,042,460)
------------ ------------

Cash flows from financing activities:
Proceeds from exercise of stock options ....... 4,127,801 796,115
------------ ------------

Net cash provided by financing activities . 4,127,801 796,115
------------ ------------

Effect of exchange rate changes on cash and
cash equivalents .............................. (26,754) (12,355)
------------ ------------

Net increase in cash and cash equivalents ....... 5,007,676 3,479,696

Cash and cash equivalents, beginning of period .. 15,605,329 18,796,973
------------ ------------

Cash and cash equivalents, end of period ........ $ 20,613,005 $ 22,276,669
============ ============

Cash paid for income taxes ...................... $ 241,311 $ 25,000
============ ============

The Company did not pay any interest for the three months ended March 31, 2007
and 2006.

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 compensation expense. Actual results could differ
from those estimates.

(d) UNAUDITED INTERIM FINANCIAL INFORMATION

The unaudited interim condensed consolidated financial statements of the
Company as of March 31, 2007, and for the three months ended March 31, 2007 and
2006, 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 March 31, 2007, and the results of its operations for the
three months ended March 31, 2007 and 2006. The results of operations of any
interim period are not necessarily indicative of the results of operations to be
expected for the full fiscal year.

(e) CASH EQUIVALENTS AND MARKETABLE SECURITIES

The Company considers all highly liquid investments with maturity of three
months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$11.6 million and $11.0 million at March 31, 2007 and December 31, 2006,
respectively. Marketable securities at March 31, 2007 and December 31, 2006
amounted to $31.7 million and $25.4 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, as amended by
SOP 98-4 and SOP 98-9, and related interpretations to determine the recognition
of revenue. 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 maintenance, software services and other
revenue.

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, if any, are complete and the software
product master is delivered and accepted.

The Company has transactions in which it purchases hardware and bundles
this hardware with the Company's software and sells 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 March 31, 2007, the Company had two customers
that together accounted for 42% of revenues, and three customers that together
accounted for 30% of the accounts receivable balance at March 31, 2007. For the
three months ended March 31, 2006, the Company had one customer that accounted
for 26% of revenues.

(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 $801,109 and $736,518 for the three months
ended March 31, 2007 and 2006, 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 Financial Accounting Standards Board
("FASB") Statement of Financial Accounting Standards ("SFAS") 142, GOODWILL AND
OTHER INTANGIBLE ASSETS, the Company has not amortized goodwill related to its
acquisitions, but instead tests the balance for impairment. The Company's annual
impairment assessment is performed as of December 31st of each year, and an
assessment is made 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 $54,355 and $45,180 for the three months ended
March 31, 2007 and 2006, respectively. The gross carrying amount and accumulated
amortization of other intangible assets as of March 31, 2007 and December 31,
2006 are as follows:

March 31, December 31,
2007 2006
------------ ------------
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 .................. $ 1,074,719 $ 1,023,093
Accumulated amortization ............... (670,132) (615,777)
----------- -----------
Net carrying amount .................... $ 404,587 $ 407,316
=========== ===========

(i) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY

In accordance with the provisions of SFAS No. 86, ACCOUNTING FOR THE COSTS
OF SOFTWARE TO BE SOLD, LEASED OR OTHERWISE MARKETED, costs associated with the
development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility of the product
has been established. Based on the Company's product development process,
technological feasibility is established upon completion of a working model.
Amortization of software development costs is recorded at the greater of
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 $158,042 and $183,578, net of accumulated
amortization of $5,034,389 and $5,008,853 is included in other assets in the
balance sheets as of March 31, 2007 and December 31, 2006, respectively.
Amortization expense was $25,536 and $151,722 for the three months ended March
31, 2007 and 2006, 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 asserts 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 recognizes interest and
penalties accrued related to unrecognized tax benefits as part of income tax
expense in its consolidated statements of operations.

On January 1, 2007, the Company adopted FASB Interpretation No. 48,
ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES, ("FIN 48"). FIN 48 is an
interpretation of FASB Statement No. 109, ACCOUNTING FOR INCOME TAXES, and
addresses the determination of whether tax benefits claimed or expected to be
claimed on a tax return should be recorded in the financial statements. Under
FIN 48, the Company may recognize the tax benefit from an uncertain tax position
only if it meets the "more likely than not" threshold that the position will be
sustained on examination by the taxing authority, based on the technical merits
of the position. The tax benefits recognized in the financial statements from
such a position should be measured based on the largest benefit that has a
greater than fifty percent likelihood of being realized upon ultimate
settlement. FIN 48 also provides guidance on de-recognition, classification,
interest and penalties on income taxes, accounting in interim periods and also
requires increased disclosures. The adoption of FIN 48 did not result in any
adjustment to the recognized benefits from the Company's uncertain tax
positions. See footnote No. 6, "Income Taxes" for additional information.

(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 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 compensation expense is measured
at the grant date, based on the fair value of the award, and is recognized as an
expense over the requisite employee service period (generally the vesting
period) for awards expected to vest. The Company estimates the fair value of
share-based payments using the Black-Scholes option-pricing model. Stock option
exercises are expected to be fulfilled with new shares of common stock.

(m) FINANCIAL INSTRUMENTS

As of March 31, 2007 and December 31, 2006, 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 months ended March 31, 2007 and
2006, all common stock equivalents were excluded from diluted net loss per share
for the periods. As of March 31, 2007, potentially dilutive common stock
equivalents included 10,029,155 stock options and shares of restricted stock
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 March 31, 2007 Three Months Ended March 31, 2006
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------ ------------- --------- ------------ ------------- ---------
Basic EPS $ (554,575) 48,594,410 $ (0.01) $(3,636,886) 48,006,309 $ (0.08)
======== ========
Effect of dilutive securities:
Stock Options -- --
----------- ---------- -------- ----------- ---------- --------
Diluted EPS $ (554,575) 48,594,410 $ (0.01) $(3,636,886) 48,006,309 $ (0.08)
=========== ========== ======== =========== ========== ========

(p) COMPREHENSIVE INCOME (LOSS)

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

Three Months Ended March 31,
2007 2006
---- ----

Net loss $ (554,575) $(3,636,886)
----------- -----------
Other comprehensive income (loss):
Foreign currency translation
adjustments (41,212) 11,439
Unrealized gains on investments 23,896 10,879
----------- -----------
Other comprehensive income (loss) (17,316) 22,318
----------- -----------
Comprehensive loss $ (571,891) $(3,614,568)
=========== ===========

(q) NEW ACCOUNTING PRONOUNCEMENTS

In February 2007, the FASB issued SFAS No. 159, THE FAIR VALUE OPTION FOR
FINANCIAL ASSETS AND FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB
STATEMENT NO. 115. SFAS No. 159 permits entities to choose to measure eligible
items at fair value at specified election dates and to report unrealized gains
and losses on items for which the fair value option has been elected in earnings
at each subsequent reporting date. SFAS No. 159 is effective for fiscal years
beginning after November 15, 2007. The Company is currently evaluating the
impact of the provisions of SFAS No. 159 on its consolidated financial position,
results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS
("SFAS No. 157") to clarify the definition of fair value, establish a framework
for measuring fair value and expand the disclosures on fair value measurements.
SFAS No. 157 defines fair value as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date (an exit price). SFAS No. 157 also
stipulates that, as a market-based measurement, fair value should be determined
based on the assumptions that market participants would use in pricing the asset
or liability, and establishes a fair value hierarchy that distinguishes between
(a) market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. The Company is currently evaluating the
impact of the provisions of SFAS No. 157 on its consolidated financial position,
results of operations or cash flows.

(2) SHARE-BASED PAYMENT ARRANGEMENTS

As of May 1, 2000, the Company adopted the FalconStor Software, Inc. 2000
Stock Option Plan (the "2000 Plan"). The 2000 Plan is administered by the Board
of Directors and, as amended, 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. ISOs
granted must have exercise prices 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. Non-qualified options granted must have
exercise prices not 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. All
options granted under the 2000 Plan must be granted before May 1, 2010.

On May 14, 2004, the Company adopted the FalconStor Software, Inc. 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 FalconStor Software, Inc. 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. Initially, a maximum of 1,500,000 of the authorized but
unissued or treasury shares of the common stock of the Company could be issued
upon the grant of restricted stock 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
not greater than 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.

On May 8, 2007, the Company's stockholders approved an amendment to the
Company's 2006 Plan. The amendment relates to the number of shares available to
be issued under the 2006 Plan upon the exercise of stock options and upon the
grant of shares with such restrictions as determined by the Company. The 2006
Plan was amended so that if, on July 1st of any calendar year in which the Plan
is in effect (the "Calculation Date"), the number of shares of stock with
respect to which options may be granted is less than five percent (5%) of the
number of outstanding shares of stock, the number of shares of stock available
for issuance under the Plan shall be increased so that the number equals five
percent (5%) of the shares of stock outstanding on the Calculation Date, but in
no event shall the number of shares of stock subject to the Plan in the
aggregate exceed twenty million shares, subject to adjustment as provided in the
2006 Plan.

On May 8, 2007, the Company's stockholders adopted the FalconStor
Software, Inc. 2007 Outside Directors Equity Compensation Plan (the "2007
Plan"). The 2007 Plan is administered by the Board of Directors and provides for
the issuance of up to 300,000 shares of Company common stock upon the vesting of
options or upon the grant of shares with such restrictions as determined by the
Board of Directors to the non-employee directors of the Company. 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. Shares of restricted
stock have the terms and conditions set by the Board of Directors and are
forfeitable until the terms of the grant have been satisfied.

The following table summarizes stock option activity during the three months
ended March 31, 2007:

Weighted
Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic
Options Price Life (Years) Value
------------ ------------ ------------ -----------

Outstanding at December 31, 2006 10,835,975 $ 5.62
Granted 64,000 $ 8.75
Exercised (998,353) $ 4.13
Canceled (97,467) $ 6.95
---------- ----------

Outstanding at March 31, 2007 9,804,155 $ 5.77 6.45 $45,595,769
========== ========== ========== ===========

Options exercisable at March 31, 2007 7,008,546 $ 5.21 5.57 $36,541,063
---------- ---------- ---------- -----------

Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended March
31, 2007 and 2006 was $4,127,802 and $796,115, respectively. The total intrinsic
value of stock options exercised during the three months ended March 31, 2007
and 2006 was $6,309,312 and $1,474,427, respectively.

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

Three Months Ended Three Months Ended
March 31, March 31,
2007 2006
------------------ ------------------
Cost of maintenance, software services and other revenue $ 284,849 $ 343,390
Software development costs 923,656 1,054,961
Selling and marketing 718,917 660,852
General and administrative 262,663 205,317
---------- ----------

$2,190,085 $2,264,520
========== ==========

The Company did not recognize any tax benefits related to share-based
compensation expense during the three months ended March 31, 2007 and 2006.

In 2006, the Company granted options to purchase an aggregate of 25,000
shares of common stock to certain non-employee consultants in exchange for
professional services. The aggregate fair value of these options as determined
using the Black-Scholes method was $199,353 as of March 31, 2007, and is being
expensed over the periods the services are provided. The related cumulative
expense amounted to $38,763 through March 31, 2007, of which $20,849 was
recognized during the three months ended March 31, 2007.

In 2006, the Company granted 225,000 shares of restricted stock to certain
officers and employees at an average fair value per share at date of grant of
$7.06 per share. As of March 31, 2007, no restricted shares have vested or been
forfeited. There were no restricted shares issued or outstanding as of March 31,
2006.

Options granted during both fiscal 2007 and 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%. 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 treasury yield curve in
effect at the time of grant.

As of March 31, 2007, there was approximately $9,841,427 of total
unrecognized compensation cost related to the Company's unvested options and
restricted shares granted under the Company's stock plans.

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 March 31, 2007,
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 months
ended March 31, 2007 and 2006 and the location of long-lived assets as of March
31, 2007 and December 31, 2006 are summarized as follows:

Three Months Ended March 31,
2007 2006
------------- --------------

United States $11,744,748 $ 6,294,997
Asia 1,885,764 1,382,348
Other international 2,710,166 1,530,975
----------- -----------

Total revenues $16,340,678 $ 9,208,320
=========== ===========

March 31, December 31,
2007 2006
------------- --------------

Long-lived assets:

United States $10,296,033 $10,113,633
Asia 1,429,281 1,498,534
Other international 326,094 279,695
----------- -----------

Total long-lived assets $12,051,408 $11,891,862
=========== ===========

(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. There were no stock repurchases during
the three months ended March 31, 2007 and 2006. As of March 31, 2007, the
Company had repurchased a total of 865,200 shares for $5,780,164.

(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 2007 through 2015. The following is a schedule of future minimum
lease payments for all operating leases as of March 31, 2007:

2007............................................ $1,482,676
2008............................................ 1,600,757
2009............................................ 1,622,221
2010............................................ 1,426,182
2011............................................ 1,369,059
Thereafter...................................... 713,441
----------
$8,214,336
==========

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.

(6) INCOME TAXES

For the three months ended March 31, 2007 and 2006, the Company's
provision for income taxes consists of U.S. and foreign taxes in amounts
necessary to align its year-to-date tax provision with the effective tax rate
the Company expects to achieve for the full year, including U.S. federal
alternative minimum taxes and state minimum taxes that are expected to be
incurred (despite the Company's pre-tax book loss) primarily as a result of the
limitations on its ability to utilize net operating losses under the alternative
minimum tax system and the non-deductibility of certain share-based compensation

expense for income tax purposes that has been recognized for financial statement
purposes. For the three months ended March 31, 2007, the Company's income tax
provision also includes discrete items for (i) $57,058 related to state income
taxes incurred in periods prior to 2007, and (ii) $120,000 related to a change
in the Company's estimate of amounts due in certain foreign jurisdictions for
periods prior to 2007, based upon the Company's evaluation of information
obtained in 2007.

As of December 31, 2006, the Company reported deferred tax assets and a
corresponding full valuation allowance, of $50.2 million. As of January 1, 2007,
the Company revised the recorded amounts of certain deferred tax assets (and
corresponding valuation allowance) to be $14.3 million, primarily due to the
limitations on the Company's ability to utilize certain deferred tax assets
relating to net operating losses acquired in the Company's 2001 reverse merger
transaction. During the three months ended March 31, 2007, the Company's gross
deferred tax assets increased for, among other things, approximately $1.9
million related to compensation deductions from exercises of employee and
consultant stock options.

At March 31, 2007 and December 31, 2006, the Company maintained a full
valuation allowance against its deferred tax assets due to the Company's prior
history of pre-tax losses and uncertainty about the timing of and ability to
generate taxable income, in the future. In the event that the Company (1)
generates taxable income and (2) its forecasts indicate that it is
more-likely-than-not that it will recover a portion of its deferred tax assets
in the future, the Company will likely reverse a portion of its deferred tax
asset valuation allowance. If the entire deferred tax asset were realized,
approximately $5.5 million (related to the tax effects of excess compensation
deductions from exercises of employee and consultant stock options) would be
allocated to paid-in-capital, with the remainder reducing income tax expense. In
determining the period in which related tax benefits are realized for book
purposes, excess share-based payment deductions, and deductions from
discontinued operations included in net operating losses are realized after
regular net operating losses are exhausted.

The Company's total unrecognized tax benefits as of January 1, 2007 were
$4.4 million, which, if recognized, would effect the Company's effective tax
rate. Total accrued interest and penalties as of January 1, 2007 were $22,193.
The Company does not expect that its unrecognized tax benefits will
significantly change within the next 12 months. The Company files a consolidated
U.S. Income tax return and tax returns in various state and local jurisdictions.
The returns filed in various state and local jurisdictions may be filed on a
separate company, combined or consolidated basis depending on the legal
requirements of the taxing jurisdiction. The Company's subsidiaries also file
tax returns in various foreign jurisdictions. In addition to the U.S., the
Company's major taxing jurisdictions include China, Japan, Taiwan, Korea, United
Kingdom, Germany, France and Australia. There have not been any past tax
examinations nor are there any current tax examinations in progress.
Accordingly, as of January 1, 2007, the Company remains subject to examination
in all tax jurisdictions for all periods since inception.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. THESE FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
USE OF PREDICTIVE, FUTURE-TENSE OR FORWARD-LOOKING TERMINOLOGY, SUCH AS
"BELIEVES," "ANTICIPATES," "EXPECTS," "ESTIMATES," "PLANS," "MAY," "INTENDS,"
"WILL," OR SIMILAR TERMS. INVESTORS ARE CAUTIONED THAT ANY FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE SIGNIFICANT
RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THE FOLLOWING DISCUSSION
SHOULD BE READ TOGETHER WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.

OVERVIEW

Our results for the first quarter of 2007 showed strong growth from the
same period in the prior year. Both our revenues and our gross margins
increased.

Revenues for the first quarter of 2007 increased 77% to $16.3 million
compared with revenues in the first quarter of 2006. Revenues from both our OEM
partners and our resellers increased from the same period last year.

Due to typical industry seasonality, our revenues were down from the
fourth quarter of 2006. This decrease was anticipated, as our first quarter
revenues have historically declined from our fourth quarter revenues. We are
pleased that revenues for the first quarter of 2007 were higher than revenues
for the first, second or third quarters of 2006. We believe this shows continued
momentum for our products and services.

EMC Corporation accounted for 26% of our revenues, and Sun Microsystems
accounted for 16% of our revenues, in the first quarter of 2007. We anticipate
that each of these customers will account for 10% or more of our revenues during
2007. EMC has consistently contributed 20% or more of our revenues for a
significant period of time. Sun's revenue contribution has fluctuated on a
quarterly basis, but their announcement regarding their VTL strategy in the
fourth quarter of 2006, and the announcement in April 2007 that Sun will carry
our full product line, gives us reason to believe that their contribution to our
revenues will remain at or above the 10% level.

We continue to monitor our channel sales operations to determine whether
changes or additional resources will help to continue or to accelerate the
positive momentum. We 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.

While we had an operating loss for the three months ended March 31, 2007,
including $2.2 million of share-based compensation expense related to SFAS No.
123(R), the loss was significantly lower than in the same period in 2006, and
cash flows from operations in the first quarter of 2007 were again positive. We
continue to believe that our ability to fund our own growth internally bodes
well for our long-term success.

Deferred revenue at March 31, 2007 increased 76%, compared with the
balance at March 31, 2006. 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.

Operating expenses increased by $4.2 million, or 33%, over the same period
in 2006. Operating expenses include $2.2 million in share-based compensation
expense for the first quarter of 2007, and $2.3 million in share-based
compensation expense for the first quarter of 2006. We are pleased that our
revenues, on both an absolute and a percentage basis, continue to grow at a
higher rate than our expenses.

Our gross margins increased to 83% for the first quarter of 2007 from 77%
for the first quarter of 2006. Share-based compensation expense within cost of
maintenance, software services and other revenue was 2% of revenue in the first
quarter of 2007 and 4% in 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 MARCH 31, 2007 COMPARED WITH
THE THREE MONTHS ENDED MARCH 31, 2006.

Revenues for the three months ended March 31, 2007 increased 77% to $16.3
million compared with $9.2 million for the three months ended March 31, 2006.
Our operating expenses increased 33% from $13 million for the three months ended
March 31, 2006 to $17.2 million for the three months ended March 31, 2007.
Included in our operating expenses for the three months ended March 31, 2007 and
2006 was $2.2 and $2.3 million, respectively, of share-based compensation
expense related to stock-based compensation in accordance with SFAS No. 123(R).
Net loss for the three months ended March 31, 2007 was $0.6 million compared
with net loss of $3.6 million for the three months ended March 31, 2006. The
increase in revenues was due to significant increases in software license
revenue and maintenance revenue as well as moderate increases 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 March 31, 2007 as compared with the same period in 2006. Revenue from
resellers and distributors also increased in absolute dollars for the three
months ended March 31, 2007 as compared with the same period in 2006. Expenses
increased in all aspects of our business to support our growth. During the three
months ended March 31, 2007, we continued to increase the number of employees
and to invest in our infrastructure by purchasing additional computers and
related equipment. We increased the number of employees from 308 as of March 31,
2006 to 364 employees as of March 31, 2007.

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 84% from $5.7 million for the three
months ended March 31, 2006 to $10.4 million for the three months ended March
31, 2007. Increased market acceptance and demand for our products 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 first quarter of 2007 we increased the amount of hardware we
bundled with our software as compared with the first quarter of 2006. 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 67% to
$5.9 million for the three months ended March 31, 2007 from $3.5 million for the
three months ended March 31, 2006.

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
from our continued customer base and product offerings expansion, 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 $1.7
million from $2.6 million for the three months ended March 31, 2006 to $4.3
million for the three months ended March 31, 2007. Software services and other
revenue increased approximately $0.6 million from $0.9 million for the three
months ended March 31, 2006 to $1.6 million for the three months ended March 31,
2007. 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 March 31, 2007, we had $0.2 million of purchased software licenses,
net of accumulated amortization of $5.0 million that are being amortized over
three years. For the three months ended March 31, 2007, we recorded $26,000 of
amortization related to these purchased software licenses. As of March 31, 2006,
we had $0.4 million of purchased software licenses, net of accumulated
amortization of $4.8 million and recorded approximately $0.2 million of
amortization for the three months ended March 31, 2006 related to these
purchased software licenses. We will continue to evaluate third party software
licenses and may make additional purchases from time to time, which would impact
the amount we record as amortization expense in future periods.

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 compensation expense associated with 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 March 31, 2007 increased by 38% to
$2.7 million compared with $2.0 million for the three months ended March 31,
2006. The increase in cost of maintenance, software services and other revenue
was principally due to the increased cost of hardware resulting from the higher
number of transactions in which we bundled this purchased hardware with our
software and sold the bundled solution during the three months ended March 31,
2007 as compared with the same period in 2006. 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 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 March 31, 2007 was $13.6 million
or 83% of revenue compared with $7.1 million or 77% of revenue for the three
months ended March 31, 2006. The increase in our gross margin was primarily due
to the increase of our revenue combined with our continued focus on our cost
structure. Share-based compensation expense included in the cost of maintenance,
software services and other revenue decreased slightly in absolute dollars for
the three months ended March 31, 2007 compared with the same period in 2006.
Share-based compensation expense was equal to 2% and 4% of revenue for the three
months ended March 31, 2007 and 2006, respectively.

SOFTWARE DEVELOPMENT COSTS

Software development costs consist primarily of personnel costs for
product development personnel, share-based compensation expense associated with
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 20% to $5.5 million for the three months
ended March 31, 2007 from $4.6 million for the three months ended March 31,
2006. The major contributing factors to the increase in software development
costs were higher salary costs and personnel related costs as a result of
increased headcount to enhance and test our core network storage software
product, as well as to develop new innovative features and options during the
three months ended March 31, 2007 as compared with the same period in 2006.
Share-based compensation expense included in software development costs
decreased slightly in absolute dollars for the three months ended March 31, 2007
compared with the same period in 2006. Share-based compensation expense included
in software development costs was equal to 6% and 11% of revenue for the three
months ended March 31, 2007 and 2006, respectively. 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 compensation expense associated with
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 42% to $7.0
million for the three months ended March 31, 2007 from $4.9 million for the
three months ended March 31, 2006. The increase in selling and marketing
expenses was primarily due to higher commissions paid as a result of our 77%
increase in revenue during the three months ended March 31, 2007 as compared
with the same period in 2006. In addition, higher salary costs and personnel
related costs as a result of increased sales and marketing headcount during the
three months ended March 31, 2007 as compared with the same period in 2006
contributed to the overall increase. Share-based compensation expense included
in sales and marketing increased slightly in absolute dollars for the three
months ended March 31, 2007 compared with the same period in 2006. Share-based
compensation expense included in selling and marketing expenses was equal to 4%
and 7% of revenue for the three months ended March 31, 2007 and 2006,
respectively. 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 compensation expense
associated with 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 47% to $1.9
million for the three months ended March 31, 2007 from $1.3 million for the
three months ended March 31, 2006. The increase in general and administrative
expenses was primarily due to higher professional fees related to the
implementation of FIN No. 48 and other tax related planning during the three
months ended March 31, 2007 as compared with the same period in 2006.
Share-based compensation expense included in general and administrative
increased slightly in absolute dollars for the three months ended March 31, 2007
compared with the same period in 2006. Share-based compensation expense included
in general and administrative expenses was equal to 2% and 2% of revenue for the
three months ended March 31, 2007 and 2006, respectively. Additionally, as our
revenue and number of employees increase, our legal and professional fees and
other general corporate overhead costs have increased and are likely to continue
to increase.

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 $0.5 million for the three months ended March 31, 2007 compared
with $0.3 million for the three months ended March 31, 2006. This increase is
primarily due to higher interest rates and increased cash balances as of March
31, 2007 as compared with the same period in 2006, which resulted in a higher
average cash balance invested at greater interest rates.

INCOME TAXES

For the three months ended March 31, 2007 and 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
March 31, 2007 consists 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 on our ability
to utilize net operating losses under the alternative minimum tax system, and
the non-deductibility of certain share-based compensation expenses for income
tax purposes that have been recognized for financial statement purposes. For the
three months ended March 31, 2007, our income tax provision also includes
discrete items for (i) $57,058 related to state income taxes incurred in periods
prior to 2007, and (ii) $120,000 related to a change in our estimate of amounts
due in certain foreign jurisdictions for periods prior to 2007, based upon our
evaluation of information obtained in 2007.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

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 March 31, 2007,
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 a portion of such valuation allowance. If the entire
deferred tax assets were realized, approximately $5.5 million (related to the
tax effects of excess compensation deductions from exercises of employee and
consultant stock options) would be allocated to paid-in-capital with the
remainder reducing income tax expense.

ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to
Unaudited Condensed Consolidated Financial Statements - Note (2) SHARE-BASED
PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified
prospective method.

We have used and expect to continue to use the Black-Scholes
option-pricing model to compute the estimated fair value of share-based
compensation expense. The Black-Scholes option-pricing model includes
assumptions regarding dividend yields, expected volatility, expected option term
and risk-free interest rates. The assumptions used in computing the fair value
of share-based compensation expense reflect our best estimates, but involve
uncertainties relating to market and other conditions, many of which are outside
of our control. We estimate expected volatility based primarily on historical
daily price changes of our stock and other factors. 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 compensation expense that was recorded
for the three months ended March 31, 2007 and 2006 could have been materially
different. Furthermore, if different assumptions or estimates are used in future
periods, share-based compensation expense could be materially impacted in the
future. During the three months ended March 31, 2007 and 2006, the total
compensation costs recognized relating to share-based compensation expense in
our financial statements totaled $2.2 million and $2.3 million, respectively.
Total compensation cost related to unvested share-based payment awards not yet
recognized as of March 31, 2007 is $9.8 million.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In February 2007, the FASB issued Statement of Financial Accounting
Standard ("SFAS") No. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND
FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB STATEMENT NO. 115. SFAS
No. 159 permits entities to choose to measure eligible items at fair value at
specified election dates and report unrealized gains and losses on items for
which the fair value option has been elected in earnings at each subsequent
reporting date. SFAS No. 159 is effective for fiscal years beginning after
November 15, 2007. We are currently evaluating the impact of the provisions of
SFAS No. 159 on our consolidated financial position, results of operations or
cash flows.

In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS
("SFAS No. 157") to clarify the definition of fair value, establish a framework
for measuring fair value and expand the disclosures on fair value measurements.
SFAS No. 157 defines fair value as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date (an exit price). SFAS No. 157 also
stipulates that, as a market-based measurement, fair value should be determined
based on the assumptions that market participants would use in pricing the asset
or liability, and establishes a fair value hierarchy that distinguishes between
(a) market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. We are currently evaluating the impact of
the provisions of SFAS No. 157 on our consolidated financial position, results
of operations or cash flows.

LIQUIDITY AND CAPITAL RESOURCES

Our total cash and cash equivalents and marketable securities balance as
of March 31, 2007 increased by $11.3 million compared with December 31, 2006.
Our cash and cash equivalents totaled $20.6 million and marketable securities
totaled $31.7 million at March 31, 2007. As of March 31, 2006, we had
approximately $22.3 million in cash and cash equivalents and $18.8 million in
marketable securities.

We continued to invest in our infrastructure to support our long-term
growth during the three months ended March 31, 2007. We made investments in
property and equipment and we increased the number of employees during the first
quarter of 2007. 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, 865,200
shares have been repurchased at an aggregate purchase price of $5.8 million. We
did not repurchase any shares during the three months ended March 31, 2007 and
2006.

Net cash provided by operating activities totaled $8.3 million for the
three months ended March 31, 2007, compared with $4.7 million for the same
period in 2006. Net cash provided by operating activities of $8.3 million was
primarily derived from: (i) a decrease in accounts receivable of $4.6 million;
(ii) an increase in deferred revenue of $2.6 million; (iii) non-cash charges of
$0.9 million for depreciation and amortization; and (iv) $2.2 million related to
share-based compensation expense. These amounts were partially offset by: (i)
our net loss of $0.6 million for the three months ended March 31, 2007; and (ii)
a decrease in accrued expenses and accounts payable of $1.3 million. The cash
provided by operating activities for the three months ended March 31, 2006 was
mainly comprised of: (i) a decrease in accounts receivable of $5.3 million; (ii)
an increase in deferred revenue of $0.5 million; (iii) non-cash charges of $0.9
million for depreciation and amortization; and (iv) $2.3 million related to
share-based compensation expense. These amounts were partially offset by: (i)
our net loss of $3.6 million for the three months ended March 31, 2006; and (ii)
a decrease in accrued expenses and accounts payable of $0.6 million.

Net cash used in investing activities was $7.4 million for the three
months ended March 31, 2007, due primarily to: (i) net purchases of marketable
securities of $6.3 million; and (ii) purchases of property and equipment of $1.0
million. Net cash used in investing activities was $2.0 million for the three
months ended March 31, 2006, due primarily to: (i) net purchases of marketable
securities of $1.0 million; (ii) purchases of property and equipment of $0.8
million; and (iii) purchases of software licenses and intangible assets of $0.3
million.

Net cash provided from financing activities was $4.1 million for the three
months ended March 31, 2007. We received proceeds from the exercise of stock
options of $4.1 million. Net cash provided by financing activities was $0.8
million for the three months ended March 31, 2006. This amount was related to
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 2007 through 2015. 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 March 31, 2007, 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 March 31, 2007, 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 March 31, 2007, 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 in Item 1A to our Annual Report on Form 10-K for
the year ended December 31, 2006 (the "2006 10-K"). The information below sets
forth additional risk factors or risk factors that have had material changes
since the 2006 10-K, and should be read in conjunction with Item 1A of the 2006
10-K.

WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS AND A SIGNIFICANT PORTION OF OUR
RECEIVABLES IS 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 March 31, 2007, we
had one customer who accounted for 26% of our revenues and one customer who
accounted for 16% of our revenues. While we believe that we will continue to
receive revenue from these customers, our agreements do not have any minimum
sales requirements and we cannot guarantee continued revenue. If our contracts
with either of these customers terminate, or if the volume of sales from these
customers significantly declines, it would have a material adverse effect on our
operating results.

In addition, as of March 31, 2007, two customers accounted for a total of
24% of our outstanding receivables, 13% and 11%, respectively. While we
currently have no reason to question the collectibility of these receivables, a
business failure or reorganization by either of these customers could harm our
ability to collect these receivables and could damage our cash flow.

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.

Historically, information technology spending has been higher in the
fourth and second quarters of each calendar year, and somewhat slower in the
other quarters, particularly the first quarter. Our quarterly results reflected
this seasonality in 2006 and in the first quarter of 2007, and we anticipate
that our quarterly results for the remainder of 2007 will show the effects of
seasonality as well.

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 trailing twelve months ended
March 31, 2007, the closing market price of our common stock as quoted on the
NASDAQ Global Market fluctuated between $6.06 and $11.23 per share and
subsequent to March 31, 2007 the closing market price had a high of $12.10 per
share. 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.

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

As of March 31, 2007, we had an aggregate of 10,779,155 outstanding
options and outstanding restricted shares and warrants to purchase our common
stock. The weighted average exercise price of the outstanding options and
warrants is $5.80 per share. We also have 828,040 shares of our common stock
reserved for issuance under our stock plans with respect to options (or
restricted stock) that have not been granted. In addition to the 828,040 shares
of our common stock reserved for future issuance as of March 31, 2007, the
stockholders of the Company approved the 2007 Outside Directors Equity
Compensation Plan that authorized a maximum of 300,000 shares of common stock
for future issuance upon the grant of restricted shares or options on May 8,
2007.

The exercise of all of the outstanding options and warrants and/or the
grant and exercise of additional options or restricted stock 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.

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 5. OTHER INFORMATION

On May 8, 2007, the Company's Stockholders approved an amendment to the
FalconStor Software, Inc., 2006 Incentive Stock Plan (the "2006 Plan"). This
amendment provides that if, on July 1st of any calendar year in which the 2006
Plan is in effect (the "Calculation Date"), the number of shares of Stock with
respect to which options may be granted is less than five percent (5%) of the
number of outstanding shares of Stock, the number of shares of Stock available
for issuance under the 2006 Plan shall be increased so that the number equals
five percent (5%) of the shares of Stock subject to the 2006 Plan in the
aggregate exceed twenty million shares, subject to adjustment as provided in the
2006 Plan.

On May 8, 2007, the Company's Stockholders approved the FalconStor
Software, Inc., 2007 Outside Directors Equity Compensation Plan (the "2007
Plan"). Under the 2007 Plan, beginning with the 2007 Annual Meeting of
Stockholders, each non-employee Director will receive an annual grant of 5,000
options to purchase Company Common Stock and 5,000 shares of restricted Company
Common Stock.

On May 8, 2007, the Company's Board of Directors approved a cash
compensation plan for the Company's non-employee Directors. The plan provides
for annual Director fees of $26,500. The chairperson of the Audit Committee will
receive an additional $10,000 per annum and the chairpersons of any other
committees will receive an additional $5,000 per annum. Non-employee Directors
will also receive $3,000 per annum for each committee on which they serve in a
capacity other than chairperson. Cash fees will be paid quarterly in arrears.

On May 8, 2007, the annual cash compensation for each of Wayne Lam, James
Weber and Bernard Wu, all of whom are executive officers of the Company, was
increased to $250,000. None of such individuals has an employment agreement with
the Company.

ITEM 6. EXHIBITS

4.1 FalconStor Software, Inc., 2006 Incentive Stock Plan, as amended and
restated

4.2 FalconStor Software, Inc., 2007 Outside Directors Equity Compensation Plan

31.1 Certification of the Chief Executive Officer

31.2 Certification of the Chief Financial Officer

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

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

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
(principal financial and accounting officer)

May 9, 2007

EX-4.1 2 ex41to10q04637_03312007.htm sec document



                                                                     Exhibit 4.1


                              AMENDED AND RESTATED

                            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.

      The  persons  eligible  for  participation  in the Plan as  recipients  of
Options (the  "Optionees") or 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.

4.    STOCK RESERVED FOR THE PLAN.

      An initial 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.  Subject to
adjustment as provided in Section 8 hereof,  if on July 1st of any calendar year
in which the Plan is in effect (the "Calculation  Date") the number of shares of
Stock with  respect to which  Options  may be granted is less than five  percent
(5%) of the number of outstanding shares of Stock, the number of shares of Stock
available  for  issuance  under the Plan shall be  increased  so that the number
equals five percent (5%) of the shares of Stock  outstanding on the  Calculation
Date,  but in no event shall the total number of shares of Stock  subject to the
Plan in the aggregate  exceed twenty  million  shares,  subject to adjustment as
provided in Section 8 hereof.  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 three hundred  thousand  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
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:

                  (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 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.

            (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 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
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.

            (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
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.

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.

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
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
                                                             Amended May 8, 2007

EX-4.2 3 ex42to10q04637_03312007.htm sec document



                                                                     Exhibit 4.2


                            FALCONSTOR SOFTWARE, INC.

                 2007 OUTSIDE DIRECTORS EQUITY COMPENSATION PLAN

1.    PURPOSE.  The  FalconStor  Software,  Inc. 2007 Outside  Directors  Equity
      Compensation Plan (the "Plan") is established effective as of the 26th day
      of March, 2007, (the "Effective Date") to create additional  incentive for
      the non  employee  directors  of  FalconStor  Software,  Inc.,  a Delaware
      corporation,  and any successor corporation thereto (collectively referred
      to as the "Company") to promote the financial  success and progress of the
      Company and any present or future parent and/or subsidiary corporations of
      the  Company.  For  purposes  of the  Plan,  a  parent  corporation  and a
      subsidiary  corporation  shall be as defined in sections 424(e) and 424(f)
      of the Internal Revenue Code of 1986, as amended (the "Code").

2.    ADMINISTRATION.  The Plan shall be  administered by the Board of Directors
      of the Company (the "Board")  and/or by a duly appointed  committee of the
      Board  having  such  powers  as  shall  be  specified  by the  Board.  Any
      subsequent references herein to the Board shall also mean the committee if
      such committee has been appointed and,  unless the powers of the committee
      have been specifically limited, the committee shall have all of the powers
      of the Board granted herein, including,  without limitation,  the power to
      terminate  or amend the Plan at any time  subject to the terms of the Plan
      and any  applicable  limitations  imposed by law.  The Board shall have no
      authority, discretion or power to select the non-employee directors of the
      Company who will receive options or be granted shares of restricted  stock
      under the Plan, to set the exercise price of the options granted under the
      Plan,  to  determine  the  number of shares of common  stock to be granted
      under  option or the time at which  such  options  are to be  granted,  to
      establish the duration of option grants, to determine the number of shares
      of  restricted  stock to be granted  or the time at which  such  shares of
      restricted  stock are to be granted or to alter other terms or  conditions
      specified  in the  Plan,  except in the  sense of  administering  the Plan
      subject to the provisions of the Plan. All questions of  interpretation of
      the Plan,  of any options  granted  under the Plan (an "Option") or of any
      restricted stock granted under the plan  ("Restricted  Stock" and together
      with the Options,  an "Award") shall be determined by the Board,  and such
      determinations  shall be final  and  binding  upon all  persons  having an
      interest  in the Plan and/or any Award.  Any officer of the Company  shall
      have the  authority  to act on behalf of the Company  with  respect to any
      matter, right,  obligation,  or election which is the responsibility of or
      which is  allocated  to the  Company  herein,  provided  the  officer  has
      apparent  authority  with respect to such matter,  right,  obligation,  or
      election.

3.    ELIGIBILITY AND TYPE OF AWARDS. Awards may be granted only to directors of
      the  Company  who,  at the time of such grant,  are not  employees  of the
      Company  or of  any  parent  or  subsidiary  corporation  of  the  Company
      ("Outside  Directors").  Options  granted  to Outside  Directors  shall be
      nonqualified  stock  options;  that is,  options  that are not  treated as
      having been granted under section  422(b) of the Code. A person granted an
      Option is  hereinafter  referred  to as an  "Optionee".  A person  granted
      Restricted  Stock is hereinafter  referred to as a "Grantee" (and together
      with  the  Optionees,   the  "Participants").   Notwithstanding   anything
      contained herein, no Participant may take any action that is prohibited by
      the Sarbanes-Oxley  Act of 2002 and the rules and regulations  promulgated
      by the Securities and Exchange Commission or any other agency thereunder.

4.    SHARES  SUBJECT TO AWARDS.  Options shall be for the purchase of shares of
      authorized but unissued common stock or treasury shares of common stock of
      the Company (the "Stock"),  subject to adjustment as provided in paragraph
      8 below.  The  maximum  number of  shares of Stock  which may be issued or
      granted under the Plan shall be Three Hundred Thousand  (300,000)  shares.
      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.




5.    TERMS,  CONDITIONS AND FORM OF OPTIONS.  Options  granted  pursuant to the
      Plan shall be evidenced  by written  agreements  specifying  the number of
      shares of Stock covered thereby, in substantially the form attached hereto
      as  Exhibit  A (the  "Option  Agreement"),  which  written  agreement  may
      incorporate  all or any of the  terms of the Plan by  reference  and shall
      comply with and be subject to the following terms and conditions:

      a.    AUTOMATIC  GRANT OF  OPTIONS.  Subject  to  execution  by an Outside
            Director  of an  appropriate  Option  Agreement,  Options  shall  be
            granted  automatically  and without  further action of the Board, as
            follows:

            i.    Each person who is newly  elected or  appointed  as an Outside
                  Director  on or after the  Effective  Date shall be granted an
                  Option on the day of such initial  election or  appointment to
                  purchase Fifty Thousand (50,000) shares of Stock.

            ii.   On the date of each  Annual  Meeting  of  Stockholders  of the
                  Company  occurring  after the  Effective  Date,  each  Outside
                  Director  shall be granted an Option to purchase Five Thousand
                  (5,000) shares of Stock; provided,  however, that in the event
                  an Outside  Director  was elected or  appointed  as an Outside
                  Director and was granted an Option  pursuant to the provisions
                  of  subparagraph  5(a)(i) above within six months prior to the
                  Annual Meeting of Stockholders, that Outside Director shall be
                  ineligible  to receive an Option  with  respect to such Annual
                  Meeting of Stockholders.

            iii.  On the date of the 2007 Annual Meeting of  Stockholders,  each
                  Outside   Director  who  served  as  the  Chairperson  of  any
                  committee of the Company's Board of Directors for at least six
                  months during the Company's  most  recently  concluded  fiscal
                  year  shall be  granted an Option to  purchase  Five  Thousand
                  (5,000)  shares of Stock.  In the  event an  Outside  Director
                  served as the  Chairperson  for two or more  Committees,  such
                  Outside  Director  shall be granted an option to purchase Five
                  Thousand  (5,000) shares of Stock for each committee for which
                  the Outside Director served as Chairperson.

            iv.   Notwithstanding  the  foregoing,  any  person may elect not to
                  receive an Option to be  granted  pursuant  to this  paragraph
                  5(a) by  delivering  written  notice of such  election  to the
                  Board no later  than the day  prior to the date on which  such
                  Option would  otherwise  be granted.  A person so declining an
                  Option shall receive no payment or other consideration in lieu
                  of such declined  Option.  A person who has declined an Option
                  may revoke such election by delivering  written notice of such
                  revocation  to the  Board no later  than the day  prior to the
                  date on  which  such  Option  would  be  granted  pursuant  to
                  paragraph 5(a).

            v.    Notwithstanding  any  other  provision  of  the  Plan  to  the
                  contrary,  no Option shall be granted to any  individual  on a
                  day when he or she is no longer serving as an Outside Director
                  of the Company.

      b.    OPTION EXERCISE PRICE. The exercise price per share of Stock subject
            to an Option  shall be the fair market value of a share of the Stock
            on the close of business on the date of the  granting of the Option.
            Where there is a public  market for the common stock of the Company,
            the fair  market  value per share of Stock  shall be the mean of the
            bid and asked  prices of the common stock of the Company on the date
            of the  granting  of the  Option,  as  reported  in the Wall  Street
            Journal  (or,  if not so  reported,  as  otherwise  reported  by the
            National  Association  of  Securities  Dealers  Automated  Quotation
            ("Nasdaq")  System) or, in the event the common stock of the Company
            is listed on the Nasdaq Global Market or a securities exchange,  the
            fair market  value per share of Stock shall be the closing  price on
            such  Global  Market  or  exchange  on the date of  granting  of the
            Option,  as reported in the Wall Street Journal.  If the date of the
            granting  of an Option  does not fall on a day on which  the  common
            stock of the Company is trading on Nasdaq,  the Nasdaq Global Market
            or securities exchange,  the date on which the Option exercise price
            shall be established shall be the last day on which the common stock
            of the  Company  was so  traded  prior to the  date of the  granting
            Option.

      c.    EXERCISE  PERIOD AND  EXERCISABILITY  OF OPTIONS.  An Option granted
            pursuant to the Plan shall be  exercisable  for a term of ten years.
            Options granted pursuant to the Plan shall first become  exercisable
            on the day (the "Initial  Vesting  Date") which is one year from the
            date on which the Option was  granted.  The  Option  shall  first be
            exercisable  on and  after  the  Initial  Vesting  Date and prior to
            termination of the Option in an amount equal to the number of Option



            Shares  multiplied by the Vested Ratio (as  hereinafter  defined) as
            set forth below, less the number of shares previously  acquired upon
            exercise of any portion of the Option.

      The "Vested Ratio" shall mean, on any relevant  date,  except as otherwise
provided herein, the ratio determined as follows:


                                                                 Vested Ratio
                                                                 ------------

            (i)    Prior to Initial Vesting Date:                     0

                   On Initial Vesting Date,                          1/3
                   provided the Optionee's Service has not
                   terminated prior to such date:

      Plus
      ----

            (ii)   For each full year
                   of the Optionee's  continuous Service
                   from the Initial Vesting Date until the
                   Vested Ratio equals 1/1, an additional:           1/3

For purposes of the Plan,  "Service" shall mean the Optionee's  service with the
Company, whether in the capacity of an employee, a director or a consultant. The
Optionee's  Service shall not be deemed to have  terminated  merely because of a
change in the  capacity in which the  Optionee  renders  Service to the Company,
provided that there is no interruption or termination of the Optionee's Service.

      d.    TERMINATION OF OPTIONEE.  In the event of an Optionee's  termination
            of  Service  for any  reason  other  than as a  result  of  death or
            disability  of the  Optionee,  in which case all  Options  that have
            become vested will remain  exercisable  for the earlier of 36 months
            or the  expiration  date of the  Options,  all Options that have not
            become vested and  exercisable  as of the date of such  cessation of
            Service  shall be forfeited and to the extent that such Options have
            become vested and  exercisable as of such date, such Options must be
            exercised,  if at all,  within ninety (90) days after the Optionee's
            termination  of  Service,   after  which  time  such  Options  shall
            automatically terminate; provided, however, in the event an Optionee
            ceases  being  a  director   because  the  Optionee's   Service  was
            terminated for cause, all Options granted hereunder  (whether vested
            or unvested) shall terminate immediately.

      e.    PAYMENT OF OPTION  EXERCISE.  Payment of the exercise  price for the
            number of shares of Stock  being  purchased  pursuant  to any Option
            shall be made (i) in cash, by check, or cash equivalent, (ii) by the
            assignment  of the  proceeds  of a sale of some or all of the shares
            being  acquired upon the exercise of an Option  (including,  without
            limitation,  through an exercise  complying  with the  provisions of
            Regulation  T as  promulgated  from  time to time  by the  Board  of
            Governors of the Federal Reserve  System),  (iii) by the delivery to
            the  Company of shares of Stock  which have been owned by the holder
            of the Option  for more than six months and which have an  aggregate
            value  equal  to such  exercise  price,  or (iv) by any  combination
            thereof.  The Company reserves,  at any and all times, the right, in
            the Company's sole and absolute discretion, to establish, decline to
            approve  and/or  terminate  any  program  and/or  procedure  for the
            exercise of Options by means of an  assignment  of the proceeds of a
            sale of some or all the  shares  of Stock to be  acquired  upon such
            exercise or the delivery of previously owned shares of Stock.

      f.    TRANSFER OF CONTROL.  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  Global 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:

            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 (i),
                  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 (a) 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"),  (b) the
                  Company or any Related Entity, or (c) 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:

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

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

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

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

                  2.    A complete liquidation or dissolution of the Company; or

                  3.    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.

      g.    STOCKHOLDER  APPROVAL. No Option may be granted pursuant to the Plan
            prior to obtaining stockholder approval of the Plan.

      h.    TRANSFERABILITY OF OPTIONS.

            (i)   Except as provided  in  paragraph  5(h)(ii),  an Option may be
                  exercised  during the  lifetime  of the  Optionee  only by the
                  Optionee or the  Optionee's  guardian or legal  representative
                  and may not be assigned or transferred in any manner except by
                  will or by the laws of descent and distribution.




            (ii)  Notwithstanding the foregoing,  with the consent of the Board,
                  in its sole  discretion,  an Optionee  may  transfer  all or a
                  portion of the Option to: (i) an Immediate  Family  Member (as
                  defined below),  (ii) a trust for the exclusive benefit of the
                  Optionee and/or one or more Immediate Family Members,  (iii) a
                  partnership in which the Optionee and/or one or more Immediate
                  Family  Members  are the only  partners,  or (iv)  such  other
                  person or entity as the  Board  may  permit  (individually,  a
                  "Permitted  Transferee").   For  purposes  of  this  paragraph
                  5(h)(ii)  "Immediate Family Members" shall mean the Optionee's
                  spouse,  former  spouse,  children or  grandchildren,  whether
                  natural or adopted.  As a  condition  to such  transfer,  each
                  Permitted  Transferee  to  whom  the  Option  or any  interest
                  therein  is  transferred  shall  agree in  writing  (in a form
                  satisfactory  to the  Company) to be bound by all of the terms
                  and conditions of the Option Agreement  evidencing such Option
                  and any additional  restrictions  or conditions as the Company
                  may require.  Following  the  transfer of an Option,  the term
                  "Optionee"  shall refer to the  Permitted  Transferee,  except
                  that, with respect to any requirements of continued Service or
                  provision for the Company's tax withholding obligations,  such
                  term shall refer to the original  Optionee.  The Company shall
                  have no  obligation  to notify a Permitted  Transferee  of any
                  termination  of the  transferred  Option,  including  an early
                  termination  resulting from the  termination of Service of the
                  Original Optionee.  A Permitted Transferee shall be prohibited
                  from  making a  subsequent  transfer of a  transferred  Option
                  except  to  the  original  Optionee  or to  another  permitted
                  Transferee or as provided in paragraph 5(h)(i).

      i.    RE-PRICING OF OPTIONS / REPLACEMENT  OPTIONS.  The Company shall not
            re-price  any Options or issue any  replacement  Options  unless the
            Option re-pricing or Option  replacement shall have been approved by
            the holders of a majority of the outstanding shares of the Company.

      j.    DIVIDEND  EQUIVALENTS.  Simultaneously  with the grant of any Option
            and under such terms and  conditions as the Board deems  appropriate
            and  subject  to  Section  10  herein,  the Board 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 Board) 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,  if any).  Unless otherwise
            determined by the Board 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 Board,  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 Board shall  determine
            whether any deferred Dividend Equivalents will accrue interest.  The
            Board 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 Board.

      k.    TIME FOR GRANTING OPTIONS.  All Options shall be granted, if at all,
            within three years from the Effective Date.

6.    TERMS  AND  CONDITIONS  OF  RESTRICTED  STOCK:  Restricted  Stock  awarded
      pursuant to the Plan shall be evidenced by written  agreements  specifying
      the number of shares of Restricted Stock covered thereby, in substantially
      the form attached hereto in Exhibit B (the "Restricted Stock  Agreement").
      Grants of Restricted  Stock 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 Board shall deem desirable:

      a     AUTOMATIC  GRANT OF  RESTRICTED  STOCK.  Subject to  execution by an
            Outside  Director  of an  appropriate  Restricted  Stock  Agreement,
            Restricted Stock shall be granted  automatically and without further
            action of the Board, as follows:




            i.    On the date of each  Annual  Meeting  of  Stockholders  of the
                  Company  occurring  after the  Effective  Date,  each  Outside
                  Director  shall be granted  Five  Thousand  (5,000)  shares of
                  Restricted  Stock;  provided,  however,  that in the  event an
                  Outside  Director  was  elected  or  appointed  as an  Outside
                  Director and was granted an Option  pursuant to the provisions
                  of  subparagraph  5(a)(i) above within six months prior to the
                  Annual Meeting of Stockholders, that Outside Director shall be
                  ineligible  to receive any  Restricted  Stock with  respect to
                  such Annual Meeting of  Stockholders.  Such  Restricted  Stock
                  shall have the same Vested Ratio as is provided  under Section
                  5(b) hereto.

            ii.   Notwithstanding  any  other  provision  of  the  Plan  to  the
                  contrary,   no  Restricted  Stock  shall  be  granted  to  any
                  individual on a day when he or she is no longer  serving as an
                  Outside Director of the Company.

      b     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 Board. 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(e) below.

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

      d     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 Board at the time of grant.

      e     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 Board has  specified  such
            restrictions have lapsed.  Unless otherwise provided by the Board 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.

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

      g     TERMINATION  OF GRANTEE.  In the event the  Grantee  ceases to be an
            Outside  Director 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 Board 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 Board may in other  cases waive in
            whole or in part restrictions or forfeiture  conditions  relating to
            Restricted Stock.

7.    AUTHORITY TO VARY TERMS.  The Board shall have the authority  from time to
      time to vary the  terms of the  Option  and  Restricted  Stock  Agreements
      either in connection with the grant of an individual  Option or Restricted
      Stock or in connection  with the  authorization  of a new standard form or
      forms of Awards; provided,  however, that the terms and conditions of such
      revised or amended  standard form or forms of stock option agreement shall
      be in accordance with the terms of the Plan. Such authority shall include,
      but  not  be  limited  to,  the  authority  to  grant  Options  which  are
      immediately  exercisable  subject to the Company's right to repurchase any
      unvested  shares of Stock  acquired by the  Participant  on exercise of an
      Option in the event such Participant's  service as director of the Company
      is terminated for any reason.




8.    EFFECT OF CHANGE IN STOCK SUBJECT TO PLAN.  Appropriate  adjustments shall
      be made in the  number  and class of shares of Stock  subject to the Plan,
      the number of shares to be granted  under the Plan and to any  outstanding
      Options or shares of Restricted  Stock and in the Option exercise price of
      any  outstanding  Options in the event of a stock  dividend,  stock split,
      recapitalization,  reverse stock split, combination,  reclassification, or
      like change in the capital structure of the Company.

9.    TERMINATION OR AMENDMENT OF PLAN. The Board,  including any duly appointed
      committee  of the  Board,  may  terminate  or amend  the Plan at any time;
      provided,  however,  that without the approval of the  stockholders of the
      Company, there shall be no increase in the total number of shares of Stock
      covered by the Plan (except by operation of the  provisions of paragraph 8
      above).  In  any  event,  no  amendment  may  adversely  affect  any  then
      outstanding  Option,  or any  unexercised  portion  thereof,  without  the
      consent of the Participant. 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 Board 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.

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).

11.   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.   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  Board  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 Board 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 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
            service of any of its directors at any time.

      c.    LIMITATION OF LIABILITY.  No member of the Board,  or any officer or
            employee  of the  Company  acting on behalf of the  Board,  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 Board 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 Board
            may also give appropriate stop transfer instructions with respect to
            such Stock to the Company's transfer agent.

13.   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.

EX-31.1 4 ex311to10q04637_03312007.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: May 9, 2007                                /s/ ReiJane Huai
                                                 -------------------------------
                                                 ReiJane Huai
                                                 Chief Executive Officer
                                                 (principal executive officer)

EX-31.2 5 ex312to10q04637_03312007.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: May 9, 2007                                /s/ James Weber
                                                 -------------------------------
                                                 James Weber
                                                 Chief Financial Officer
                                                 (principal financial and accounting officer)

EX-32.1 6 ex321to10q04637_03312007.htm sec document



                                                                    Exhibit 32.1


                            CERTIFICATION PURSUANT TO
                             18 U.S.C. SECTION 1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

      In connection with the Quarterly  Report of FalconStor  Software,  Inc., a
Delaware  Corporation  (the Company) on Form 10-Q for the period ended March 31,
2007, as filed with the  Securities  and Exchange  Commission on the date hereof
(the Form 10-Q),  I,  ReiJane  Huai,  Chief  Executive  Officer of the  Company,
certify,  pursuant to 18 U.S.C. section 1350, as adopted pursuant section 906 of
the Sarbanes-Oxley Act of 2002, that to the best of our knowledge:

(i)   the  Form  10-Q  fully  complies,  in  all  material  respects,  with  the
      requirements of section 13(a) or section 15(d) of the Securities  Exchange
      Act of 1934; and

(ii)  the  information  contained  in the  Form  10-Q  fairly  presents,  in all
      material respects, the financial condition and result of operations of the
      Company.

                                                  /s/ ReiJane Huai
                                                  ------------------------------
                                                  ReiJane Huai
                                                  Chief Executive Officer
                                                  May 9, 2007

EX-32.2 7 ex322to10q04637_03312007.htm sec document



                                                                    Exhibit 32.2


                            CERTIFICATION PURSUANT TO
                             18 U.S.C. SECTION 1350,
                             AS ADOPTED PURSUANT TO
                  SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

      In connection with the Quarterly  Report of FalconStor  Software,  Inc., a
Delaware  Corporation  (the Company) on Form 10-Q for the period ended March 31,
2007, as filed with the  Securities  and Exchange  Commission on the date hereof
(the Form  10-Q),  I, James  Weber,  Chief  Financial  Officer  of the  Company,
certify,  pursuant to 18 U.S.C. section 1350, as adopted pursuant section 906 of
the Sarbanes-Oxley Act of 2002, that to the best of our knowledge:

(i)   the  Form  10-Q  fully  complies,  in  all  material  respects,  with  the
      requirements of section 13(a) or section 15(d) of the Securities  Exchange
      Act of 1934; and

(ii)  the  information  contained  in the  Form  10-Q  fairly  presents,  in all
      material respects, the financial condition and result of operations of the
      Company.

                                                  /s/ James Weber
                                                  ------------------------------
                                                  James Weber
                                                  Chief Financial Officer
                                                  May 9, 2007

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