sec document

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